10 Aug 2007 Perspective
Before getting involved with the numbers, the whys, and the wherefores of the latest global market volatility, let me reassure you, our clients, that your portfolios are conservatively allocated and diversified with higher than usual levels of cash. We do not try to time the markets, but during times of high volatility and uncertainty we err of the side of caution, particularly in the more risk-averse models. This global sell-off is all about the question of whether the growth outside of the US sustains itself in the face of a US slowdown or recession. Because it is unprecedented, investors are re-assessing their earlier rosy assumptions.
There is no news that the US economy is slowing. Retail sales reported yesterday showed that sluggish home sales and tightening credit are slowing the economy, but most retailers left their modest earnings forecasts as they were. They and economists believe that the consumer has not thrown in the towel. According to the Wall Street Journal most economists expect the turmoil in credit markets to have just a minor impact on growth, but they cut their economic forecasts and nearly a third expect higher borrowing costs to be a significant contributor to a slowdown.
But investors seem to be paying more attention to the drumbeat of headlines regarding the continuing impact of sub-prime loans. The Fed earlier this week acknowledged that credit-market turmoil is darkening the economic outlook. “Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.”
While world central bankers say they want investors to bear the pain of past excesses, the recent turmoil in credit markets made them blink. Yesterday, the European Central Bank and U.S. Federal Reserve both added extra cash to money markets to stem investor fears. The Fed’s announcement yesterday that it would provide reserves as necessary was the first such announcement since 9/11. The statement can be taken by investors as a Fed endorsement of their concerns, causing further sell-off. But this morning it appears that the statement has had the intended calming affect on investors.
Ed Yardini says it will take a Fed rate cut to have any meaningful impact on stemming the selling. They meet again in September, but he is calling for a cut before then. He sites the positive results in calming fears when they cut rates during the Russian debt crisis in 1998 which caused the collapse of the huge hedge fund Long Term Capital.
The ‘body language’ of central bankers has clearly indicating an aversion to cutting rates as the bankers almost universally continue to fear inflation more than slowdown. Of course, continued market turmoil will impact their thinking. Since their peak on July 17th,US stock averages have lost between 6% and 9% with the Dow Jones Industrials faring the best and the Russell 2000 the worst. Noteworthy is that the tech-heavy NASDAQ is only down little more than the Dow suggesting investors see good value in the tech sector. Global stocks are down by the same range as evidenced by the MSCI EAFE and the European Monetary Union indices respectively.
These times are no 9/11 or even 1998 for that matter. A few hedge funds freezing assets do not compare to the drama the world’s largest trading center under terrorist attack or the debt default of an entire large country. Today’s stock valuations are not as far out of whack as they were in these times either.
Stock valuations are converging as markets tumble worldwide. Better performing companies no longer trade at the large premiums to mediocre ones that they once did. Bloomberg notes that “shares of growth companies in the Standard & Poor’s 500 Index trade at an average 16.3 times estimated earnings, while value stocks, those priced at a discount to the market or their historical average, trade at 14 times profits. The gap between them, now 2.3 points, has narrowed from 25.5 at the beginning of the decade.” Please do not miss this point. These values represent an incredible long-term opportunity.
When I started my career in the brokerage business 26 years ago, inflation was in the mid-teens. The most effective way I found to open new accounts was selling triple-tax-free municipal bonds.North Carolinaexempted the income from these bonds for residents from all three taxes; the intangible (the tax later stopped on constitutional grounds), the state, and federal. I remember as clearly as it was yesterday the absolute amazement I shared with my fellow brokers at how difficult it was to sell AAA municipal bonds with a completely tax free yield of 14%! That was equivalent to a guaranteed taxable return of almost 30%. What did many prospects say when offered these bonds? I believe rates are going higher – ‘I’ll wait.’ Well rates didn’t go up any further and a fixed income opportunity of a lifetime was lost. A man named Paul Volker, then Chairman of the Federal Reserve strangled inflation from the economy with a very tight grip. Since, then, municipal bond yields have not been even close to half of 14%.
What’s the point? It’s very easy to get caught up in the news or trends of the day and miss the larger picture. Market gyrations are real and can be scary, but they are not permanent. Markets historically rise by an average of 10-12% and as long as companies continue to grow their earnings stocks will continue to rise. As said earlier, we are conservatively invested now and expect to stay so until volatility diminishes. But there are some attractive opportunities out there and we will be actively pursuing them in our two growth funds. We will hold the conservative line in our more conservative models for now.