Today, the Dow Jones Industrial Average ended down by 504.48 points on Monday, off 4.4%, at its daily low of 10917.51. This brings the blue chip average down 18% on the year. The S&P 500 declined 4.71% and the Nasdaq, 3.6%. In both percentage and absolute value, this was the worst one day decline since September 11, 2001. The carnage was indiscriminate; every stock in the Dow declined.
The general drop can be attributed to Lehman Brothers’ declaration of bankruptcy this morning, following Treasury Secretary Paulson’s notification on Friday that no bailout package (ala Bear Stearns) was coming. It’s true to point out that any earlier effort to cut its losses would have meant a dramatic reduction in Lehman’s size and scope, but obviously, the alternative was worse. Lehman made a gamble that liquidity would return to the high risk mortgage market and it was wrong.
American International Group experienced a dramatic decline (60.8%!) as investors finally accepted the reality that the international insurer has very unclear exposure to risks coming out of Europe and that some kind of save the shareholder – type bailout seems unlikely. The insurer is facing substantial downgrades of its credit ratings, which would likely devastate the firm’s ability to continue as a growing company. It is, in fact, possible that AIG may not be able to honor insurance contracts. Given the massive capital that the company directs ($1 trillion by some estimates), the potential consequences to other companies of an AIG collapse seem to necessitate some kind of government – mandated recovery plan. A shareholder “wipe out” seems likely.
“Deleveraging” seems the order of the day. Trying to unload junk (bonds, loans) to make your balance sheet look better. Banks have been trying to shed risky mortgages, investment banks have been trying to shed commercial loans and everyone seems to be trying to shed real estate. Attempting to strengthen one’s financial situation has led companies to dump assets, which in turn has driven down prices; forcing banks to shed more assets and so forth; A classic viscous cycle.
The question now seems to be what degree of “spillover” will occur between the investment and commercial banks that are now deleveraging (or collapsing) and the broader economy. Will the losses that banks have taken on commercial and personal loans turn into tighter lending standards, which will, in turn, hamper broader economic growth?
My guess is that the effects are being overblown at present. While the collapses of Lehman and (potentially) AIG are concerning, they are a necessary and normal part of the gyrations of the capital markets. While their destruction has been hard on the company’s shareholders and employees, they will generally free up investor funds to be allocated to companies deserving of investors’ money. The bailout of Bear Stearns and the government sponsored enterprises (Fannie Mae and Freddie Mac), while necessary, sent a message (and gave hope) to corporate boards that the consequences of being poor stewards of investors money could be blunted by the taxpayer. Hopefully, this will encourage greater diligence and responsibility. Ultimately, these events are good things for investors in the short term.
So, does this mean that I’m doing anything differently?
By and large, these recent events aren’t affecting my investment strategy. Most of what I’m updating has been little changed by the recent turmoil in the credit markets.
As I have stated pretty much consistently since last summer; I believe that large financial companies are likely to find growth hampered by both governments and investors. It is likely that smaller banks will benefit in the environment going forward. “Too big to fail” are words that no one wants to hear and capital is likely to be much looser for smaller private banks, which will likely dominate aggressive (and profitable) residential and small scale commercial lending. Credit markets are likely to be more discriminate over the next few years, but not completely seize up. This is basically a good thing.
Value indexes, dominated by banks and insurance companies, are likely to experience slower growth for the foreseeable future. And it is for this reason that I think growth stocks are likely to outperform value in the next market upswing.
I suspect that companies that don’t enjoy high levels of investor goodwill and without high levels of transparency in their earnings (e.g. insurance companies) will underperform companies with high visibility. For this reason, I’m recommending that clients reallocate their portfolios towards companies with solid names and positive public perception.
Because of lower accounting standards and more friendly relations with regulators, I suspect that the worst isn’t over for European and Japanese banks. Given the greater sensitivity to banks that the non-US developed economies have historically experienced, I expect that European and Japanese equities will underperform the US for the next few years.
Emerging markets are highly sensitive to credit, investor appetites and regression to the mean. I continue to believe that the risks outweigh the potential benefits of holding these companies and I am recommending that we significantly reduce exposure to these stocks for all, but the longest time horizon portfolios.
For investors in fixed income investments, I have favored cash over bonds for some time. This has been generally the wrong approach, as interest rates have continued to decline over the last year, increasing the value of bonds. But, at this point, I am not intending to change this strategy, as I still feel that investing in longer maturities simply doesn’t justify the risk and the consequences of holding cash over bonds has not been particularly dramatic.
For the truly aggressive, spreads on high yield bonds are looking attractive and it makes sense to start delving into these spaces if one can handle a rocky ride over the next few years. The same thing is true for (shiver) mortgages, which represent probably some of the best buying opportunities for the next several years.
I plan on touching base with all of our clients over the next few weeks to review their portfolios as we approach the end of the year, but, as always, please don’t hesitate to give me a call to discuss your portfolio before then.
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