Tuesday, October 07, 2008

How We Turn the Markets

I spoke with one of the savviest financial people I know this morning on my way into work. He asked me for my take on why the markets’ seemed to be in such a tailspin. Before I could get into my explanation, he said, “The markets are acting completely irrational. Business is not falling off the table the way that stock prices are.” I told him that his explanation was my explanation. Fear was driving the selling with rationality having left the building. I explained that the bank rescue plan came as a surprise to Congress and they did not do a good job of selling it to the American people. The plan is certainly a rescue, but in its original form, it was not a bailout of $700 billion because the government would be buying frozen assets at greatly discounted prices and would likely make back their investment from the mortgage payments alone, let alone the fact that a house was attached to every loan. The public got up-in-arms because they were angry at not only Wall Street but also the politicians, and as a result, they inflicted their wrath on the halls of the House of Representatives. The House, sensing that they were in a no win position with the electorate, punted and voted the rescue plan down. The stock markets reacted with a vicious sell off that continues to this day, even though the plan was eventually passed. My friend asked why the sell off has continued now that the bank rescue plan had been passed. I answered that I thought there were three reasons:
  1. We have a real problem of liquidity and bad loans in our economy and the rescue plan will take weeks if not months to get moving, so there is still bad news almost everyday to which the markets must react. The volatility will continue until the bank rescue plan and other measures taken by the government begin to work and unfreeze liquidity.
  2. Bank bailouts have hit Europe, with banks in Holland, Germany, and England being bailed out in one form or another.
  3. The most important issue, however, is that stock traders realize that the bank rescue plan being on the front pages for nearly a week has raised the awareness of the American people to the problems in the banking system and will lead to a pullback in consumer spending. Consumers are angry and frightened, and since they represent roughly two-thirds of US GDP, the economy, which has been muddling along, will likely slow; perhaps even dip into negative territory in the coming quarters.

Consumers were already on alert before the banking crisis was on the front pages. Recently released Federal Reserve data show that for the first time since 1998, consumer debt fell in August by 3.7%.

My friend said he agreed the economy would slow but that the stock market was down over 25%, which was dramatically more than the economy would fall. He said, “How does a market get over these kinds of irrational fears.” I said that I thought the market would get over its fears, the same way it got over its greed.

Three years ago everyone thought that home prices would go up forever and everyone got in line to buy a house. The banks, particularly in the hot real estate areas, bought into the forever-rising real estate story along with their customers and they started cutting corners on assuring the creditworthiness of their home buyers. So greed took over. Prices went up everyday. Buyers started offering more for houses than the sellers were asking -- and on and on. What killed greed is that in the end you run out of foolish buyers. The higher you go, the more value-oriented people, shall we say “rational” people, drop out, so at the end it is just the greedy doing business with the greedy. Then some of the value-minded people realize that prices have gotten too high and they start selling. Pretty soon, prices start leveling off and then start down because value-minded people keep putting more real estate on the market. As prices begin to fall, the people who were still buying at the end are quickly underwater. In stocks it’s the same way. Right now some people are selling because they believe that earnings and dividends will be significantly hit by a slowing economy, which would make their stocks worth less in the short run. But the great majority of selling is being done by people who aren’t thinking about earnings or dividends at all; they are selling because the market is going down and they are afraid. Fear has seized the day and it will run its course the same way that greed did: until value-minded people step up.

So far it has not made much sense for value-minded people to get in a hurry to start buying. The markets have been getting rocked everyday, but value-minded people realize that there will come a day very soon when the sellers will run out of steam. At that point, the value-oriented buyers will begin buying and the markets will at first calm down and then begin to move higher.

Here’s a very simple reason why: the sell-off in stocks has created great values. The Dow Jones Industrials now yield over 3%. That is a higher yield than a 5 year Treasury bond. That means that investors who buy the Dow today will at least match the income from Treasury bonds and get all the growth in dividends and prices over the next 5 years for free. It is that kind of value that brings the value-minded people off the sidelines.

Another thing that would help a lot would be if the Fed and other world central banks did a coordinated rate cut.