Here are Larry Swedroe’s thoughts on the credit crisis and the steps that are being taken to kick start the economy. For those of you not familiar with Larry, read the disclaimer at the bottom of the post. Also, Larry just published a brand new book titled, The Only Guide to Alternative Investments You’ll Ever Need*.
Probably the question I am asked most goes something like this: “Buy and hold has worked in the past, but this time is different. Why can’t this be like the Great Depression?” I answer the question by stating that there is certainly the risk that this can turn out to be like the Great Depression. There are always risks when investing in stocks. That must be the case or stocks would provide the same return as Treasury instruments. And that is true regardless of the investment horizon. And it is important to remember that there are only three types of forecasters: Those that don’t know where the market is going, those that don’t know they don’t know, and those that know they don’t know but get paid a lot of money to pretend that they do. Thus, investors can only control the amount of risk they take, not the returns they earn. With that perspective in mind, it is important to understand that there are dramatic differences between then and now. Consider the following:
The policy responses to the Great Depression were to raise interest rates and to raise taxes. We learned from those policy mistakes. And while most economists believe that this crisis is the worst we have faced since the Great Depression, it is important to keep in mind that the policy responses to counter the problem have also been, by far, much greater than in the past.
The Federal Reserve acted quickly to not only dramatically lower interest rates, but they also have provided the market with tremendous amounts of liquidity—using their expanded powers to rapidly expand their balance sheet. In addition, through the TARP program the government has injected a huge amount of capital into the banking system in the form of direct investments. And on the 25th the Fed announced that they would buy about $600 billion of Fannie Mae and Freddie Mac mortgages. That had the immediate and desired impact of lowering interest rates on 30-year mortgages by 88bp to 5.5 percent. In addition, they announced major programs to support the ABS (asset backed security) market a market that had been virtually brought to a dead stop. It set up a $200 billion program to support consumer (credit card, student, and auto) loans and small-business loans. It also stated that this was just the beginning of its efforts in these markets. But that was not all. The Treasury also announced it would provide $20 billion of “credit protection” to the Fed using funds from the $700 billion financial-rescue package. The Treasury said in a statement that the facility might expand over time and cover other assets, such as commercial and private residential mortgage-backed debt. This is extremely important, as the spread on ABS versus Treasuries, which, before the crisis began was typically about 0.5% had risen to about 7.5%. This move will not only bring liquidity to the market it should result in much lower rates. This will allow the Fed to leverage those funds (perhaps at a 10:1 multiple) and buy assets, using the capital as a first layer of loss protection. (In other words, the Fed has now become a big hedge fund).
In addition, The Federal Deposit Insurance Corp. last week finalized its Temporary Liquidity Guarantee Program, or TLGP, creating a window of opportunity for banks to issue government-guaranteed debt—easing strains that kept them from even the normal process of refinancing maturing debt for months, and that were crimping their ability to lend to consumers and businesses. Goldman Sachs became the first to take advantage of that when on the 25th they sold $5 billion of debt maturing in June 2012. Goldman sold the notes to yield 3.37 percent, or about 2 percent more than 3-year Treasury debt. That is about 5 percent less than the spread on Goldman’s non-guaranteed debt. Note that since the note is guaranteed by the Treasury, there is no credit risk. Despite that, it is still yielding 2 percent more than a similar Treasury bond. That is a measure of the extent of the liquidity crisis (the only difference between the two issues is liquidity)—it is still a large problem. Note that investors that don’t need liquidity can earn large liquidity premiums without taking credit risk by investing in debt that is the same credit quality as nominal Treasuries (such as the Goldman notes and TIPS).
In total the Treasury has now directly or indirectly assumed obligations of about $7.4 trillion. To put that in perspective, that is approaching half the size of the GNP.
On top of all of this, the government will almost certainly deliver a massive fiscal stimulus program in the near future (probably no later than January). And the U.S. is not alone with its policy responses. Almost all of the major central banks are cutting rates and governments are enacting stimulus programs. Earlier this week Switzerland lowered rates 1% and on the 26th China followed suit.
As you can see, while the policy responses to the Great Depression were actually in the wrong direction, the actions being taken today are not only in the right direction, they are massive in scale—in proportion to the size of the problem. Thus, it seems the risks of a repeat performance have been greatly diminished, if not eliminated.
While it will take a while for the economy to feel the full effects of these efforts (and more are on the way), it is important to remember that financial markets are forward looking. Thus, it is certainly possible that we may have seen the worst. Possible, but not certain.
Because it takes time for policy responses to impact the economy, it is likely that investors will continue to be bombarded with bad news on the economy——such as the announcement on the 25th that housing resales fell over 3 percent in October, leaving supply at 10.2 months (normal is about 5 months), and the Case Shiller index of home prices showed prices are down almost 17 percent in the last year. On the 26th, the durable goods number was down 6.2%, or twice what was expected. And consumer spending fell for the fourth month in a row. October saw a drop of 1%, the largest drop since the period following the event of September 11, 2001. And the FDIC reported that the number of troubled banks jumped 50% to about 175. However, it is important for advisors to remind investors that financial markets are forward looking. And because that is true, stocks have historically provided their best returns just when the economic situation seemed darkest. That is the reason Warren Buffett concluded that temperament is more important to successful investing than intellect.
With Buffett’s insight in mind, I will conclude by relating an incident that was reported to me by an advisor who had done all he could to try and convince his client that he had a well-thought-out plan that anticipated this type of bear market and that he should stay the course. On Thursday the 20th, just before the largest two-day rally in history, the client called to say he just could not take it any more and demanded that the advisor sell everything. He had reached his GMO (Get Me Out) point. On the Tuesday the 25th, following the rally, he called again to admit he was wrong. He admitted that there was nothing the advisor could have said to convince him to stay the course but he has now learned it was a mistake and he promised never to repeat it—he had reached his GMBI (Get Me Back In) point. Let’s hope he does not now get whipsawed. This tale demonstrates the importance of disciplined investing.
Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide to a Winning Investment Strategy You’ll Ever Need* (2005), What Wall Street Doesn’t Want You to Know* (2000), Rational Investing in Irrational Times – How to Avoid the Costly Mistakes Even Smart People Make Today* (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest* (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need* (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).
His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.
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