This Week in Panic

August 17, 2011

Such a wild ride since our last article in mid-July... 

We got through the debt ceiling faux-fight, but the bickering and inconclusive conclusion led to a U.S. government debt rating downgrade by one of the esteemed ‘Nationally Recognized Statistical Rating Organizations’, Standard & Poor’s. 

If you believe  the brilliant minds at Standard & Poor’s, the U.S. must be mere months from collapse. After all, this is the same agency that continued to confer "Triple A" status on Enron debt until just a few months before its downfall. Standard & Poor's also waited too long to downgrade highly-rated debt created by Wall Street that contained sliced and diced home equity loan super tranches on bubble-inflated Vegas and Miami properties. We continue to believe U.S. government debt is safer from actual default risk than any debt in the world –though our debt probably is ever-so-slightly more at risk of a temporary default as politicians seem to think choosing default is a legitimate strategy.

Anyhoo, the debt fight and resulting debt downgrade was too much for stock markets already concerned about spreading problems in Europe. Investors ran for the exits in one of the worst and rapid slides since the housing bubble went pop.

The S&P 500 has recovered in recent days, but as of August 15th, it's still down just over 10% from the slide that began on July 22nd. That's better than foreign stocks, which were down about 18% at the worst of it last week, compared to our market’s roughly 16% slide. Smaller cap stocks here fell just over 22% - official bear market territory, while emerging markets were down just over 18%. European stocks slid 20%.

And what of U.S. government debt – the supposed nucleus of the problem? Long-term government bonds were up about 13% when stocks hit bottom last week. Once again, the market has a way of doing the opposite of what investors expect.

Speaking of what investors expect, fund investors have been bailing out of U.S. stock funds at over $10 billion a week now, demonstrating an aversion to U.S. stocks that's been in place for months and is now accelerating. 

More recently, investors seemed to have noticed that foreign markets aren't doing better than U.S. stocks, either in recent weeks, or over the last few years, although they still seem to offer protection from a falling dollar and generalized U.S. malaise. These investors finally started selling funds that invest abroad, although not nearly at the rate that they dumped U.S. funds. 

For the week ending August 3rd, fund investors took about $10.4 billion out of U.S. stock funds and $2.6 billion from foreign funds. If this continues (and it probably will,) we’ll increase our foreign allocations and possibly add back an emerging market fund pick, something we haven’t had in quite some time. Investors have a long way to go in bailing out of foreign markets before we reach a real good deal here relative to U.S. markets.

Investors have been piling into bond funds, which, with falling interest rates, are fast becoming an almost guaranteed low-return asset class over the next few years – unless we have a deep recession and even lower rates. 

The Vanguard 500 Index fund (VFINX) is very close to yielding more than Vanguard's Total Bond Index Fund (VBMFX) – 1.89% to 2.35% as of 8/15 (both yields with fund fees). The gap was closer on August 10th, near the recent bottom. If rates go a bit lower, and stocks sink anew, we’ll see stocks yield more than the total bond index. 

Since the Eisenhower administration, the S&P 500 has only yielded more than 10-year government bonds twice, most recently in late 2008 and early 2009. Very briefly last week, the S&P 500 yielded 2.35% (without fund expenses,) while the ten-year bond yielded 2.11%. Keep in mind that dividends, which are often cut in rough times, tend to go up over time, unlike fixed bond yields. During the last recession, we saw big cuts in dividends, notably at financial firms, and those dividends have not yet fully recovered. Today, we're not seeing such cuts. This historic situation doesn't mean stocks are the deal of a generation, just that they're cheap relative to bonds.

The stock market had been riding on a wave of growing global growth, albeit slower in larger economies. Now, fears of a double-dip recession are more prevalent and accompanied by the elevated risk of no foreign government help if another slide begins. There won’t be a Cash-4-Clunkers, or new homebuyer credits this time around. No tax credits for buying insulation or windows, much less billions in loans to banks on the verge of a nervous breakdown. The debt ceiling fight proved this loud and clear.

The average American investor sees what's starting to look like something that's happened twice now in roughly a decade – a 50% slide in stock prices that makes retirement goals seem that much further away. The run away from stock funds kicked in earlier this time than it has in past slides. If investor confidence is destroyed, investors could spend years parked in low-return assets like short-term CDs and bonds – asset classes the Federal Reserve just said will have no yield, perhaps even a negative inflation-adjusted yield, until at least 2013 (and probably beyond), as the Fed tries to juice the economy and higher-risk asset prices, stocks, commercial real estate, lower-grade debt, and the like. 

This low-yield issue is a major problem for us, because normally we’d have no beef about parking some money in cash and bonds yielding a safe 4-6% until bargains hit stocks. No such good fortune this time, unlike the last two major stock slides.

Instead, we see what could be the beginning of a very long period of individual investor fear of stocks as an asset class. Of course, that's what happened following the 1929 crash, which was in memory’s distance from other severe crashes before the 1929 drop. Then as now, investors don’t want their retirement money in a casino. This semi-permanent move from stocks – if it happens – may lead to a long, slow slide as the exit continues, but will lead to longer-term, higher stock returns once things turn around. 

You don’t want to be heavy in stocks during periods of investor fascination with stock investing, like the late 1990s. You'll be fine if most investors see the stock market as a crap shoot. We'll continue to buy as investors leave stocks, and sell the areas they favor. That won’t keep us from riding the Dow down to 9,000 if we get another recession soon, but it should increase our longer-term returns.