As I prepared to write the quarterly newsletter, it became very clear that current events in the financial markets had taken precedent over all topics. As a recent polling of voters during the primaries indicated, the turmoil in the stock market and an economy apparently headed toward recession has become the primary concern of most Americans.
In my most recent newsletter, I discussed how the sub-prime mortgage debacle has created great uncertainty about the direction of the economy. Although the stock market will likely continue to be volatile, I reiterate now as I offered then that, in my opinion, the worst is behind us.
Unfortunately, the $100 billion plus of write-off in financial stocks resulting from defaults in sub-prime mortgages have created a downdraft that has severely impacted many stock prices and asset classes. Furthermore, overseas markets, fearing that a recession in the United States would result in a reduction of demand for their products, have also declined precipitously. And even commodities stocks with 2007 returns at 30% plus, have plummeted as investors fear that their demand will subside. All in all, most markets and many asset classes experienced a 10% plus decline during the first three weeks of January.
Nervous investors sought refuge in investment grade securities that sent yields plunging to near record lows. Many media pundits have painted a doom and gloom economic scenario as a confluence of negative factors - high energy prices, rising inflation, rising unemployment, negative GDP growth, falling dollar, etc. - have created the impression that the economy is headed toward recession.
Clearly, these problems pose a threat to future economic growth. However, in order to assess their impact long term, considerations must include measures that have already been taken to alleviate these problems. There is no question that we are experiencing the worst credit crunch in decades. The Federal Reserve understands the urgency of this problem and reduced the discount rate by 1.25% in a week and a half in January. Their objective is to ensure that funds are made available to borrowers that can promote the growth of the economy. Additionally, Congress recently passed an economic stimulus package that will add dollars in the hands of low and middle income taxpayers. These two measures will take some time to trickle through the economy and their positive impact will not take effect until the second half of the year.
Meanwhile, the falling dollar has created opportunities for US corporations to significantly increase exports. Despite the domestic economic slowdown, many US corporations are actually increasing earnings as revenues from exports replace the decline in domestic spending.
What is the proper course of action for a typical investor? First, this stock market slide that began last summer has the characteristics of a classic bear market. Even corporations with rising earnings have experienced declining share prices as financial stocks have impacted the entire stock market. This fact probably represents the reason that the market rose 600 points during the last week in January as astute investors jumped at the opportunity to add high quality but depressed stocks to their portfolio. For long-term investors, the answer is obvious - stay the course and upgrade their portfolio where possible in anticipation of rising values. Additionally, bear markets provide opportunities to harvest tax losses that can offset gains in other positions. For many clients, this downturn has presented me with the opportunity to sell assets with large gains but limited upside potential and re-position the portfolio for future appreciation as the markets recover. For investors who have short term liquidity needs, my advice is to stay liquid, although interest rates on savings and money market funds are falling rapidly due to the Federal Reserve rate cuts.
Perhaps my most important piece of advice concerns investments in long term bonds. With credit issues still unresolved, it seems wise to avoid junk bonds that may experience defaults as the recession broadens. However, it may be equally unwise to invest in investment grade bonds in the event interest rates rise. Fixed income investors may be better served by investing in short term or low duration taxable bonds, longer term investment grade municipals bonds with their comparative high yield, and international bonds that take advantage of both strong GDP growth in their respective countries and the falling US dollar.
Clifford L. Caplan, CFP®
In The News: Recently, I was quoted in the February 25th issue of Forbes in an article titled "7 Steps to Savings Sanity." I was also quoted on Forbes.com on January 30th in an article titled , "The Last Bush Tax Cut." Copies are available upon request.