Stock Market Blues

It's So Bad

The stock market has been so bad this year -- and since mid-September -- that it seems like a tremendous accomplishment that the S&P 500 is now down only 12 percent year to date. Last Monday it was down 25 percent year to date. To keep these numbers in perspective, the S&P was down 38 percent last year and 22 percent in 2002. Other than that, you have to go back to 1974 for a year when the S&P was down as much as 12 percent. While the economy is terrible, the stock market has been discounting a lot. We will only know in retrospect when the bottom hits. But the results of past financial crises show that once the crisis passes, stock markets have had significant rebounds within the first two years.

Some Positive Signs

Harbingers of Spring

Like the flu, a recession is mostly bad. Like a recession, it's also hard to spot the good sides of getting the flu, particularly since it can be fatal. While it's easy to spot the misery of a recession, today I heard three positive things about this one. First, more people are planting vegetable gardens to save money. A side effect will be to have healthier food and some enjoyment. Traffic is down, leaving roads less congested. Finally, I heard an economist say today that because the job losses in this recession have happened so quickly, the recovery in jobs could be equally quick. He predicted that the recovery in jobs could start by late summer. He may not be right but after all the gloom recently, it's nice to hear an optimist.

The Last Stand

Guarding the Federal Treasury

The underlying assumption of all the economic rescue plans, is that the U.S. Government remains an unassailable credit. In the economic textbooks and financial theory, the interest rate on short-term Treasury securities is the "risk free rate." That is the bedrock upon which sits the world credit markets and indeed the entire superstructure of the global economy. There is no more powerful term of art in the financial markets than the guarantee that comes with "the full faith and credit" of the U.S. Government. As we spend voraciously to stimulate the world economy, this requires careful attention.

If for a second, this assumption is shattered, woe be to all of us. The last line of defense cannot be breached. This goes by different names: a dollar crisis, runaway inflation, a systemic crisis. It all boils down to the same thing. In a modern economy, everything depends on faith and confidence and most importantly faith in the U.S. Government to have the capacity and will to honor its debts. The remarks by China's Premier Wen Jiabao on Thursday were an early warning. When you owe someone $1 trillion, it pays to listen. Of course, he also needs to be careful or we won't be able to pay him.

Debtors generally lose their standing not when they have too much debt but when their liquidity runs out; they have no more capacity to raise additional funds to service their debts. The U.S. borrows for the long term, as long as thirty years, to finance highways and airports and all types of infrastructure -- many projects that won't pay off for years or decades. Over time those debts have always been paid but they cannot all be paid today. The danger is when the debts mount so high and rapidly and when funding dries up. Even the mightiest borrower can be brought down if they have not carefully planned for such a rainy day.

The U.S. must guard against this possibility in every available way. The U.S. Government balance sheet -- it's tally of cash and borrowings -- is the critical defense against the economic troubles spreading around the globe. If the Federal balance sheet is perceived as shaky, there is no saving the global economy from complete disaster. While this sounds dire, it is, but it is also highly unlikely if proper precautions are taken.

Part of the recklessness of this decade has gone largely unmentioned. While the Federal debt has roughly doubled, the average payment period has halved. This seemingly technical point is in fact a major risk factor that should be reversed as soon as possible. At one point early in the decade when debt was low, the Treasury briefly stopped issuing its longest bonds, 30 year maturities. The average debt maturity shortened to only three years. That means that every year the Treasury had to raise enough money to cover one-third of the debt. Between the shortened maturity and the rise in debt, annual funding needs more than quadrupled.

The Government's action was comparable to a homeowner putting his mortgage or car loan (typically four to seven years effectively) on their credit card, whose balance is payable in full on demand.

Why did this happen? Interest rates were historically low and short-term borrowing was a lot cheaper than long (the yield curve was historically steep). Now interest rates for the Government are even cheaper and it's still beneficial to borrow for short term -- months rather than years.

The Government should resist that temptation and step up the longer-term borrowing. One expert has even proposed 100 year borrowings to get us over the hump of baby boom retirements. In the short-term it will be more expensive to extend borrowings. But if we put too much pressure on the credit markets by constantly coming to market with tens of billions of dollars of short-term borrowings, it raises the likelihood of the credit markets balking. By taking precautions, that need not happen. Once it happens, there's no turning back so we should sacrific whatever is necessary to avoid that possibility.

Famous Last Words

Irrational Exuberance Anybody?

When Alan Greenspan gave his famous testimony to Congress and questioned whether the U.S. was in a stock market bubble characterized by "irrational exuberance," the Dow Jones Industrial Average was at 6,437. That level on Dec. 5, 1996 had climbed 24 percent over the previous year and nearly doubled in three years. It would double again before the next major bear market began in 2,000.

Now that we are back at that level of 13 years ago, does anyone feel irrational or any exuberance about the stock market or the economy?

