"Where in the World is This Thing Taking Me!?" - The Wild Ride of the "Shock-Market"

If you have been watching the markets these last few weeks, there is a strong possibility that you could be now suffering from Vertigo, or at the very least a mild nausea. 

The volatility and dyslexic nature of the price movements (starting Monday, Aug 8th, the S&P500 was down 6.5%, up 4.7%, down 4.5%, up 4.6%, and up 0.5%), along with the historic rise in the price of gold (now at record highs over $1,800), illustrates the huge levels of anxiety and uncertainty that investors, still licking wounds from two years ago, are faced with. 

This article is meant to serve as an explanation to what is happening with the markets, what is likely to happen in the near to middle term, and finally what investors should do about it.

"Whoever is driving this thing needs to get pulled over and served a DUI"
This comment, from a physical therapist that works with my wife, in response to seeing the market during that week of volatility, is a more astute analysis than any of the hours of commentary I have heard on CNBC or read in any of the financial periodicals.  So who is behind the wheel and what have they been drinking?

First of all, lets start with the backdrop.

Economic growth is sluggish, as the government and Federal Reserve stimulative measures begin to wear off.  The market has rallied over 35% in the last two years, and while corporations are making money hand-over-fist the unemployment picture has not improved nearly as much (from 10% to 9% roughly).  So for many people it does not feel like a recovery at all.  The Europeans are further complicating the situation by letting the financial drama of a few locales evolve into a near-crisis.  Bring along the Theatre of the Absurd we had in Washington over the debt ceiling debate, throw in a US debt downgrade as an exclamation point, and you have all the ingredients for a very explosive, reactionary, and indecisive market. 

These over-anxious traders behind the wheel, if they go to hard and fast in either direction, will then get a nitrous boost when the program-trades kick in.  These program-trades are set up by a computer to go off when the market hits certain technical levels and are designed to protect traders from losing too much money when the market goes against them.  The problem is that these then become self-fulfilling prophecies as an onslaught of selling leads to further panic and further selling.  At this point, economic fundamentals fail to matter as the markets ride solely on the emotion of the moment.

What happens next?

A lot and more.
The volatility we have seen lately, while hopefully not maintaining the same break-neck velocity of the last two weeks, will not go away anytime soon.  Rumors and blurbs about the Fed, the Super-Committee, and our friends in Europe will all lead to anxious times ahead for investors.  The good news, however, is that unlike 2008, corporate America, as well as John Q. Public, have all de-levered their balance sheets to a large degree.  The stimulus policies of the last two years have been used in part to pay down debts and build cash reserves (which is part of the reason they were less "stimulative" than hoped).  Banks, corporations, and individuals are all standing on much firmer footing this time around. 

Add also that corporations have been able to keep growing profits with out hiring anyone, which means that many of them are running skeleton crews.  Consumers have already gone through some painful lifestyle changes, and have not shown signs of resuming their irresponsible spending habits.  In short, this means that we have much less further to fall.  People can't stop going to Wal-Mart for groceries.

Is it possible that the economy stalls and we fall back into a recessionary environment?  Yes.  However, I do not feel like the results would be much worse than we are seeing now.  Stocks could fall further, certainly, but the unemployment rate would not get much worse and not many people really feel like we ever got out of a recession to begin with.  Times are still tough!

The upside is that there are a lot of near-term opportunities to really break out of this recent bout of negative hysteria.  If the President's job bill, (planned to be presented to congress when they get back in session next month) is a credible, meaningful, and sustainable plan to get America back to work, that would be a big economic boost.  If the super-committee comes out with a balanced approach to reduce our deficit by more than the mandated $1.5 Trillion, the markets would react very positively.  And, if the powers-that-be in Europe make serious steps to deal with their sovereign debt problems, that would instill a lot of confidence in the market.  Now what are the chances of all of this happening?  Here is a hint....its less than 100%, but even if we dont get all three, we can still come out ahead, and there is reason for optimism since we have already tried all the wrong answers, and now there are really only the right solutions left.

As an Investor, What's the Plan?

Don't Panic!
If you are a long term investor (think longer than 15 years) than you have very little to worry about and you should continue buying into this market and reinvesting your dividends.  Even though the price level of the market is flat over the past ten years, if you continually reinvested all the dividends you received from the S&P your account balance would be up 50% over that time.  You should not have any money in stocks if you have need of it sometime in the next five years.  Anything being saved for a house, or college tuition should be placed in low yielding, short duration, high quality bond funds.  These are lessons two and three of Financial planning 101.  What is lesson one, you ask?  Diversify.

What are the Best Investments Right Now in this Market?

Education!
Does this sound like a strange answer?  Let me just tell you that there has not been a better time, a more necessary time, for people to go out and get additional credentials, training, and plain old knowledge.  Borrowing rates are at all time lows, and the job environment, as we all know, is incredibly tough, and not likely to let up anytime soon as we face continuing competition from around the globe.  If you are just out of undergrad, you should look into graduate school.  The numbers show (courtesy of Bureau of Labor Statistics) that people with advanced degress earn 20% more on average than those with only an under-graduate degree.  Professional designations earn even more.  If you can borrow money over 30 years at 3% to increase your income 20% over that time frame, that seems like a pretty good deal.  Just make sure that you first have the capacity to borrow, the ability to pay back the loan, and that you are learning something relevant to your primary living pursuit.  Do not borrow $20,000 to take a photography appreciation class, if you work in the medical field.  These hobbyist pursuits need to be saved for better times.

Large Capitalization, Domestically Based, Multi-National, Dividend Paying Stocks
These companies are still making profits, hold lots of cash, can take advantage of faster growing markets, and pay you a stream of income while you wait for the market to sort itself out.  Not only that but they are trading at fairly low valuations in relation to historical norms. 

