In a previous post, I had mentioned how our current financial crisis has rippled across other sectors of the U.S. economy and overseas, sending noticeable shock waves across global financial markets. The critics and “doom and gloomers” are all lined up and waiting to unleash a heavy dose of “I told you so” to investors that will supposedly get burned if they don’t allocate their money properly, however I think much of this pessimism is overhyped.
Photo:tlindenbaum, Creative Commons, Flickr
The current credit crunch has led to much investor uncertainty so far in 2008, and a good portion of investors are skeptical of the Federal Reserve Bank’s solution of aggressive rate cuts and emergency loan programs. The critics claim that this will only fuel inflation, further adding to our woes. But before we go and draw conclusions on something that is yet to be played out, let’s travel briefly back in time to 2001, when we experienced our last recession.
In 2001, we were enduring an extensive hangover from the unprecedented economic growth from the technology boom. A market correction was inevitable and 2001 marked the start of that extended correction period. The Fed, anxious to do its part to stimulate the economy, aggressively lowered interest rates to an historic low of 1%. But why? Was that what was needed for recovery? No, it wasn’t. Lowering interest rates stimulates borrowing activity, which is a good proxy for how much liquidity is present in the marketplace. A lack of liquidity wasn’t the issue back in 2001, and the Fed just created some more liquidity that we simply didn’t need. The result? An unjustified run-up in housing prices that led to our current crises. This is a classic case of the government addressing the symptom, and not the cause. What should have been done was the implementation of relief programs for the same constraint that was suddenly choking off growth, e.g. business investment in technology. A technology-led recovery should follow a technology-led recession.
But this time around, it is a lack of liquidity that is rippling into other parts of the economy and financial markets. Therefore, aggressive lowering of interest rates directly addresses the root cause of the problem, and not the symptom. The Fed’s actions this time will have a much greater impact on the economy last time, and we should see that as interest rate cuts work their way through the system.
So far inflation has inched upward but has overall been kept relatively in check. With a slower economy projected over the near term, I expect enough downward pressure will be put on prices to offset any inflationary pressures from lower interest rates. Commodity prices have soared largely because of new supply/demand imbalances, not due to rampant inflation.
On the flip side, a slower economy will ease the commodity price surge, also lessening the risk of sparking broader inflation.There is no reason to panic right now. I will panic if and when inflation reaches the double-digit levels last seen in the early 1980’s. We are not close to that yet. I will panic if and when foreign currencies pegged to the U.S. dollar begin to decouple per the respective country’s instructions. While 2008 will be a turbulent year no matter how you look at it, one must bear in mind that these market corrections don’t happen overnight. Interest rates can start to be pushed upward again once the financial crisis eases, although that is unlikely to happen this year.
So what does this mean for stocks? We have seen plenty of volatility so far in 2008, but are we in for a prolonged stock market decline? I doubt it…..the Dow Jones dropped from 14,000 to around 11,850 earlier this year on the same gloomy news that we keep hearing about, and as such, the tough times that we are bracing ourselves for have largely already been priced in. Expectations would have to further worsen in order for more stock market losses to occur.
Can conditions really get that much worse, especially when considering recent anecdotes such as the S&P report citing that we are more than halfway through the sub-prime write-downs and better-than-expected earnings from Morgan Stanley (MS), Lehman Brothers (LEH), and Goldman Sachs (GS)?
Such anecdotes won’t tell the whole story and there is plenty more to be discussed, but I believe that the January decline of the Dow was the steepest drop that we will see in this cycle. Sure, there will be some further downward pressure on stocks as investors continue to show nervousness, though I would be surprised to see the Dow dipping more than 5% below the already-established low point. I predict a general sideways market for 2008 and for however long this cloudiness lasts afterwards.
I have been closely watching some short-oriented ETF’s this year such as UltraShort Financials ProShares (SKF), UltraShort Real Estate ProShares (SRS), and UltraShort Consumer Services ProShares (SCC), and my stomach churns as I see them violently swing back and forth. Like any individual investor, I’d love to find ways to profit during downswings, but I recently concluded that there is too much ambiguity in these markets to feel comfortable buying such risky funds. As such, I am no longer considering going short in this market and will relieve myself of some of the stress in finding the right entry point. At the same time, given the recent run-up in the Dow, I see stocks as too expensive to buy right now. During uncertain times, there is no shame in holding on to what you have. Keep your cash position high and your blood pressure low.
So is the sky falling? Nope — it already has. The acorn has already fallen on Chicken Little’s head and she has done her dance. Her head may hurt for a little while, but that’s besides the point…
Disclosure: I own none of the securities mentioned above.