Is the Worst Over?

(Written November 2009)

The stock and bond markets are indicating that we may have seen the bottom of this economic cycle. The markets are reacting to indication that the stimulus efforts may be working. Bad economic news comes less often and in many cases the numbers are improving. But is the worst over?

With the sharp rallies off the March 9th lows, the summer and fall seem to be giving way to a more somber view of a potential recovery.

Consumers continue to cope with near double digit unemployment and the ongoing recession while trying to salvage what they can of retirement and investment accounts. The U.S. auto industry operates as a former shell of itself, but manufacturing overall is showing some signs of stabilization. Banks and financial institutions still face pressures but posted substantial earnings recovery.

Economic data remains mixed and often contradictory. One must have faith in the ability of the U.S. economy to return to sustainable growth.

The tough part is the not knowing which way the economy and consequentially the stock market will move and over what length of time. No one has a crystal ball, but now being warier and wiser, we can look toward what’s on the horizon.

How It All Started

It’s hard to pinpoint the beginning of the financial crisis. The first signs appeared in late 2006 and 2007 when sub-prime mortgage lenders started going under. The government recognizes the problem and in 2007 began a series of moves to shortstop the growing number of mortgage defaults.

Through the fall of 2007 and into 2008, the government was actively injecting money into the banking system while simultaneously lowering the interest rate.

The Bank of America’s Jan 2008 purchase of Countrywide Financial, the country’s largest sub-prime lender, made BoA the nation’s largest mortgage lender. While mortgage defaults were in the news, this event put the issue on the front page and highlight for most Americans the seriousness of the mortgage defaults.

Then beginning in Jan 2008, banks began to fail. One in January, another one in March followed by two in May. JPMorgan Chase & Co. acquired The Bear Sterns Corporation in March 2008 at a fire sale price. And then the failure of Indymac Bank, on July 12th, 2008.

Many believe it was the failure of Indymac Bank that started the banking dominos to start falling. The failure of Indymac is widely blamed on Senator Chuck Schumer (D) New York who purposely leaked an internal memo on June 26th, 2008 calling into question Indymac Bank’s viability. The discloser resulted in an eleven day run on Indymac resulting in the withdraw of more than $1.3 billion dollars.

John Reich, the director of The Office of Thrift Supervision at that time directly placed the blame for the bank’s failure on the comments made in Senator Schumer’s letter. Indymac Bank was not a poster child of how to run a bank and may well have failed at a later date. And maybe not. We will never know. But at the time Indymac was the most expensive bank failure ever.

Blood was in the water and the Wall Street sharks began to circle Fannie Mae and Freddie Mac. Short sellers, who profit when the price of a stock falls, attacked these financial giants along with other large banks driving their stock price into the ground. One name that stands out is George Soro, the billionaire who broke the bank of England in late 1992 with his shorting the sterling. Soro takes major short positions in US and European stocks, the dollar and 10-year Treasuries. The book he published in April 2008 along with his many appearances on financial shows and written commentary help his positions become big winners.

And then came September 2008, the most harrowing month of all. Fannie Mae and Freddie Mac are placed under government control. Bank of America takes over Merrill Lynch and Lehman Brothers files for Chapter 11 bankruptcy. The consumer starts noticing things were not right and stopped spending which sent demand into a free fall. Washington Mutual Bank failed in September and twelve more would fail before the end of the year.

The U.S. stock market bottoms on March 9th, 2009 down 56.78% from the October 2007 high.

Getting Our Bearing

So where do we go from here? No one knows for sure except we do know that the business cycle and the economy move in a constant pattern of up and down cycles. If the pattern holds true then we should be looking at a gradual if uneven recovery. This will ultimately lead to yet another sump. Like waves on the ocean, you cannot prevent naturally occurring events.

But the one thing we did learn is that the world economies are much interwoven. The U.S. sells raw material and finished products to other countries who in turn sell us raw materials and their finished products. The U.S. is not likely to experience sustained consistent growth without the same occurring in other countries.

What we want to do is avoid overacting to the latest sentiment. Many investors now want a more actively managed portfolio which implies that somehow one can foresee which way the market will move. The best evidence that market timing is a bad idea is the market’s recent behavior. Very few people predicted the crisis. Of those who did, most have been predicting it for years. Peter Lynch famously said, “Far more money has been lost by investors preparing for corrections or anticipating corrections than has been lost in the corrections themselves.

The Road Ahead

There are investment strategies to consider going forward. The first step is to look at your overall investment portfolio within the context of a financial plan. We shouldn’t be focusing on individual investments or the hot sectors.

We do want to hedge the potential inflation risk by considering precious metals and high yield bonds. Diversification is a technique to help reduce risk, but there is no guarantee that diversification will protect against a loss. When the boat is sinking it doesn’t matter which seat you are in. You will still get wet.

We shouldn’t depend solely on the U.S. economy to drive our portfolio. Having a position in specialty sectors like emerging markets, consumer stables, science and technology in additional to the U.S. overall market will help to ensure your portfolio has a chance of growth.

In this era of American economy, investors chart their courses. Consumers set aside more savings. Workers value their jobs more than ever. The greatest cause for optimism may be that we’re grinding through this recession. This is a good thing.

Written by David Snellen.
© 2009 USA Living.com, Inc.