An Extraordinary Journey
For the last two months, stock markets worldwide have been cascading down in an unremitting collapse. Fear has been as high as we've seen in the markets in decades. We know that the outcome will not be good; the question is how bad it will be. Most predictions now are dire. Talk of catastrophe and comparisons to the Great Depression come easily. But does this financial market collapse of necessity spell doom for the world economy?
This summer a friend reported hearing this on television: "If you think you understand what's going on in the market, you're just not paying attention." Generally prognosticators sound confident even though we know that it is impossible to guess the future. The current period has been so out of the norm that few people could anticipate even the broad dimensions. Alan Greenspan has called this period a once in a century financial crisis. It's certainly bad. While we can't predict the future, investors have to make decisions. It might be a useful guide to take stock of what has happened and what we do know.
First, let’s look at the damage. Bloomberg reported today that this month alone $12 trillion of global stock market value has been eliminated. The S&P 500 has dropped 26 percent in October as of Oct. 28. In one week in September, the S&P dropped 18 percent, an all-time record including the Crash of 1987 and the Great Depression. As is frequently the case in bear markets, volatility has been extremely high. Swings up and down in the market have been the most violent since 1932. Quantitative measures of fear globally have been at record levels. Anecdotal measures of investor fear such as magazine covers, TV and newspaper coverage and our conversations with people who don't follow the market, confirm these measures. Today consumer confidence reached an all-time low.
The cascade downward has created a vicious cycle. As investors grow fearful and pull money out of mutual funds or other vehicles, those funds have to sell stocks. This leads other people to pull money out and the feedback loop continues. Yesterday, several people asked me what, if anything, can stop this vicious cycle?
Several things can stop the selling but there's no telling when they will kick in. A useful comparison is to picture a forest fire out of control. The fire will certainly stop when it runs out of fuel. It could also stop when the wind shifts, when there's rain or through the efforts of fire fighters. Each fire is different and we don't know how much damage they'll cause but they all stop at some point.
In the case of the markets, often times the selling burns out of its own accord and there’s no particular reason why it stops at a given time. An example of this type of spontaneous rally occurred in July, 2002, with no good reason for the rally. This time we've already had a record burn so maybe it will run out of fuel soon.
Sometimes what arrests the selling is when value investors with cash believe that valuations are irresistibly cheap and jump in. We've already seen selective instances of this with Warren Buffet making high profile investments in Goldman Sachs and General Electric and Bill Gross of Pimco, the largest bond investor, selectively making purchases.
By some measures, valuations in world equity markets are the cheapest in two decades. This lowers the risk of investors coming in now because the stock markets are discounting lots of calamities already. However, veteran investors know that what's cheap can get cheaper.
Once the fear subsides -- and it's hard to maintain an intense level of fear for more than a few weeks -- investors will note that competing investments are not attractive. U.S. Government bonds are yielding little by historic standards. Other potential competitive asset classes such as residential and commercial real estate and commodities also have diminished appeal now.
The record interventions by governments around the world this fall have been truly spectacular. Central banks have lowered interest rates as well as using creative strategies to flood the world with money. Government fiscal policies also have quickly adapted to the new realities. The effects of these policies are never visible for months and that always prompts doubts. In each cycle people say the Federal Reserve isn’t having an impact and each time it does.
While the news is grim now, we can recall other times when the news seemed overwhelmingly bad and remember that markets recovered then. After 9/11, the U.S. stock market was closed for a week and then dropped sharply. But little more than a month later, in early November,
2001, the market staged a good recovery. While the U.S. had a recession, it was not nearly as severe as seemed likely that dreadful September day.
In late summer of 1998, it seemed that the world financial markets would seize up. After a full year of emerging markets contagion, in August, 1998 the S&P 500 fell 15 percent, Russia defaulted and Long Term Capital failed. After a brief recovery in September, the market fell again hard into mid-October. A well-known television market personality warned that investors should sell everything. Once again, it seemed that the markets and economy were cooked but both staged rapid recoveries globally.
In short, we'd suggest that investors accept that much of the damage has already been done. We can't predict whether the bottom has been reached or what shape a recovery will take. But we would suggest that the world economy will continue to function and that in time, the financial markets will reflect that. Over the years, including the Depression, the broad U.S. stock market has returned 10 to 11 percent on average and global markets have been a little higher. For money that's for the long-term, five years or more, this is likely to be a good entry point for people investing in widely diversified mutual funds or other vehicles. For money that's needed sooner, the stock market is experiencing an unusually volatile period and there are probably better homes for that short-term savings.