U.S. stock and bond markets calmed down last week after a tightening in credit markets sent stock prices on a wild ride.
Has the market found its equilibrium or do consumers and investors face a larger storm in the weeks ahead? The Denver Post brought together a panel of market experts to help make sense of the volatility.
The panelists were Christopher Burdick, director of economic analysis with Charles Schwab & Co.; Robert Bush, founder of Eric Forecasting, an economic and fixed-income advisory service; Michael Conn, president of Investment Management Associates; and Louis Llanes, president of Blythe Lane Investment Management. Below are their comments, edited for space and clarity.
Post: A little more than a month ago, the Dow Jones industrial average set an all-time high, and even a couple weeks back the Federal Reserve seemed more concerned about inflation than the housing downturn. What is driving all the volatility in the markets?
Bush: The volatility is coming from the seizing up of a couple of sectors in the fixed-income arena. It started back with the subprime crisis and how it affected hedge funds with Bear Sterns back in the late spring and summer.
It has accelerated to where Wells Fargo began limiting jumbo loans and Countrywide began having a difficult time accessing credit, because the whole loan and mortgage environment was shutting down.
At least 50 percent of the normal day-to-day mortgage business in the United States six months ago was just not happening. The only mortgages being written have to be conforming mortgages with Fannie Mae or Freddie Mac and the federal home loan banks.
Burdick: There’s a repricing of risk that’s going on right now. When you look at the big picture internationally, when it comes to risk taking, you’ve got what is known as the yen-carry trade, where you borrowed a cheap currency, the yen, and invested in something paying a higher yield.
A lot of those moneys being pocketed were funneled into equities. People realized that they were going to get burned, so they backed off from it.
Conn: When there’s a big search for liquidity, margin calls, etc., people are forced to sell what they can; not necessarily what they want to sell. And that’s partially what’s happened in the stock market with declines in stocks that have no exposure to the liquidity crisis. Their owners can sell them, therefore they have to sell them.
Llanes: The root of the volatility is simply overspeculation in real estate. Unregulated financial intermediaries were making a lot of loans that would not have been made otherwise, and eventually they got securitized and passed around.
It was building for quite a while and the stock market is trying to figure out whether or not this is going to cause a recession. That’s the big wild card. But that’s what’s pushing things back and forth.
Post: A lot of smart people argued the fallout from the housing downturn would remain contained, including Fed Chairman Ben Bernanke. Play armchair quarterback. Are we guaranteed a cut in the federal funds rate?
Burdick: I believe they are going to cut by a quarter point within the next 10 days. There’s also a very good chance they’ll cut by another quarter point on Sept. 18.
When you look at the statement that they released on Aug. 17, when they cut the discount rate, which I think was mostly symbolic, they were concerned about the downside risk and they talked about monitoring the situation and being prepared to act. They’re doing all these little surgical things to help out and they’re trying to distance themselves from the moral hazard.
They have to bail this out in a responsible way because they have to be concerned about the rest of the economy.
Llanes: It does seem that they’re trying to balance between analyzing whether or not this is just a short term dislocation versus a serious, long-term thing.
The Fed will probably drop rates more. The danger is this could increase inflation. The regulators are probably going to come in and try to restructure the whole way lending is done in mortgages.
Burdick: The Fed is concerned about employment and they’re concerned about incomes and they’re concerned about global growth. That’s what they said in their statement back in the early part of August at their regular meeting.
When you see all these layoffs in the mortgage industry and everything else related to housing, I believe a fast deterioration in the employment situation has them concerned.
Conn: The Fed acted out of fear that the liquidity crisis would become a solvency crisis. They don’t want a run on the banks. So they had to show the flag.
It’s interesting that the bond market doesn’t seem too impressed with what they’ve done. But the Fed is basically trying to insulate Main Street from the follies of Wall Street to some extent, and not let it bleed over and cause a recession in the economy.
They will likely succeed in that. We’ve certainly seen it before. They’ll be cutting at least once, probably twice. And I think they find themselves a little bit on the horns of a dilemma because the pressures that have kept inflation low are beginning to end. If they are too stimulative, they’re going to find themselves immediately having to whipsaw around.
Bush: I actually don’t believe they’re going to cut intra-meeting. They’ll make a cut at the September meeting. They want to avoid the appearance of a bailout.
I would personally like to see them lower both the federal funds rate and the discount rate. The discount rate is the rate at which financial institutions can borrow from the Fed. The fed funds rate is the rate at which financial institutions borrow amongst themselves based on their capital reserves. So there’s a limitation in how much borrowing can take place at the fed funds rate, while there’s no limitation in terms of the discount rate.
Lowering the fed funds rate would actually be a good stimulus for the whole economy, whereas discount rate changes are very targeted at the financial community.
Post: Could you explain the link between Frank and Linda defaulting on a mortgage in Greeley, the collapse of dozens of home lenders, the freezing of debt markets and volatility in global stock markets. What does a credit crunch mean?
Bush: The reality of the credit crunch for the American consumer is that you will be restricted in taking wealth out of your house.
The total outstanding number of mortgages in the U.S. in the last six years has gone from something like $5 trillion to $10.7 trillion. There’s been an extremely aggressive increase in credit. We’ve jammed two or three years’ worth of homebuyers, maybe five or 10 years worth,’ into a very narrow window and it’s going to take time for them to financially recover.
