back to blog homepage

Perspectives

ted-spread

Given today’s market selloff, I thought we should check out the TED Spread to see if this could turn into a full fledged crash and implosion of the financial system. As you can see, we are bounding along in a normal range and it is not flashing warnings like it did in 2008. We are seeing the margin clerks and machines in charge today, which is making things more volatile than we are used to, but we are not seeing a risk of collapse to the entire financial system that we saw in 2008 with the sub-prime crisis. That said, we added to gold miners a few weeks ago on a relative valuation basis – and as a risk management technique in case something crazy happened. Good thing we did since they are one of the few things up today.

I was interviewed a bit ago by Mary Lynn Foster on Connect FM 93.5/95.3 Radio relative to the S&P downgrade.

Here is a paraphrased transcript of that interview based upon the notes I was taking while we talked – I also added some other points not discussed on the radio that help flesh out the discussion. Mary Lynn’s questions are in italics.

What does an S & P rating really mean?

Standard and Poors is a ratings agency, among other things. This means they are an independent analyst that provides arms-length review of financial information and then provides a risk rating for the entity that is issuing debt. It’s not completely unlike how a bank reviews a person’s financial information prior to granting them a new mortgage.

When you buy a government bond, you are really making a loan to that government. S&P’s purpose, then, is to provide investors with some idea of what type of risk they will incur if they loan money to the entity that is issuing the debt. And those entities can be governments of countries like the United States, local governments like Champaign County, or publicly traded companies like General Electric.

How does that effect the U.S?

There can be many impacts, some of them that we won’t even understand for several months into the future.
Realistically, or at least theoretically, an investor that is taking on more risk requires more return. That could mean that our government might have to pay higher interest rates for the money they borrow when compared to when they had the highest credit quality rating of Triple A.

Getting away from theory, though, if you look at Japan for instance, they were downgraded several years ago and their interest rates are half of what ours were at Triple A. So, much more goes into interest rates than a simple bond rating.

In our case, because we have to issue so much debt to fund our deficits, we could likely see a bigger impact from our lenders – specifically China – demanding higher interest rates in order to continue to buy our bonds.

More than anything though, this is a major tarnish to our image. From a hopeful standpoint, maybe this will be the catalyst for our politicians in Washington to admit their policy errors over the past couple of decades wherein they drove our debt to unsustainable levels through profligate spending beyond our means.

The best thing we can hope for out of this situation is that it leads to comprehensive reform of all spending priorities and our tax system, from defense to entitlements and to a tax system where everybody pays their fair share and loop-holes and special breaks for political contributors and key constituencies are eliminated.

The worst thing that could happen is that we stay on the current trajectory, continue to add to the debt, have the Federal Reserve continue to buy what we can’t sell the rest of the world, and never seriously address the problems that are keeping unemployment high, economic growth low, and that will eventually lead to serious inflationary issues.

How does it effect us?

For you and me, the real impact will be on whether interest rates rise because of the theoretical impact of investors requiring additional return for additional risk. Those interest rate increases can impact interest rates on everything from home mortgages to credit cards to bank deposits. But again, there are significantly more important factors in the level of interest rates than the S&P rating on government debt.

As far as people’s 401k’s are concerned, there will always be ups and downs. The absolute worst strategy anyone could take is to sell everything today based upon the knee jerk reaction of the market to this news. By adding money on a set schedule to an investment portfolio and buying through the ups and downs of the market, over the long-term people are able to accumulate a significant amount despite the swings.

However, everyone should be prudent and periodically look at their investment allocation between stocks, bonds and cash equivalents, and as they begin to approach retirement they need to reallocate their holdings into a more conservative portfolio allocation. That way, when we have news-driven selloffs like we have currently, the overall impact to equity portfolio value is mitigated.

How are the markets reacting today?

The stock and bond markets are down, but gold and gold miners are up.

This is a classic case of risk avoidance, and my best assessment is that the stock market will be down for a day or two because of this, but this is not the beginning of a major 2008-level correction.

To have a 2008-level correction or crash, you need for the economy to be heading into recession and for corporate earnings to be falling (or have the financial system imploding, but the TED Spread is not indicating that this is the case, even with the level of stress caused by the European debt situation).

If you look at the leading indicators, we just don’t see that at this time. If you look at the earnings that were reported by General Motors and Ford, you see that there is a major recovery in the auto sector underway which means the consumer is not completely pessimistic about the future.

