Shock and Awe

I’m sure that you, like many, are sickened by the recent slate of financial news, and the daily reports of further declines in the equity and debt markets. You might be among those that simply want to ignore your investment statements, or you might even feel numb to the constant battering the markets have received. Believe me, I understand.

I’m going to ask that you not ignore the news, your statements, or the difficulties around us. Rather, this is precisely the time you need to stay informed, and understand as much as possible about our markets, your money, and our collective futures. Believe it or not, right now, you are among the single most important group of decision makers in the country. You are a voter and a consumer, and two of the most important events in recent years are about to unfold: the US Presidential Election, and crucial holiday buying season.

This week’s issue of Signature Update will present numerous topics, far more than usual, because there has been such unusual activity in the domestic and global financial markets. Hopefully, as you learn more about the markets and economy, you’ll better understand the impact your decisions, and those of others, have on all of us.


The Three C’s: Confidence, Clarity, and Credit

The value of stocks can be expressed in many different ways, and one of those is the ratio between the price of the stock and the earnings per share of the company they represent. This is referred to as the P/E Ratio and can range widely depending on the industry the company is in. It is an indication of whether or not the stock is overpriced, oversold, or priced in line with their peers in the market. As of Wednesday afternoon, the average P/E ratio of the stocks that make up the S&P 500 was less than 11, an astoundingly low figure, perhaps half of what it should be, and an indication that the US stock market is dramatically oversold, or undervalued.

Likewise, credit markets have their own indicators of value. One of these is the LIBOR, or the London Inter Bank Offering Rate, and this figure typically is slightly higher than the US Fed Funds rate and short term treasury rates. When the LIBOR is high against benchmark rates, it suggests that there is a lack of confidence in the credit markets, and a concern that those banks involved may not be able to make good on their promises to repay. As of 6:47 am EDT this morning, the LIBOR was at 4.82%, one week ago it was at 4.33% and one month ago it was at 2.82%. By contrast, the Fed Funds rate is at 1.5% today, was at 2% one week ago, and was at 2% one month ago. The LIBOR spread has widened dramatically.

The question is, 'Why is the LIBOR so high, and why is the average P/E ratio of the S&P so low’? The answer has everything to do with Confidence, Clarity, and Credit.

Consumers and businesses around the world have been shocked by the constant negativity and stories of doom and gloom reported through the press. In a day when we have near constant access to financial news, 24/7 reporting of even the most minor economic, political or social event, coupled with inexpensive trading of stocks, bonds, and mutual funds, it creates a scenario ripe for volatility. Reactions run high, common sense goes out the window, and the volume of selling transactions goes through the roof. This puts immense downward pressure on the price of stocks unless there are ready buyers; and with the credit markets being as constrained as they are, money becomes tight and few buyers are present. Likewise, with such negativity reported in the press, coupled with lower stock prices, investors often demand redemptions in mutual funds, private equity funds, and hedge funds and the selling pressure expands. The result: stock prices tumble.

The issue in the credit markets includes that of clarity. The complex credit instruments used in today’s markets can be difficult for even the most experienced investor to understand. Often the complexity impedes the ability to know exactly what the value of the instrument is and what assets, or collateral, stand behind the instrument. When the value of these assets start to fall, as is the case when the value of real estate declines, it becomes very difficult to clearly assess the value of the instrument; and whatever clarity was present when the instrument was created becomes clouded. Without clarity, there is no confidence, and the credit markets slow down, or can seize up altogether.

This is exactly the scenario we’ve faced for the past several weeks in the markets. The DOW is down some 3,000 points in the face of all of this; all due to emotion, fear, and a lack of confidence, not due to any meaningful economic shifts.

Recognize that the fundamentals of our economy haven’t changed in this time frame. Oil prices continue to fall, now well below $90 per barrel. Unemployment, though higher than we’d like at 6.1%, is still low by historical standards. Interest rates, with the Fed Funds rate at 1.5%, are low. Businesses continue to grow, and the buying and selling of goods and services continues throughout our economy, though at a slower rate than in previous years.


Real Estate

August existing home sales figure were reported earlier this week and represented an increase of 7.4%. That’s great news for the real estate markets and a meaningful figure for all of us to understand. While it doesn’t necessarily mean that the housing market is now in a sustained upward correction, it does mean that there are buyers willing to step in at today’s prices, many of whom are now finding home ownership affordable for the first time in years. With the recent tightening in the availability of credit, many of these buyers are being forced to wait on the sidelines, but the signs that they are there and interested are unmistakable. As credit availability eases, especially at the low interest rates being seen today, these buyers may be able to present a strong front in the battle to stabilize the residential real estate market.


Warren Buffett

Warren Buffett is a name virtually every financially-aware American is aware of, and a shrew investor. Among the many things for which Buffett is famous is the saying ‘When everyone around you is frightened, it’s time to be brave’. This holds especially true for the financial markets today, and Buffett has once again shown why he is one of the nation’s premier investors. Last week alone, Buffett invested more than $8 billion of his company’s surplus cash into the stock market as he purchased interests in both Goldman Sachs and General Electric. This week the shares of each of those companies declined with the rest of the markets. Buffett, though, only sees profitability in his purchases. At more than eighty years of age, Buffett continues to focus his vision to the long term - one of the traits that has made him one of the wealthiest individuals in the world.