For Frank and Linda, accessing credit will be very difficult. They’re going to have a more difficult time refinancing. If they have credit-card debt that gets out of control, they’re going to have a much more difficult time living the lifestyle they’ve been living. So that’s really the major impact.
The secondary impact would be if we go into a big layoff cycle. Obviously that’s when we start talking about something incredibly different.
Post: How do you rate the odds that this credit crunch translates into a recession or the first bear market for stocks in five years?
Burdick: First of all I’m not forecasting a recession, nor do I think that we’re going to be in a bear market.
If you look at different futures markets, the odds of a recession are at 30 or 40 percent. I don’t believe it’s that strong. Recessions and depressions are caused by the inability of companies to work through excesses, and the excesses are minimized this time because of technology, just-in-time delivery systems, that sort of thing. Corporations have held it tight to the vest.
The economy is going to slow. Using GDP, I think we will be in a range of 1.5 to 2.25 percent growth for the balance of this year and probably the first half of 2008. I don’t see a recession, but I do have a concern the consumer won’t be able to support things as much as in the past.
The National Bureau of Economic Research has five different points that they look at when they try to call a recession – real GDP, real income, employment, wholesale and retail sales, and industrial production. All those things right now look OK, but I do see them softening going forward.
Bush: My odds of a recession are 50 percent, up from 40 percent. We are walking a fine line and the risk is to the downside, not the upside.
We are at risk from an employment point of view. At this juncture, small businesses create 70 percent of the jobs. So far, they are no less optimistic and haven’t had access to credit restricted.
We have to have the employment gains we have seen over the last seven to nine months. If that diminishes at all, we are at risk of a recession.
The economy is growing at 2 or 2.5 percent without housing. The problem is that housing has now reached into every part of our daily lives. That is the risk we have in housing, that it goes from cocktail conversation to knowing someone who walked away from a house that is worth 25 percent less and the house is just down the street from you. You begin to change when that happens to you individually.
Post: How much of the turmoil represents a change in investor psychology rather than a deterioration of the fundamentals?
Llanes: Things don’t look too bad in the fundamentals, but the stock market is going the other way. The fundamentals could change because of that. Most clients aren’t getting nervous unless they are in the real estate or mortgage business.
Post: Let’s end with advice to our readers. Describe how you are adjusting your client portfolios or what you’re doing with your own portfolio.
Bush: I would just advise them to stay calm, no violent reactions are required. If equity exposure is appropriate for you, I think you can continue to average into the marketplace.
Interest rates will continue to go down, so if you’re looking to park funds, your fixed-income returns are not going to be any higher than they are today. I would continue to stay on the higher quality side of things in the bond market, because even though spreads are wider than they were six to eight weeks ago, historically they’re still so very, very narrow.
Stay with quality for three to six months, durations somewhere in that kind of range. The municipal bond market remains very attractive and tax rates are going to do nothing but go up. Money invested today compounded on a tax-free basis is going to be very difficult to match as tax rates increase over the next few years.
Post: What about the concerns surrounding money market funds?
Bush: I would want people to step back and be very calm about the money market funds. There is in my mind no chance that any money market fund would ever break the buck. The financial system is so much stronger today than when we worried about that problem in 1998. I would be very comfortable on that side.
Conn: If Bob is correct that there is a 50 percent chance of recession, I would prefer to own stocks that really aren’t affected much by the economy.
A lot of stocks in the health care area are not growing as fast as they used to, but they’re selling at lower valuations. They’re a high quality. They may be a place that money will go to seek safety and quality, so I would overemphasize health care.
In the financial areas, I would be a little leery of the money center banks, because when you start trying to analyze them they look like hedge funds. But you can find good regional banks that actually lend money to people who pay it back.
I would avoid, because of the risk, stocks that depend on consumer discretionary income. You can put together a pretty good portfolio right now that has some defensive characteristics versus risk in the economy.
Burdick: My view is consistent with Mike’s. Health care looks attractive. In contrast, consumer discretionary, with consumers reining things in, is probably not the best place to go.
There’s some opportunity not here yet, but technology could look attractive. I also think that right now, because of my belief on net exports, that good quality multi-nationals are benefiting. I think those are favorable places to go.
As far as our firm, Charles Schwab, we basically have a strategic asset allocation approach. It’s more long term. Look at where your risk tolerance is and then see if your portfolio matches that type of risk-taking. And if it doesn’t, then you need to make some changes.
If you are comfortable with what you have, then the other thing to do is simply rebalance. That means if you’ve got one area that’s doing better and one area that’s not, take some money off the table where you’ve had some profits and put it into an area that hasn’t been doing so well.
Llanes: I agree with you. I think it really all starts with what is your risk tolerance. What is your goal and objective?
Around that, I’d like to talk about the tactical areas and how we’re positioning. We’ve been short on the yield curve for quite a while. And I think that still makes sense, although the real short end of the yield curve is getting a ridiculously low rate, I believe. There’s a question as to how much further that will go down.
In the U.S., I think large-cap stocks generally make more sense, due to exposure to European and Asian markets that are growing faster and potentially benefiting from a lower dollar. We’re underweighting small-cap stocks and we’re overweighting international bonds.
Start to underweight emerging markets because relative to the developed markets, they are more expensive. On a secular basis, I still like emerging markets. In this cycle, we think it’s a good time to take some of that money off the table and to get a little bit more conservative.
Staff writer Kelly Yamanouchi contributed to this report.
