Will the Current Sell-off Morph into 2008's Market?

Posted on August 10, 2011 by David Laidlaw

Since July 22nd, the S&P 500 has dropped about 16% and the market has declined by 4.8% and 6.6% in two out of the past four trading days.  The vital issue for investors that has to be addressed is whether or not this is the beginning of another painful bear market as experienced from October 2008 to March 2009 when the market lost half of its value or are these losses a temporary correction. 
 
There are a number of eerie similarities between the market action now and in 2008.  The first is the severity of the selloff.  Equity losses of this magnitude are not normal.  Similar to 3 years ago, Thursday’s and Monday’s losses ranked in the top 10 Dow point losses even though percentage losses were not in those extreme ranges.  These losses have the potential to produce a negative wealth effect similar to that which occurred in 2008 and early 2009.  Wealthy individuals account for a much larger portion of consumer spending than less wealthy Americans.  The top 10% of wealth holders account for 40% or more of consumer spending.  Since the majority of these individuals have most of the their wealth in the stock market, they will necessarily feel poorer following large losses in the equity markets.  If this slump is prolonged, spending will decrease and our slow growth economy will turn into a recession. 
 
Another similarity is that our government does not appear up to the task to confront the challenges it faces.  In 2008, the government alternated between bailing out Bear Stearns and Fannie Mae while letting Lehman fail unexpectedly.  The original TARP program was supposed to allow the Treasury to buy problem securities from the banks to strengthen their balance sheets.  The market swung wildly while Congress debated whether or not to follow this course.  The government ultimately decided on pumping the capital directly into the banks, but officials dithered when forceful action was necessary.
 
For the past year, the message from investors and rating agencies to Congress and the Administration has been clear.  It has been “you are going bankrupt unless a credible plan is put in place to reduce long-term liabilities.  However, the recovery is weak and spending cannot be slashed now.”  During the protracted negotiations, Congress decided to do …. nothing.  There was no plan to reduce spending growth or raise taxes, so S&P downgraded the debt. 
 
There are also a number of differences between the two periods.  In 2008, the banking sector was crumbling due to huge losses associated with mortgage-backed securities.  Now, the domestic banks have plenty of capital, but Europe’s governments and banks are weak.  While downgraded, the US does not face the same risks as Europe where Greece, Ireland and Portugal are insolvent and Italy and Spain are on the edge.  These insolvency risks could infect the global banking system and tighten credit worldwide if the healthy countries (Germany et al) do not backstop the weaker nations.  However, traditional measures of credit tightening are no where near the levels seen during the 2008 panic when Libor increased over 2% above the Fed Funds rate compared to now when that spread is only about 0.2%.
 
Unlike the lead-up to the previous recession, there is no bubble in the real economy left to pop.  When credit was easy from 2003-2007, the US consumer was binging on housing purchases and construction.  Over the past few years, construction spending has been at depression levels.  There will be no similar industry event that will increase unemployment and decrease spending to anywhere near the same degree as in 2008.  Corporations cut deeply during the recession so that their businesses are structured to be profitable even if sales slow as in a recessionary environment. 
 
While we believe that a recession is more likely than it was a month or two ago, we are not making dramatic changes to the portfolios under our management.  While losses could mount, our expectation is that they will not be as severe as in 2008/2009.  We reduced our exposure to the financial sector and added a very defensive retailer, but have not raised cash trying to time the market.  The risk of a recession is already priced in to value at which stocks are trading.  Most companies are now trading for 10-12 times what they will earn over the next year.  Even if earnings fall, stocks are still the most attractive asset class compared to fixed-income and commodities.  After the downgrade, US Treasuries rallied strongly so that now the 5 and 10-year Treasury Notes yield 0.9 and 2.1% respectively.  Again, this compares very unfavorably with many stocks providing dividend yields of over 2% and earnings yields of 10%.   
 
Please call us if you would like to discuss these issues or anything else.  We are never too busy to speak to our clients regardless of what is transpiring in the marketplace.