It is important to note the cause of yesterday's market decline and to then judge the effect in terms of whether it is warranted by what I call the "fundamentals", or it is nothing more than a herd of frightened investors reacting to what they perceive as a credible "cause". Let's explore today's market free fall a bit more carefully by reviewing recent history.
Following a strong beginning for the DOW in 2007, in mid February the DOW suffered what many would consider to be a substantial decline in one day, more than 300 points. Beginning to sound familiar? What was the culprit for such a sharp decline. Wasn't it investors concerns about "lending worries" and the sub-prime mortgage time bomb that is waiting to explode on certain home owners? Yes, in fact it was! The media made a lot of fuss over sub-prime mortgages and naturally they ruffled the feathers of one too many investors, causing what could have appeared as a legitimate reason for the markets to tumble.
I recall speaking with one of our clients this past February and informing her that "today's decline isn't the start of a recession, nor is it the beginning to a prolonged downturn in the market." I'm no prophet however the result was that nearly 60 days later the DOW began its march to it most recent high of 14,000! Of course we know that, PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS!
However, Every high will be challenged by some sort of correction. In fact, when the market heads for a new peak, please be prepared for a correction because corrections creates nice buying opportunities. Especially the ones that in my opinion are not supported by economic stimuli that should warrant a prolonged decline in the markets.
An example of the type of economic stimuli that warrants a prolonged decline in the markets to name a few are:
- A steady (quarter after quarter) increase in interest rates
- An increase in the Consumer Price Index (CPI)
- An increase in jobless claims
Economics 101 teaches us that as Gross Domestic Product (GDP) continues to grow/increase, the threat of inflation is just around the corner. The primary weapon that the Federal Reserve (Bernake & Co.) has against inflation is the ability to influence the direction of interest rates to either offset inflation by raising interest rates, or by lowering interest rates, which serves to refuel the economy. Remember in 1998 as the DOW was charging towards its former high of 12,000 and former Fed Chairman Alan Greenspan raised rates almost 11 times between 1998 and March, 2000? What immediately followed was a "warranted" correction known as a recession.
Capital spending between corporations fell sharply as a result of higher interest rates. Corporate profits followed in the free-fall, then came the avalanche of Analysts downgrading a number of Large Cap stocks, and within a few months, the United States economy had posted 3 consecutive quarters of negative GDP, which according to my Economics 101 textbook is a recession. But, this wasn't nearly the end of the story because Fed Chairman Greenspan continued to make a name for his self by bringing interest rates to 40+ year lows in an effort to fuel the economy.
The problem with recessions is that corporations have an automatic "recession kill switch" in their arsenal called "layoffs"! Yep, corporate America is not about to wait around for the Federal Reserve to determine when they are going to lower interest rates. Layoffs present an immediate "fix" to a corporations declining stock price because they recoup a lot of employee related expenses and this savings is redirected back in production or back to the balance sheet as cash. Cash is always a good thing for the balance sheet because it helps the stock price.
Back to Alan Greenspan and his recession "fix". Okay, so as interest rates declines, the economy begins to speed up, inflation isn't that much of a concern, oil prices aren't so bad and eventually, the economy pulls itself out of the slump. This is the result of an ever rising GDP, which is another way of saying, "America is mak'in some money!" The problem with rising GDP is that it brings along another friend called "inflation". So, Americans have to decide at which point life begins to "feel" too expensive before we cry out to the Fed's to begin increasing interest rates, and the long cycle back to an eventual recession begins to reset itself.
In our present situation there is one small (well, okay maybe not that small,) snag and that happens to be the real estate market. This "snag" doesn't hurt those with good credit and a nice 30 or 40 year fixed mortgage/interest rate. It is only a detriment to those who are tied to one of them nasty Adjustable Rate Mortgages (ARM) and for whatever reason, cannot break free from it. This is where the current worries are coming from. There are a lot of sub-prime ARMS out there, but are there so many of them that it warrants a 300 point drop in the DOW?
The sub-prime market doesn't represent an enormously large percentage of U.S. mortgages. However, there are still enough of them out there (I recall reading that the sub-prime mortgage market represents less than 5% of all U.S. homes) for the media to create a frenzy over, and of course yesterdays disappointing home sales report released by the Commerce Department doesn't help.
If I may quote the Associated Press' comments this evening, "Feeding the plunge were concerns that higher corporate borrowing costs will curb the rapid pace of takeovers that had driven stocks higher this year. Investors also feared the sluggish environment for home sales and continued defaults in sub-prime loans would spur debt defaults and weigh on corporate earnings."
The question that we have to ask is 1) what is the association between potential mortgage defaults and corporate earnings IF they sub-prime market does not make up a large percentage of mortgages held by homeowners? Let's assume the worse for a minute. Suppose a person with a sub-prime mortgage has to default on a mortgage because they can no longer afford the payments. Well, this may be a blow to the ego for sure, but guess what they are probably going to do? They are going to leave their home (lose some equity) and become renters, which is going to result in more money saved per month, which will eventually lead to more spending because consumers will continue to consume!
So, I disagree with the view that mass defaults will hit corporate earnings in the gut and therefore cause a decline in the economy. Maybe the housing market will take it on the chin, maybe mortgage companies like Countrywide will take it on the chin, BUT Wal-mart, AT&T, IBM, APPLE, Safeway (especially the grocery stores because now those who have defaulted can afford more milk and bread), and perhaps even the automobile industry will produce more and earn more profits. I believe that IF a person loses their home because they cannot afford their mortgage, they will eventually be inclined to replace the money that they were spending on a mortgage with another consumer service or good, whether it means investing in a mutual fund (which will help the financial sector like brokerages and banks), buying more clothes, or purchasing an Video iPod! (I just purchased one of these for myself, what a cool device)
What I am essentially communicating is that the money that is saved in ones pocket will eventually find it's way into the hands of someone else and will result in "economic profits", which is exactly what drives the economy. Disappointing Commerce Department news is what impacts the economy, but profits translated into "earnings" is what drives the economy, in addition to interest rates.we can't forget about interest rates.
So, take courage, do not fear, don't go shopping for the best Certificate of Deposit or Bond just yet! Let's allow the economy to do what it does when corporations reports positive quarterly earnings. In the meantime, you should be seriously thinking about backing up the pick up truck to your IRA, ROTH IRA, 401(k) or taxable brokerage account so that you can load up on some more shares of what you currently own inside of your portfolio! Why? Because like I said in the subject line of my commentary, "Lending Markets Fuels Buying Opportunity on the DOW".
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