What really helped the market in 2009 has been government intervention and investor optimism in the aftermath of the Lehman Brothers and Bear Stearns failures. The extreme swings in the stock market in the last quarter of 2008 should still be fresh in investors’ mind. One day the Dow Jones Industrial Average was up 196, the next day down 777, then up 486, or up 300 points in the morning and only to experience triple digit losses in the last half hour of trading. The Treasury and Federal Reserve have removed much of the uncertainty in the market where people are now confident that the government will bail out companies that are too big to fail regardless of what it takes. However, we may be digging ourselves into another hole with the excessive printing of money and by giving our government huge power to interfere with the free market mechanism and drastically change our economic landscape to one that no one knows how to deal with. But we know that the “crisis” of another major financial institution failing will be avoided at all costs and that knowledge has helped to stabilize the market – at least in the short term.
A vast amount of money has been pumped into our economy by the government through the stimulus plan and by the Federal Reserve through its asset purchase programs. Programs such as Cash for Clunkers and the Homebuyers Tax Credit have encouraged automobile purchases and helped stabilize home prices. The Fed has also freed up some liquidity in an environment of tight credit by aggressively buying assets in the open market. The end result of all this, however, is that the Fed’s balance sheet is ballooned to $2.24 trillion at the end of 2009 from $858 billion at the start of 2007.
The positive impacts resulting from these government programs and activities have revived investor confidence that we are back into a healthily growing economy and more investors started to invest back into the stock market. As investors observe the S&P 500 climbing from its March low, many people became afraid of missing out on investment gains. This is the same fear that has driven investors to invest in technology stocks in the late 90s and the real estate market in the last few years.
Focusing on not missing out on short-term gains rather than the fundamentals is a risky investment practice. For example, during the Great Depression (1929-1941), the market dropped about 89% from September 1929 to July 1932 and it took investors 25 years to recover their losses. However, there were short-term market rallies in between. A famous bear rally was from November 1929 to April 1930, where the Dow Jones Industrial Average advanced about 50%. Investors who invested during this temporary spike in the market had indeed made some handsome gains. Unfortunately, after the short but strong recovery, most of them continued to suffer disastrous losses in a bear market that troughed in 1932. The lesson is that the market does not go up or down in a straight line and it is important to take a longer term approach when investing. But sometimes it is tempting for investors to jump back into the market as it rallies, especially when some of these rallies like the recent one that started in March of 2009 can be very strong and last for months.
Investors must observe not just what is in front of them, but also the bigger picture. If you read my book The Strategist’s Mind, you will understand that stocks are priced by discounting many cash flows from the future time periods to the present. Long-term factors that affect many periods of cash flows would have material impact on stocks while short-term factors have relatively negligible impact. Keeping this in mind, the resulting growth in our economy that came from the government’s aggressive intervention cannot last forever. They are short-term factors that are intended to help jumpstart our economy. Thus, investors must not just take the growth in front of them as reflective of future growth. People have to understand the root of this growth and determine if it is sustainable.
You can think of the economic situation like a car that would not start. Your AAA tow truck can come to jumpstart your engine so that you would not be left stranded in the middle of the freeway. But you should know that just because your car starts to run again does not mean that all your problems are resolved. You still need to bring it to a mechanic to diagnose and treat the root of the problem correctly. Otherwise, you could be caught with the same problem again sooner or later. What the government has done to boost our economy in this financial crisis is similar to how the AAA tow truck jumpstarts the car. Now the real challenge is how we diagnose and treat the root of the problem effectively. Otherwise, we could go back to ground zero or even worse. For instance, how can we get consumers to spend, businesses to employ, banks to lend, and everyone - including our government- to recover from their disastrous finances?
This is not to say that what our government has done is futile. Rather, it was the right and necessary first step. But it was just the “first step”, and investors should be wary not to take it as an accomplished success and that all our problems are forever resolved. This is just the beginning of a new chapter and a lot more work needs to be done.
Disclosure: No Position