Protect by planning, not predicting.
Though some do a great job playing market timers on business TV, with the assistance of sound horns and theatrical performances, the advice granted is not worth the damage to our eyes or ears. Timing short-term markets is a loser's game. Let's be honest with ourselves - we really don't know.
The problem with forecasting short-term market movements is that even if you get the economic event right and Lady Luck kisses you on the cheek and you nail its timing, the market may just spit in your direction and chose to ignore it until a later date.
Last summer, for example, the housing bubble finally burst, bringing toxic waste (subprime) loans to the surface. Credit markets froze - and you'd think the stock market would decline? No, the Dow went on to make an all time high, hitting 14,000 and ignoring the problems for months.
Let's leave the market timing to the media, take a drink of cold water and approach forecasting the right way. Even a long-term investor has to recognize that long-term consists of a series of short-terms. We have to accept that we probably won't get the timing right, adopt an "I'd rather be vaguely right than precisely wrong" attitude, focus on identifying shorter-term risks and stress test our portfolio accordingly.
It would be careless to dismiss the possibility of a recession (some argue that we're already in a recession). Past recessions were caused by excesses of inventory and overcapacity in the corporate sector. As corporations rationalized their inventories and factories, higher unemployment followed - we were in a recession. Excesses were worked out, corporations started to hire, and voila - we were out of the recession.
This time around the seeds of the recession were planted by the American consumer, the mighty force responsible for two-thirds of the U.S. Gross Domestic Product, or GDP. Betting against the U.S. consumer was a losing bet; time after time they've pulled us from the edge of recession, putting the economy back on the growth track. You could knock the consumer down, but he kept getting up.
Consumers are exhausted from relentlessly carrying the U.S. economy on their backs through good and bad times, but thanks to low interest rates and promiscuous lending standards that helped to create the housing bubble, consumers are also heavily leveraged.
Median wage growth has been lagging economic growth, and consumers have responded by spending their wealth - borrowing against it. If consumers' household debt had continued to grow during the 2000s at the same (low) rate it did in the 90s, spending would have been several trillion lower. This is the excess that needs to be worked out this time around.
Today consumers' biggest asset -- the house -- the source of confidence and cheap financing, is on the decline. Consumers are up to their ears in debt. As a percent of GDP, it has ballooned from 68% of GDP in 2000 to close to 100% today. Despite lower interest rates, the household debt burden (percent of our discretionary income that went to interest and principal payments) went up 16% from 12.3% from 2000 to 14.3% in 2007.
The financial system, the oil on the wheels of capitalism, is strained. Escalating defaults from housing and consumer loans, which are spreading beyond subprime, have triggered a chain reaction in defaults and downgrades in complex, opaque, leveraged but highly rated at the time (not anymore) collateralized securities.
Many of these securities were also insured by mono-line insurers such as MBIA (MBI) and Ambac (ABK), and thus insurers are teetering on the edge of going under. Although rating agencies maintain their view that MBIA and Ambac are highly rated, their respective debt is traded as if it were junk. Thus, credit problems stemming from defaults have the possibility of reaching levels we haven't seen before, already being supplemented by the loss of trust in rating agencies and a crisis of confidence in financial markets.
The Federal Reserve and politicians are "coming to the rescue" with rates cuts and tax rebates, and they may manage to bail out the economy. There is a very real risk, however, these actions will only postpone the inevitable (a recession) but won't cure it. The Fed's intervention by lowering rates may also create bubbles in other asset classes, as it did in the housing sector after the post-2001 rate cuts.
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