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MAKING CENTS OUT OF THE NEWS
Blog #26
(August 14th, 2011)
1987 All Over Again?
By Tom McAllister, CFP®
These past two weeks the stock market reminded me more of 1987 than 2008.
Following 60 days of “sloppy markets” in the summer of 1987, stocks suffered a 22% drop in one day. All this was followed by a quick market recovery, and for that year, the market finished up 4%! There were the usual assignments of blame quoted in the press at the time, but, looking back, the real reason for the crash of 1987 was investor panic. That panic was exacerbated by the then-new computerized trading programs, which had been triggered automatically and which had begun to feed upon themselves. (The exchanges and regulators fixed that problem with “circuit breakers” and that particular phenomenon has not since recurred.)
Returning to the present, in the past weeks the market has dropped 15%, featuring much volatility, with sharp “ups” and equally sharp “downs” and causing considerable discomfort for investors.
The two primary reasons for the present discomfort are the loss of confidence in our Washington political leaders, and repercussions among the weaker members of the European Common Market as they respond to mandatory cutbacks in government entitlement programs.
Let’s talk about those government entitlements. No welfare state can sustain the process of taking wealth from the more affluent and redistributing it to the less affluent. Sooner or later many of the more affluent stop playing the game. They move, retire, stop expanding, or just quit! This is where many of the European countries now find themselves, after decades of socialist experimentation with the “rob Peter to pay Paul concept.” Politicians, of course, can always count on the support of “Paul” for these programs, while “Peter” eventually focuses on tax avoidance schemes or just quits the game.
It appears that the U.S. and its political allies are ignoring what has been happening to the European democracies relative to government entitlements. In so doing, I believe they are jeopardizing the underpinnings of this country. Over the past hundred years, we have become the most powerful and wealthy country in the history of the world. Yet with our government’s increasing pervasive attempts to redistribute the “economic pie”, including constant interventions and roadblocks to our private businesses, and new regulations at every turn, all of those accomplishments are at grave peril.
During the past week, I came across an interesting analogy. Shrink the federal budget to reflect an average lower-income family and see what it looks like. Drop eight zeros from our national income and we come up with $24,500 annual income. But our hypothetical family spends $38,500. The family charges their $14,000 deficit to their credit card, on which it already owes $143,000! Meanwhile the husband and wife are quarrelling bitterly over whether to reduce future deficits by $560 or just $300. This is our government’s problem in miniature. It simply cannot continue. Those purchasing our debt will inevitably look at these numbers and go elsewhere!
Due to the nature of the current U.S. crisis, the financial weapons we used during the crash of 2008, just won’t work in the event we slip into recession now. Because there are no real excesses in our economy other than the huge and rapidly expanding debt, I judge the chances for a new recession at only 25%. Yes, consumer confidence has been weak for several months now and obviously has dropped even more these past few weeks. A turnover in national political leadership in November of next year could cure many of the current and impending problems.
Commenting on the market, Warren Buffett once said, “We have usually made our best purchases when apprehensions about some macro event were at a peak.” It appears to me that we currently have two macro events unfolding at the same time.
a) The U.S. equity risk premium (the comparative return on stocks as compared with Treasuries or cash is huge. We can buy the stock of large American corporations at very cheap prices right now.
b) The recent stock market crash — and the concurrent collapse of bond yields -- has many people believing the U.S. economy is headed toward a recession. The capital markets seem to be pricing in a dramatic slowdown from the current sluggish pace of growth.
We need to remember: the markets are not the economy and the economy is not the markets. The most significant indicators, (lagging, coincident, and leading), are NOT flashing a recession. We need to remember, too - the stock market discounts the economic future twelve to eighteen months ahead.
I committed my own cash reserves to the market last week, I urge my readers to do the same.
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