If we were going into a recession, you’d see Fed Ex deliveries falling, rail car deliveries falling, sea container shipments falling, etc. None of that is happening at this time. Plus the stronger than expected July non-farm payroll number shows that we might see an increase in the economic growth numbers reported in the next few months than people are currently anticipating.

My best assessment is that we will continue on with a slow-growth economy for into 2012, and that the stock market will move higher in coming weeks or months reflecting further growth in corporate earnings. However, if a recession does develop sometime in 2012, look for a major pull back in the stock market – I know we will be raising cash in our clients’ accounts as the market recovers into year-end as one of our standard risk-management practices.

What should we be thinking about for our money now?

The first and best rule is “Don’t Panic.”

As computers do more and more of the trading for mutual funds and hedge funds, the volatility that we have seen in the past few days will continue – to the upside as well as the downside. Market swings that used to take weeks to play out will take (as we’ve seen) days or even hours instead.

Instead, looking at corporate earnings growth is the key. If earnings are growing and the market is fairly valued, then you can feel fairly safe buying stocks. However, you have to have a long-term horizon if you want to own stocks – I always counsel people to keep a rolling seven-year horizon for their stock portfolio. If you need to liquidate your assets within seven years, stocks are not the investment for you.

As far as our current strategy for our clients’ equity portfolios, we have been using the current selloff as an opportunity to add to companies with strong earnings, strong financial statements, and share-holder friendly policies in anticipation of a recovery from the current sell-off. And then, as noted earlier, we will likely be raising cash as we assess the likelihood of a mid-2012 recession based upon some of the leading indicators I previously mentioned.

““““““““

As you know from following the blog, I was on vacation for three weeks traveling around Europe, specifically the Balkans. As I read through local English language newspapers, I got a feel for how bad things really are in Europe compared to how they are reported here. I conferred with John and Charlie about various investment matters while I was away, but the key thing impacting us on a going forward basis is debt – both here and abroad.

For those of you that remember my year-end newsletter entitled 2011: A Debt Odyssey, you know that I was concerned that debt would rule the direction of our country and the financial markets in 2011 and beyond. If you’d like to re-read it, or for that matter read it for the first time, you can find it at this link:

2011: A Debt Odyssey

I will be back at the blog in coming days with greater details on our specific activities relative to the current market sell-off.

But I wanted to leave you with one perspective from my trip.

In the early 1990’s, war was rampaging through the Balkans, and the town of Mostar in Bosnia was the front line of the fighting. There was a bridge that was constructed in the 1400’s that connected two sides of a river gorge and advanced a trade route through the Balkans. It survived numerous wars, including WWI and WWII, but was destroyed as the Catholic Croats and Orthodox Serbs tried to divide the Muslim Bosnia and add it to their territories. You will recall that President Clinton had us join in to stop the tragedy, and the Dayton Accords ended the armed conflict, but not before the bridge was destroyed.

Below is an eight minute BBC film on Mostar the bridge that you might want to watch – including the destruction of the bridge. I am a firm believer that if we don’t understand history we are bound to repeat it.

Here is the rebuilt bridge today, a UNESCO World Heritage site:

Mostar Bridge Rebuilt

Managing money in today’s world requires an understanding of its inhabitants. For me, the best way to understand part of the world and how it impacts potential investment opportunities or current portfolio strategy is to be there and learn about it.

The importance of the Balkans is its impact on the wider European investment landscape, whether it’s the assassination of Arch Duke Ferdinand that initiated WWI or the 1990’s war that you can experience on the video above – or even the riots in Greece in which I got a bit of flavor as you can see in the photo below, we cannot invest our clients’ money living in a vacuum. It is critical that we understand how varying parts of the world can impact corporate earnings or investor sentiment and so much of the potential impact comes from the history and culture of a region which is best understood face-to-face discussing it with those who live it.

Athens Riots

Did I find any specific companies to invest in on this trip like I have when traveling in Singapore or Switzerland? No. But I did learn more about the European debt crisis, European’s view of our own issues, and the emerging markets of Eastern Europe – three valuable things that I believe our clients will benefit from in the future.

Mark

PS – thanks to John and Charlie for their posts on the blog in my absence. I hope that you will soon see their input on a more frequent basis.