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April 2008
Capital Markets Outlook
‘Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.’
- Warren Buffett, 2005 Chairman’s Letter
As fear casts its sinister shadow over Wall Street, the average investor is left wondering how the current market landscape affects his/her portfolio. President Bush recently described the present economic downturn as “a rough patch,” and he remains confident in the vitality of the US economy; however, compared to previous economic expansions, the bull run since 2002 is aged and timeworn. As with the Tech boom of the late 1990s, a bubble has been created – this time in the housing market.
The marketplace today is rife with uncertainty and increased volatility (huge daily market swings). Listening to the radio, reading the newspaper, or watching the news on television we are inundated with reports about the unprecedented levels of market volatility as the average investor is set adrift in a roiling sea of Wall Street hysteria. This putative rise in volatility is deceptive. The period from 2004 – late 2007 was actually below the historic average (from 1990-present). By comparison, today’s market swings may seem rapid and massive after four years of below-average volatility. The VIX Index (charted below) measures the implied volatility of S&P 500 options on the Chicago Board of Options Exchange (CBOE) as an indicator of overall market volatility.
How do the housing market and sub-prime mortgages affect me?
New data shows that US housing prices are falling at their fastest rate since the 1930s, and there is little sign yet that the housing market is bottoming out (Q4’07 building activity fell by 16.9%: the biggest fall in 25 years). Furthermore, foreclosures (repossessions) in 2007 topped 2 million after many sub-prime mortgages went sour. Sub-prime mortgages, those given to people with poor credit, generated high returns for lenders because of their high interest rates. These mortgages were then divided and bundled into various investment vehicles (Collateralized Mortgage Obligations (CMOs), Collateralized Debt Obligations (CDOs), etc.) which were, in turn, sold to other investors. Once these credit derivatives were leveraged (used to borrow more money) the fate Wall Street became entangled with the fate of the housing market. Bear Stearns, the fifth largest US investment bank, was recently bought by JP Morgan Chase for the bargain basement price of $2/share and renegotiated for $10/share primarily because of massive over exposure to these complex credit derivatives.
What does this mean for the average investor? Wall Street is not certain when this housing decline will level off, and because mortgages have been sliced, diced, and repackaged into more complex instruments, companies are unable to price the value of their current holdings. This pervasive uncertainty means that companies are unwilling to assume more risk during these unpredictable times. As a result, credit will be harder to obtain as companies refrain from lending. A larger down payment may be necessary for loans, and those with suspect credit histories may be turned down altogether.
In order to combat this market decline, the Federal Reserve Board has attempted to inject liquidity (i.e. money) into capital markets by reducing the Federal Funds rate, the rate banks charge each other for loans, from 5.25% (September 2007) to 2.25% (March 2008). Pumping in money may increase inflation and reinforce the ongoing devaluation of the US dollar, the consequences of which are already being felt by American citizens. The price of oil (reaching a record high of $110.20 per barrel) has risen with the dollar’s decline, and with the price of gasoline heading towards $4 per gallon, transportation costs are likely to increase, affecting food and goods prices. To foster economic improvement and encourage consumer confidence, the government has issued a Stimulus Package allocating approximately $150 billion in checks and tax incentives to most tax filers by late spring of this year. Whereas the rebate checks may have a limited economic impact, the business tax incentives and restructured mortgage regulations may offer a better chance of success to the overall economy.
For some US industries, the dollar’s devaluation imparts a salutary effect: namely, US exports and tourism. As US goods are priced at more competitive levels abroad and the US becomes a more attractive holiday destination for foreigners, these industries profit. As seen in the chart to the right, exports constituted nearly 3 times as much of the US GDP as housing. With export levels expected to increase, the trade deficit should shrink.
What does this mean for the global economy if the US is not there to buy up the products of emerging markets? The idea that emerging markets are solely dependent upon the US and other advanced economies as export destinations is an outdated one. The rise in emerging market to emerging market commerce mitigates the effects of US economic decline on the global economy. Certainly, one cannot simply dismiss the effects of Wall Street on the global stage, but the chances of a tumbling global economy are markedly less than even just 10 years ago. Increased intra-
emerging market trade offers some protection, but this is not
absolute - as seen by Asia’s recent decline.
Stalwart investment discipline is the key to weathering market uncertainty. From a long-term perspective, volatility and decline in the marketplace are an inevitability, and we have worked closely with you to develop a sound, long-term, and well-diversified investment plan built to capitalize on the good times and withstand the bad times. Reflex reactions to sell during market downturns often result in investors missing out on dramatic market gains.
Source: Raymond James Financial Services, Inc.
We have constructed your portfolio in anticipation of bull and bear markets and we do not want to see you miss out on favorable market upturns. Together, we will continue to plan effectively for your long-term goals.
Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from the sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.
Any opinions are those of Marcus Financial Advisors and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Investments mentioned may not be suitable for all investors. Investing in the oil sector involves special risks, including the potential adverse effects of state and federal regulations and may not be suitable for all investors. Diversification does not assure a profit nor guarantee against a loss.
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