The prices of risky assets have been soaring over the past two and a half months as investors continue to pile into stocks, corporate bonds, commodities, and anything else that has the potential to go up in price.
Some of this optimism is justified.
We have clearly avoided the worst-case scenario of a second Great Depression. The federal government's countless initiatives to stop the bleeding have stabilized the economy and financial markets for the time being. However, while we agree that the March 9 low on the S&P 500 represented a rare opportunity to increase exposure to stocks, we now believe that investors may be ahead of the fundamentals. Numerous risks remain that keep me cautious.
Faithful readers of my commentaryknow that I have attributed the severity of the market downturn (at least in part) to past government policy. Rather than going through the normal process of wringing out the excesses in the economy following the tech bubble collapse, the government felt compelled to limit the fallout at all costs. The Federal Reserve lowered the Fed Funds rate to below 2% and kept it there for a full 3 years. Prospective homeowners used the cheap money to buy houses in droves, thereby driving prices up to the stratosphere. Banks and finance companies in search of ever-increasing profits also used cheap money and the securitization market to offer credit to anyone with a pulse. Investors claiming that the emerging economies were no longer dependent on the US ("decoupling thesis") drove commodity prices to the moon. The net result of the government's cheap-money policy was that the internet bubble became the housing, consumer-credit, and commodity bubbles. The simultaneous bursting of these bubbles was the cause of the meltdown in stocks and the economy at large. The one massive erroneous assumption was that housing prices would never decline.
Recessions are normal and necessary for the long-term health of the economy. Even a five-year old knows that if you squeeze a balloon a bulge will form in another spot. Following the tech collapse at the turn of the millenium, the federal government did not allow the normal recessionary process to unfold because it would have entailed some degree of pain for its constituents. The government engaged in one of its most predictable behaviors - it kicked the can down the road so that the problems could be addressed at a later date. Is the government now repeating the same destructive pattern?
In the months and years preceding the "Great Recession", as it is now being called by some, we were increasingly worried that the entire global economy had become heavily dependent on the US housing market. Consumer spending in the US, which had become increasingly dependent on housing price appreciation, had increased to nearly 70% of US GDP and 17-18% of global GDP. Now that housing prices have fallen nearly 30%, consumers can no longer rely on their home for retirement savings. An estimated 20% of existing mortgages are currently underwater (borrower owes more than the house is worth), unemployment is surging, and a huge amount of Option-ARM and Alt-A mortgages is scheduled to reprice over the 2010-2011 time frame. Is it any wonder why the government is so intently focuses on driving down mortgage rates?
Our view is that a fundamental shift is taking place in the way consumers spend and save for retirement. The days of buying on credit without regard to one's financial situation are over. Consumers are borrowing less, and banks are less willing to lend. Houses are no longer considered piggy banks for retirement.
Consider this study released by Wells Fargo yesterday:
"A Wells Fargo & Company (NYSE: WFC) quarterly survey found that nearly one in four homeowners (24 percent) do not have any savings to cover their living expenses should they lose their income. At the same time, anxiety over job stability increased significantly (from 21 percent to 29 percent indicating jobs as their top concern) since fourth quarter 2008, the last time the survey was done. Respondents also have a significantly higher desire to increase savings while reducing debt (60 percent versus 53 percent) and pay down debt faster (53 percent versus 46 percent) compared to the last survey. Less than a quarter of respondents (23 percent) have increased their savings, but 37 percent say they have paid down debt and 12 percent paid off debt completely in the past year.
Many people are taking drastic actions to reduce expenses. Since last year, one-third of homeowners (34 percent) say they have had family or friends move in with them, and 42 percent are spending less on their children. And, compared to a year ago, many have adjusted their spending. About two in five say that they are budgeting more or buying more of only what they need (39 percent and 41 percent respectively) and 30 percent say they are learning how to better manage their budgets on their own."
Below is a chart I like to show in my presentations to clients and prospective clients. As you can see, the savings rate has ticked up recently, and debt levels have come down slightly relative to incomes. How much more adjustment is to come? And how will these adjustments affect an economy so heavily dependent on consumer spending?