Federal Reserve and Treasury Actions

A large portion of the decline in investor confidence has been due to the House and Senate’s delay in passing the Troubled Asset Relief Program bill, or TARP. Not only did our legislators delay the passing of this important piece of legislation, they amended it to the point that frustrations among investors reached a fever pitch, and they’re yet to subside. TARP will be effective once the Treasury begins to purchase the targeted assets, but this will take another 3-4 weeks to begin, and likely several more weeks for the effects to be felt. Had confidence remained as high as it was the day this legislation was introduced, there would have been an immediate and positive effect on the markets, once passed. Now we’ll have to wait for it to actually impact the economy before we can enjoy any positive impact in the markets.

The passage of TARP may not be the ideal solution to the problem at hand, but it appears to have been the best solution available in the time frames dictated by the credit and equities markets.

The most recent actions of the Treasury and Federal Reserve, including a historic coordinated rate cut with other central banks, and greatly expanded credit facilities to assist money center, commercial and investment banks, as well as American businesses, will have a positive impact on the flow of funds throughout the domestic and international economy. But it will take time, perhaps four to eight weeks before the impact can be measured or felt by investors and consumers.


Short Sales Resume

Short sales on all publically traded companies were once again allowed as of 12:00 am midnight on October 9th. Little wonder then that companies like General Motors became the target of such aggressive selling pressure after Standard and Poors announced a down grade in GM’s credit worthiness. S&P’s announcement wasn’t news to anyone paying attention to GM’s balance sheet in recent months or years, but short sellers in the market hammered the stock, just as they resumed attacks on various financial services stocks and sent the markets into a veritable freefall.

The SEC simply must bring back the ‘up tick’ rule that only allows for short selling of a stock when the last transaction has been to the positive, otherwise, short sellers can create their own profits by pressuring the stock price downwards.


The Penalty for Missing the Market

Over the past 20 years, the US stock market has been much like a tide, experiencing ebbs and flows. These ups and downs remind us of the unpredictability of market movements. When stock prices are declining, many investors run the risk of making emotion-based decisions and pulling out of the market. We believe that by remaining fully invested through volatile weeks or months, however, investors can potential avoid sitting on the sidelines at the wrong time.

Unless there is a specific guarantee program active on a client account that strategically takes money out of the market when faced with volatility and then moves back into the market when appropriate, staying the course of a diversified and considered investment strategy works.

Remember: It’s time in the market that matters, not market timing. How significant is the potential penalty for missing the market? In the time period shown below, being out of the market on the 70 days when the market advanced most would have significantly reduced an investor’s average annual total return.

During the period of 1987 to 2007, those who were invested in the S&P 500 all 5,296 day posted an annualized return of 11.5%; those that missed the best 10 days only received 7.96%; those that missed the best 40 days saw an 1.3%; and those that missed the best 70 days actually lost 3.63%.

While market fluctuations can be disconcerting, timing can be costly. A strategic, personalized investment plan, combined with the ongoing counsel of your Investment Professional, can help you to remain focused and keep market downturns in perspective.

Source: Goldman Sachs Asset Management. Calculation is based on 5,296 days, excluding weekends and holidays The returns are based on the S&P 500 Index, a market-weighted index of 500 of the largest U.S. stocks in a variety of industry sectors. It is not possible to invest directly in an unmanaged index.


Jim Cramer – the Mad Man of Wall Street

On Monday morning of this week, Jim Cramer was a guest on The Today Show and declared that anyone needing access to their money within the next five years should take it out of the market now, and then proffered that the US stock markets would see another 20% decline before regaining stability. Cramer’s a well respected guy and The Today Show is seen by millions – his pronouncement helped move the market over 800 points lower before sanity prevailed and the DOW closed off some 369 points. Many have suggested his remarks, and The Today Show’s release of them, was nothing short of irresponsible, some citing no observable evidence that Cramer has reduced his own long or short positions in the current market.

By Monday afternoon, many had asked what I thought of Cramer’s comments. Though I had my own opinions, fortunately I had already asked the same question while on a conference call with a portfolio manager from the UK, and again later in the day of a fellow economist I pay attention to. They both gave a similar answer, consistent with my own thoughts:

Cramer is an entertainer and a trader, not an investor – there’s a big difference. He often treats 3-6 months as long term, and has been much better at calling the direction of a particular stock than he has the market, economy or a given industry. That said - he's also a really entertaining guy, has a wealth of experience, and I've learned a lot from listening to him over the years. If you believe that TARP and the other Federal Reserve and Treasury actions don’t have enough horsepower to be effective, then Cramer's right and we're in for a tough time that will likely take 3-5 years to overcome. However, if you think the package will do what it is intended to do, then Cramer's over-reaction, like many of his media peers, is patently incorrect. By the way, Cramer is famous for his over reactions and on-air rants.

To be candid, the 20% decline figure may not be far off, but the five year time frame is excessive, to be sure.