More Bad Numbers

It's Bleak but not Hopeless

Boeing announced that in February they only received four orders for freight and passenger jets. The previous year they got 125 orders. That's a year over year decline of 97 percent. In good years, Boeing is the single largest U.S. exporter. So this is bad news for manufacturing jobs and our trade deficit. Orders are a forward looking indicator with new orders delivered years in the future, so this doesn't mean a collapse of current production. Anyway you look at it, it's not good. The only plus is that across the board, inventories are getting leaner and eventually people will want stuff again.

Planning for Sunnier Days Ahead

Comeback Insurance for the Stock Market

Some day the sun will shine and the flowers will bloom and the economy will recover. Companies will still be in business and begin to grow profits and the stock market will rise again. It's hard to look past the current carnage but how do you prepare for a brighter future? Do you abandon the stock market permanently as two generations of Americans did after the Great Crash and the Depression? Or do you participate as did the people who reentered the market and enjoyed a two decade bull market after World War II.

One way to participate is to put together an ultra-diversified portfolio. Think of an ultra-diversified portfolio as comeback insurance for the stock market. In normal times, diversification is seen as a luxury or something that prevents you from racking up big gains. In tough times, it may be the difference between riding out the storm and getting permanently sunk.

What is ultra-diversification? In simple terms it means buying lots and lots of different things. So far in this super bear market, everything has been falling and falling a lot. It hasn't mattered what stocks you owned anywhere in the world; they've all gone down. Usually that's not the case and this is unlikely to last forever.

Even now financial stocks -- primarily banks -- have been hammered mercilessly. While the broad averages are down roughly in half since the bear market began, Citicorp is down more than 95 percent from its peak of the last year and many formerly blue chip stocks are down nearly as much. While they may regain prior values, it will be a long tough slog and many may never regain their formerly lofty heights.

Trying to foresee the future is always difficult. Now it's impossible. The carnage of a bear market and steep recession obscure the good things that are happening in the economy. By the time they become apparent, the next bull market leaders will have already made big gains. The best way to capture those gains is by holding broad batches of stocks.

While some fallen angels will recover, it's much more likely that the broad market averages will benefit fully from the eventual economic recovery. Oftentimes, only a handful of stocks, industries or geographies benefit from a market move. In 1998, the S&P 500 rose more than 20 percent. That increase was accounted for entirely by fewer than ten stocks, mostly big technology companies. Without those, the index actually would have been down slightly for the year. Picking them out ahead of time was nearly impossible. Two years later to do well one needed to hold small cap value stocks and no technology. A few years later, the ticket was energy stocks.

Who is that nimble? Who is that adroit?

By the sheer law of large numbers -- if enough monkeys press on the keyboard, they'll eventually produce Shakespeare -- someone will appear to be doing well. Is it luck or skill? It may be skill in some small number of cases but even if it is, it's nearly impossible to identify that skill ahead of time. Those who persist in trying to find that rare skill more likely hold themselves open to scams or legitimate but equally devastating disappointment.

The solution is easy. Hold everything. Hold a little bit of as many securities as you can all over the world. You'll capture the best and the worst but over time these returns have been robust. Including the Great Depression of the 1930s and the current unpleasantness, stocks over the years have returned more than 10 percent a year on average. That means that a portfolio doubles every seven year on average merely by matching the market returns. While no year is average, over the long term -- 10, 15, 20 years -- returns begin to converge on those averages. That may seem like a long time but investing, as opposed to speculating, is a long-term proposition. For those who truly want to invest, the wait is worth it and the returns that accrue are spectacular. It just takes patience and heeding the fundamentals of investing.

Ultra-diversification means holding thousands of securities around the world. The most widely held index funds, those based on the S&P 500, naturally enough hold 500 of the biggest U.S. stocks. That's good most of the time but what about when small stocks do well or Asian stocks? In the early 1970s you needed to own big fast growing stocks. In the late 70s it was commodities and small stocks -- how to know that ahead of time? How to know to jump off commodity stocks in 1980 after a great five year ride and not get back on for more than twenty years. How to know to get off small stocks in June 1983 after a great eight year ride and not get back on for almost a decade. Who knew that tech would be a disaster for most of the 80s and the ticket in the 90s before being a disaster again?

A guest on television got it right last summer. He said that if you think you know what's going on, you're just not paying attention. He was being honest and right.

No one knows where the winners will come from and the best chance to hold them is to buy as many different securities as you can all over the world. A few mutual funds hold thousands and thousands and they are well worth searching out. Look at the actual holdings, not the names. Just because something says "world" or "total" doesn't mean it has as many names as possible. No one knows the optimal number to be properly diversified, but if the cost is reasonable, more is better. And remember, a few holdings, those needles in the haystack that can rise 10 - 50 - 100 times, can make all the difference and just make sure you have them.