Not Gold!!
Please ignore the commercials and the talking head gold bugs. The problem is that gold is currently being held by investors in place of interest yielding securities because interest rates are so low. The only problem is that this only works while the price is still rising. After the price stops going up, why would you continue to hold gold? At this point we get some selling for profit taking, and as the price falls we could see a negative feedback loop as many people who bought into gold really just want to protect some of the appreciation they captured over the last two years. Since there is no floor on the price of gold, there is no way to tell how far it could fall in that scenario. Basically, gold is Ultra-Risky right now (though, full disclosure, gold still can hold a small place in a portfolio as a hedge against some of the risk factors above, but it should only be used with that in mind.)

The Bottom-Line
It is important to react to stock market uncertainty the same way you should act towards any unforeseen circumstance.  Keep calm, gather the facts, determine how it effects your goals and situations, and make measured changes as the situation warrants.  Lets remember that due to the severity of the last crisis we went through, the road to recovery is going to be a difficult one, full of potholes and bumps and other hazards.  It is important to continue playing defense and make sure that your as secure as you can be with your finances, pay down debt, and keep saving.  After you have these immediate bases covered, I believe you will get rewarded in the long run for being optimistic in your investments.  I buy into Warren Buffett and Jaime Dimon when they warn that its not wise to bet against America.  This is still the greatest country on Earth, and as soon Washington starts acting like it, and people begin believing it, the sky will be the limit.

Stop Saying the Stimulus Didn't Work

The tag-line of many hard-line conservatives this year, as the economy continues to struggle, is that the stimulus package was a failure.  They say "the Democrats promised that this stimulus spending would bring the unemployment rate down to 8%."  Since this did not come to pass, they say that it was "a colossal waste of money."  While the democrats may be guilty of bad forecasting, to say that the stimulus did not work shows a complete lack of basic economic understanding.  You will also notice, if you pay attention, that none of these tag-line parroting hard-liners ever follow up this claim with what they feel would have been a better solution.

For those of you out there brave enough to take an economics course in college, and unfortunate enough to not have been able to sell back your textbook at the end of the semester, you can look back at a couple of equations that represent the most fundamental relationships for an economy.  The first is as follows:

GDP = private consumption + gross investment + government spending + (exports − imports)

Ok, so now lets take a look at what happened in 2008.  A recession of massive proportions drove down consumption and investment to the point where GDP was shrinking by 6% at its worst point.  So when you have a total absence of consumption and investment, and we all know that the U.S. has imported far more than we have exported (aka running a negative trade balance), then the only hope to get an economy to stop shrinking is to increase the government spending variable.  We have to increase spending and increase the overall debt level in order to prevent the recession from worsening.  If the economy continued to fall at a 6% clip, what would have happened to employment levels?  What would have happened to tax revenues and unemployment and social entitlement costs, if the economy continued to shrink?  Steadily falling revenues and continually increasing costs would have been worse for the debt situation than a one time shot aimed at preventing those effects.

The other important equation to consider is the following:

M * V = P * Q

What does this translate into?  Money * Velocity = Price * Quantity, or even more simply, the supply of money in the system times the speed at which it turns over, is equal to price times quantity, aka GDP.  While this is a little more convoluted for a non-economist, here is how it breaks down in real terms.  In 2008 the credit markets froze up as banks were afraid of lending any money out.  The supply of money was shrinking (which is actually a pretty rare occurrence for the US).  The money that was in the system was not being turned over as fast because consumers were not spending it.  So banks not lending, consumers not spending, will lead to a lower GDP as well.  What the government hopes to do by increasing their spending is to increase the supply of money and credit, and hope that the extra supply will turn-over (read, get spent) at a fairly rapid clip.  The absence of government spending in that situation could lead to a continuing decrease in both and thus, continuing decrease of GDP.

The choice that the government has is to allow the country to spiral dangerously close to a depression type scenario, or to add another slug of money to our debt level in order to float the economy, and also then "stimulate" the private economy back into a growth mode.  The question is not whether or not we have recovered from recession, but rather where would we be absent this critical level of government spending?

The second argument is that this money was "wasted" on bad projects that did not have the pay-off they should have.  The most famous tag-line for opponents of stimulus in this argument is pointing out a line from President Obama where he said "maybe some of these shovel-ready projects were not as shovel-ready as we thought."  Now we can argue all day and night about the stimulative effects of one congressman's pet projects vs. the others, but the bottom-line is that the difference between the two is nowhere near as important as the actual level of the funds being spent.  Further more, if you log onto to recovery.gov you can actually see what the break-down of the spending really is.  Curiously, well over a third is represented in by tax-cuts, which I thought many conservatives tend to favor.

I realize that politicians never let facts get in the way of a good argument so, with this next election season coming up, I am bound to suffer through all of the republican candidates regurgitating the stimulus package argument.  I just hope that we can make our decisions based on facts and figures instead of convenient sound-bites.  The worst mistake the democrats could have made was trying to tag a target rate of 8% unemployment to this bill.  Their big underestimation was on the productivity of Americans who are nervous about the possibility of losing their job.  Companies have not hired more workers because they have been able to get more and more out of their current skeleton staffs.  In my January prediction piece I also quoted a forecast of 7.5% unemployment by the end of the year because of the same mistake.  Today we are still seeing a 9.1% rate and this is not expected to drop much further by year end.

Bottom-line is that the stimulus was a necessary step from the government to prevent our recession from devolving into a full blown depression.  Am I satisfied with where we are in terms of our recovery?  Of course not.  It will take time to work through our malaise, and unfortunately require some action from our action-phobic congress.  In the end, I am optimistic that our country will continue to prosper... it just might not be at the level many of us were used to in the last two bubble economies of the 90's and early 2000's.