Let's begin by acknowledging that we have a crisis with the potential to do significant financial damage. The focus of investors is now on Greece, with about $500 billion of debt outstanding, and an unsustainable debt-to-GDP ratio of over 160 percent and growing. Thus, the only questions are:
- When Greece will default (as it seems more like a certainty by now)?
- How big will the losses be?
- Will the process be orderly?
- Will it be contained to just Greece?
If, when, and how this situation gets resolved is what investors are concerned about. Investors know the great difficulty the U.S. faced in coming up with a solution to our crisis, which we eventually did -- and we only have one government and two parties trying to reach agreement. Europe has 27 governments and central banks that must agree before a solution can be implemented. And different countries have different concerns, within countries different parties have different views, and European countries typically have more political parties they have to get to agree than we do. The uncertainty created while they debate the situation is what's causing the market trouble.
Photo courtesy of archer10 (Dennis) on Flickr.
How This Crisis Differs From 2008 Before drawing any conclusions as to what (if any) actions you should take, let's provide some perspective on the situation, beginning with why this crisis is different from the 2008 crisis.
The 2008 crisis was a financial crisis that led to a "seizing up" of the financial markets and eventually to a severe recession. For the U.S. at least, today's crisis isn't even an economic crisis, let alone a financially driven one. U.S. banks are in much stronger shape today, having been forced to raise huge amounts of capital as part of the government's "bail out" program. Our economy isn't contracting, though growth has slowed to a crawl. Corporate balance sheets are exceptionally strong, with companies sitting on the largest amount of cash reserves in history. And companies have experienced strong growth in earnings, despite the tepid rate of economic growth.
A good indicator of how different things are now than in 2008 is that with one-month Libor (the rate at which banks lend to each other) currently at around just 0.25 percent and one-month Treasury bills yielding 0.00 percent, the spread between one-month Libor and one-month Treasury bills (or TED spread) is just 0.25 percent. This spread is an indicator of the confidence banks have in lending to each other, and thus a good indicator of confidence in the financial system. To differentiate the current situation from the 2008 crisis, at the height of the crisis the Libor spread reached about 4.5 percent, indicating a large amount of stress in the financial system. The capital markets had seized up, with banks having to turn to the Federal Reserve to get funding, and the commercial paper market had virtually shut down. The situation was so desperate that the government had to provide guarantees on money market funds.
We don't see any such signs of liquidity problems today, even after the downgrade of the U.S. government's credit rating. The interbank market is functioning well, the commercial paper market is functioning, the repo market is functioning well, and the bond market is functioning well.
Now, we'll look at some of the good news about the economy.
Photo courtesy of tiseb on Flickr.
Japan The Japanese economy has recovered faster than expected, and is now growing, eliminating the headwinds that slowed economic growth around the world earlier in the year. Japan is the third largest economy in the world, so this matters.
Emerging Markets While economic growth has slowed somewhat in the emerging markets like China and India, growth is still strong, with China still experiencing close to double-digit growth. (On a somewhat amusing note, one of the sure things I heard from investors at the beginning of the year was that the place to be with equity investments was China. During the first three quarters, the SPDR S&P China ETF (GXC) lost about 25 percent, underperforming every major equity asset class.)
Photo courtesy of Retinafunk on Flickr.
- Next: Oil and Inflation
Oil Oil prices are down almost 40 percent since the April highs. That not only acts like a tax cut, as it puts more money in people's hands to spend on other things, but it will also help to dampen inflation.
Inflation While inflation accelerated a bit earlier in the year, with the CPI approaching a 4 percent rate for the prior 12 months, the core rate (which excludes food and energy) was increasing at a more moderate pace. And the core is a more accurate predictor of future inflation than the overall rate. With oil prices having fallen sharply, the CPI is now more likely to increase at a modest rate, allowing the Fed to continue its policy of extreme ease for an extended period.
Photo courtesy of sjorford on Flickr.
Interest Rates Defying the experts such as PIMCO's Bill Gross (otherwise known as the bond king), interest rates are much lower. For example, the 10-year Treasury, which peaked at 3.75 percent in February, is now 2 percent lower. And that has helped lower the 30-year and 15-year mortgage rates to the lowest on record.
Sovereign Credit Ratings Despite the predictions of many doomsayers, the downgrading of the Treasury's credit rating didn't lead to a rise in rates, nor the abandonment of the dollar as the safe haven currency.
Photo courtesy of ralphunden on Flickr.
Municipal Bonds The municipal bond debacle infamously forecasted by Meredith Whitney hasn't occurred. In fact, defaults are running at a lower level this year than last. And for the fourth consecutive year, actions have been taken to reduce state and municipal deficits by over $100 billion. Some states have even seen their ratings upgraded.
Valuations Valuations are at reasonable, if not historically relatively low, levels. The current forecast for 2011 earnings for the S&P 500 is about $100. At today's levels, that is a P/E ratio of about 11, well below the historical average. Historically, when the P/E ratio was in the range of 11-12, the next 10 years averaged a return of more than 14 percent, or 40 percent above the historical average of just under 10 percent.
We should consider valuations not just in absolute terms, but in relative terms as well. The historical return of 10 percent for the S&P 500 is about 6 percent above the return on one-month Treasury bills of 3.8 percent. Today, we have lower-than-average valuations and a way-below-average risk-free rate. The equity risk premium looks large, at least before the fact.
Photo courtesy of EnergeticNYC on Flickr.
Metrics Here are some other metrics that show that valuations are at modest, if not historically cheap, levels, levels that forecast high expected returns. Using Dimensional Fund Advisor funds, the P/E ratio of the emerging markets is now about 12 and the dividend yield is 2.5 percent, 60 basis points higher than the yield on 10-year Treasuries. The P/E ratio on international small-cap value stocks is now just 9.4, with a dividend yield of 2.8 percent, and the P/E ratio of international small-cap stocks is 11.6 with a dividend yield of 2.8 percent.
Evidence from Canada And finally, here's an interesting story. I was recently in Nova Scotia on vacation. On my way back to the Halifax airport for my return trip, the cab driver told me that 11 of his family and friends had recently bought condos in Miami, paying cash. The combination of the fall in prices and the rise of the Canadian dollar had turned luxury condos into bargains.
After spending a couple of days home I then went to Fort Lauderdale to visit my new granddaughter. While there I appeared on the local NBC station to discuss my book, The Quest for Alpha. The guests before me were real estate experts. They were talking about how there was now a flood of money coming in from Canadians, Europeans and South Americans buying condos for cash, and the market was quickly changing. A year ago the estimate was that there was a 10-year supply of condos on the market. The current estimate is that by the end of next year all the excess supply will be gone. Obviously, America is still viewed as a safe haven.
Photo courtesy of palindrome6996 on Flickr.
- Next: Summary
Summary Let's try to summarize. First, it is important to recognize that there are no clear crystal balls. Second, investing is always a risky proposition. We have experienced a negative market return almost 30 percent of the years. And over the last 38 years, we have experienced close to 20 serious crises, almost one every two years. That type of volatility explains why stocks have historically been priced to provide a large risk premium. We also must recognize that just as there are no clear crystal balls, there are no guarantees that crises -- this one or future ones -- will be resolved favorably. In other words, while most of the time it is darkest just before dawn, it might be that it is darkest just before the proverbial "stuff hits the fan." That's the nature of risk: It must exist, or there would be no risk premiums. And we must accept that risk or we doom ourselves to seeing our net worths fall in real terms after taxes and inflation, year after year.
Photo courtesy of rjrgmc28 on Flickr.
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