If by some chance you were visiting another planet last week, you might be wondering what all the fuss is about. For the uninformed, it was just another week of stock market recovery and positive gains for portfolios. How would you have any idea that to generate those gains the market would experience historical volatility that included a brush with financial Armageddon?
What’s that you say? Something about an experiment in socialism? Oh, that’s right, there was that itty-bitty item of a massive government bailout of Wall Street and the banking sector in general. Never mind the details, we made money right? Who cares what happened in the market on the way to profit, right?
In most cases, that would be the answer to that question. Most long-term investors really needn’t be worried about daily gyrations in the market unless there has been a dramatic change in underlying value or economic circumstance. Well, I hate to be the bearer of bad news, but what transpired last week rises to the level of where you should care… and care deeply. As some say, we are living and breathing a 100-year event (see also, “AIG Armageddon“).
The question now for investors is what should we do now?
What to Do Now
Obviously, the market was very bullish on the plan in the short- term. We avoided the abyss in the short run, and given that stocks were down and falling further we did seem to avoid a much larger drop (see “Profit as Lehman Folds & Merrill Disappears“). The question I have for you is how close did we come to the abyss? The answer to that question is quite important and should provide a clue as to what we should do going forward. If we were that close to calamity, how in the world were stocks able to perform as well as they did early in the week?
There was a huge disconnect between what was happening in the stock market versus what traders experienced in the credit markets. The credit market appeared to be trading on fear and fear alone, as investors scurried away from risky money market investments and into Treasury bills. The rush was so great for Treasuries that at one point during the week, the yield on those T-bills was negative!
Think about that for a minute.
Investors were willing to pay a price in return for knowing that principal would be returned. That move, mostly by very large institutions, created a chain reaction that ultimately resulted in the government rescue (see also, “Global Revolt Melts Down U.S. Financials“). The big issue is that lending, including the commercial paper market, essentially ceased to operate. That meant that companies depending on…> such financing to cover short term operating costs risked being left without the cash needed to pay bills.
Without that cash, the lights would go dark, and payrolls for some would not be met. Mass unemployment would ensue, and people would end up marching in the streets. It would be complete and utter chaos. I can understand much of the phony indignation regarding the dramatic government intervention that we saw over the weekend, but please spare your complaints about the bailout. Spend one week in the abyss, if that were ever possible, and I guarantee you will be begging out in no time no matter the implications!
It is clear to me that the stock market really missed the boat here with respect to proper pricing of this catastrophic event. Given that the stock market is inefficient, that should not really surprise anyone. Essentially, if we were indeed that close to the abyss, stock prices should have fallen much further than they did. And even more disconcerting, is that the market appears to be saying that the bailout will be a slam-dunk victory thus the rally on Thursday and Friday. I’m not so sure of that success.
The price for cleaning up this mess will be astronomical—that much is clear. Part of that price will come right out of GDP and will most likely result in a deeper recession than previously thought. There is no simple way out of the mess. Yes, our economy is strong, diversified and resilient. We can make our way through this, but not without some pain (see, “How to Turn Bad News Into Profits“). That pain could very well be lower profits and as a result, lower stock prices. The game has been changed, and I would contend that the market has not yet factored in the full impact of paying the bill or, god forbid, failure of this plan.
Does that mean you should sell stocks? In my opinion, the uncertain price of the bailout and how it impacts corporations increases the risks of owning stock. It may make sense to lighten up your positions until the future becomes a bit clearer. Some are claiming that the cost of the bailout at the $700 billion mark would equal a bit more than $2,000 for every taxpayer in the country (so much for those rebate checks!) And it was the rebate checks that helped keep stocks higher during the summer. The absence thereof could mean the reverse.
I do not think it would be inappropriate to reduce your exposure at these levels. I will be doing just that with my Rational Investor model portfolio and I would suggest that you do the same.
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