Where Are We Now?Submitted by Affiance Financial on November 14th, 2011
Seth Meisler CFA, CPA/PFS
In my last commentary, I suggested that the U.S. credit downgrade by Standard & Poor’s would not negatively impact the markets, but that the overall economic environment should give investors pause. Subsequent events have validated this assessment. After Standard & Poor’s downgraded the U.S, investors purchased more, not fewer, U.S. bonds, driving treasury rates even lower. The economic environment, however, continued on just-above-stall speed, as measurement of economic activity was adjusted downward and the European debt crisis rose to the top of the headlines.
The result? “Roller coaster, gut wrenching, nerve wracking.” These were your (appropriate) descriptors of the market over the last few months. Both the range and frequency of these ups and downs are historically extremely unusual and reflect the high degree of uncertainty in the market. “Occupy Wall Street” is another symptom of much larger dynamics at work. So how do we make sense of all this noise, and what strategies can we use to manage your portfolios?
The background. Many of the problems from 2008 have not been fully resolved. The crux of the issue is still too much debt. At first it was consumers and financial institutions that had too much debt, resulting in housing defaults. Consumer over-indebtedness led to a decrease in spending, causing companies to pull back on investment and hiring. This in turn led to a build-up of cash on companies’ balance sheets, but no real desire to spend.
At the same time, a significant amount of debt that had been held by financial institutions was effectively moved to the government’s balance sheet through the various bailouts by both Congress and the Federal Reserve. This reallocation of debt created three problems.
- The basic rules of investment law were abrogated. Instead of debt-holders taking a hit when defaults occurred, the government simply moved the debt to its own balance sheet, thus subsidizing debt-holders at the expense of taxpayers.
- We now have a sovereign debt crisis in which governments around the world have too much debt.
- Debtors (i.e. owners of mortgages) are still overleveraged and need to decrease spending and reduce their debt load.
The options. How does a government get out of a debt crisis? There are a few time-tested methods.
- Default on debt. (Greece, potentially.)
- Grow out of debt. (Best option, but need stronger economic growth to grow out of debt.)
- Inflate out of debt. (Euro-based countries can’t.)
- Stop spending and create austerity measures. (The U.K.)
- Financial repression. i.e., keep interest rates extremely low, effectively benefiting debtors at the expense of savers. (The U.S.)
The effects of these strategies are not fully understood by many policy makers, who have allowed these problems to metastasize—or the market.
Europe recently laid out its “grand” plan, to which the market reacted very positively. Unfortunately, this plan lacked specifics. In the meantime, U.S. growth in the 3rd quarter, while much stronger than the first half of this year is simply not enough to effectively reduce employment. The Fed continues to try and kick-start economic growth with “Operation Twist,” which is an attempt to lower long-term interest rates. To complicate matters, we are seeing additional headwinds in the U.S, which include decreased productivity, decreased inventory buildup, decreased real wages and tightened bank lending.
We can apply the following strategies to manage this slow growth, debt de-leveraging economic environment:
- Continue to diversify and invest in those asset classes that appear out of favor.
- Choose a more balanced portfolio that will serve to dampen the ups and downs in the market place. Thus increasing the focus on capital preservation when there is greater uncertainty.
- Look for areas that have solid return streams – including dividends and bonds
- Don’t fight the Fed. Efforts by the Fed through Operation Twist and a rumored 3rd round of quantitative easing may stimulate both the economy and the stock market.
It won’t require a miracle to reduce the market’s volatility. If Europe’s plan holds, economic growth (however modest) in the U.S. continues, politicians can come to agreement, and corporate profits stay level or rise, the market’s uncertainty will be mitigated — allowing for continued growth in the future.
This article was written by Seth Meisler, Director of Investments at Affiance Financial, and they are the opinions of Seth Meisler.
Seth Meisler is a registered representative of Cetera Advisor Networks LLC, member FINRA/SIPC. Affiance Financial is not affiliated with Cetera Advisor Networks