The financial industry has been transformed to a degree that few thought possible only a few weeks before. But this is all a sideshow to the real story of change as it relates to the economy and deciding how Main Street will fare in the months and years ahead.
Still, it's hard not to gawk at the spectacle that is Wall Street. First observation: Wall Street as it existed just a few weeks ago is gone. The news that Morgan Stanley (NYSE:MS) and Goldman Sachs (NYSE:GS) -- the last two large, independent investment banks standing -- will transform their businesses into bank holding companies completes the decimation of the old investment banking model. The boys had a good run. Unfortunately, they blew up the industry and now all that's left is a bunch of humbled Citigroup wannabes.
That's not so bad, if only because Citigroup (NYSE:C), sprawling and unwieldy as it is, didn't self-destruct. Neither did J.P. Morgan (NYSE:JPM) or Bank of America (NYSE:BAC). One reason: those three, as bank holding companies, operate under a tighter, more constricting regulatory framework, and so by law they were forced to operate more conservatively compared to Bear Stearns and Lehmans of the world. No problem: some of our favorite institutions are plain old banks and the world will probably survive just fine now that they've ascended the throne.
But let's not get too giddy. Keep in mind that there are still a lot of little Lehmans and Bear Stearns in the world, otherwise known as hedge funds. Collectively, this gang runs a lot of money, much of it leveraged, and some of it--perhaps most of it--is managed unintelligently. We don't really know, of course, but given what's transpired in recent weeks we're inclined to wonder.
Overall, there are still a lot of financial bodies buried in the rubble, and quite a few more that are ailing. It's unclear how much price-cutting will be necessary in the various assets held by banks, hedge funds and other institutions. Unknown or not, the unwinding rolls on. And there are still lots of dicey securities sitting on balance sheets the world over. Meanwhile, reassessing their value, and the resulting impact on companies and economies, is still in its infancy.
It's tempting to think that now that Wall Street as we knew it is effectively gone we can all breathe a sigh of relief. Indeed, the U.S. government, we read, seems likely to buy up a fair chunk of the toxic securities that caused so much pain. Assuming the bailout plan arrives, the government-sponsored buying will help drain some of the poison from the system.
Even under the best-case scenario of a quick government action that's focused on purchasing what no one else wants, there's plenty of heavy lifting to be done on the economy generally. And deciding how the macro picture unfolds is where it gets really tricky.
Predictably, there are some who see lots of trouble ahead for the economy. The headwinds start with a chastened consumer and rolls on with a weakened outlook for growth in corporate earnings.
For most investors, there are four major groups of asset classes with which to build investment portfolios: equities, bonds, REITs and commodities. The question before the house: How will the new world order impact the prospective returns for these big four?
Let's start with equities. It seems likely that raising earnings and profits will be tougher going forward as a general proposition. Some industries and sectors will fare better, or worse than others, as always. But overall, it's hard to see equity returns on a global basis besting their best pace from the recent past.
Yes, equity prices are substantially lower today than they were a year or two before. If this was a normal cyclical downturn, the outlook would be brighter for stocks at this point. But this is not a normal cyclical downturn and so it's hard to get excited by prospective equity returns until prices and valuations fall further. At the end of last month, global equities posted a 2.88% dividend yield, according to S&P/Citigroup Global Equity Indices. No doubt that's higher now, thanks to falling prices in September, But even at 3%, we're not yet convinced this is the time to overweight equities generally, although opportunistic nibbling is encouraged.
True, some regions of the world offer better value. That starts with stocks beyond the U.S. The S&P/Citigroup Global ex-U.S. Index reported a trailing dividend yield of 3.48% at the end of August, substantially above the U.S. number.
Nonetheless, higher dividend yields look set to be offset by lower earnings for the time being. Short of additional markdowns in prices for stocks--which we expect--the outlook for earnings growth is still sufficiently modest to warrant a cautious outlook on equity allocations generally. As prices go down from here, however, allocations should go up.
As for bonds, interest rates at the moment are too low to get excited about loading up on bonds. Although few are talking about it yet, the government bailouts will produce inflationary winds through the U.S. economy. This risk isn't imminent, and it probably won't be an issue for months, perhaps even a year or two. The deleveraging and unwinding of risk comes first. But eventually, bonds will suffer as interest rates rise and so long-term fixed-income weights should reflect this future. The 10-year Treasury yield closed Friday at 3.78%. Thanks, but no thanks. If it's safety you want, we'll lean to the short end of the curve. A 1-year Treasury yield, for instance, was 2.05% on Friday: more than half of the 10-year's yield at 1/10 of the maturity.
REITs, meanwhile, will attract attention for their relatively high yields. Globally, REIT yields were a hefty 5.8% at the end of last month, according to S&P/Citigroup. That's a modestly alluring margin of safety, although it's offset by the headwinds that commercial real estate faces in the new world order. Nonetheless, long-term investors will do well to focus on adding to broad-based REIT positions at those moments when Mr. Market is selling the asset class.
Then, there are commodities. A good buy? Maybe, although until we get a better sense of timing and outlook for the global economy it's premature to load up on the asset class, even when it stumbles. Nonetheless, taking advantage of price corrections is tempting, particularly for those with zero or low relative exposure to commodities in their portfolios.
Cash, finally, is still an attractive holding since it represents opportunity to exploit the continued turbulence that we think is coming. Granted, the new turbulence will be of a lower-grade than the headline-shocking experience of late. But the troubles ahead will be a slow burn, unfolding relatively quietly over time, and inspiring little in the way of massive new government handouts as solutions.
Having lived through the biggest financial calamity since the Great Depression, investors must now grapple with the economic consequences. No, we're probably not going to fall into a depression nor is the likely recession going to be especially deep. But the path back to growth could be a long, hard trek. Recovery will take longer than many think. Indeed, the addict has only just come to the conclusion that he has a problem. Several years of group therapy are coming, and it's only just begun.