If past market indicators are to be believed, the bottom of the stock market slide is likely close, according to a panel of renowned experts compiled by the CFA Institute. The problem is that this downturn is unprecedented in how it behaves, so it’s not out of the realm of possibility things could get worse.
However, it’s hard to imagine things getting worse. There’s still the Great Depression scenario, which gives some insight into what a continued decline in equities and the economy could bring about. An assembled panel of experts at the CFA Institute’s Global Financial Crisis Roundtable in New York was adamant things are not heading in that direction, even if this downturn is the worst since the 1930s.
“I’ve been in this business for four decades, and I used to say nothing could be as bad as 1973 (and) 1974. I can’t say that anymore,” said Theodore R. Aronson, CFA and managing principal and founder of Aronson+Johnson+Ortiz. “This is about as bad as it gets, and it’s certainly the case for more than 99% of the operators on Wall Street. How much worse can it get? Anything can happen. There is no bottom on this market. It could keep going down with the same sort of volatility it has recently. I personally don’t think it will, but it could.”
Abby Joseph Cohen, CFA, president of the Global Markets Institute and senior investment strategist at Goldman Sachs, believes the markets may be nearing a bottom, but the economy is likely looking at a major slowdown for at least the next two quarters.
“In our Goldman Sachs forecast for quarterly economic growth, we believe the economy is at its worst right now; GDP decline in the fourth quarter of 2008 and the first quarter of 2009 will be dreadful,” she said. “However, we could see stabilization and some glimmer of growth by the end of 2009. For those of you who think that’s not a very long recession, let’s keep in mind that as the National Bureau of Economic Research says, a recession has already been underway for a year.”
Cohen believes the market has already priced in the bulk of the bad news. “Even assuming the depths of recession we’re forecasting, we believe that an even uglier scenario is priced in the markets. Not in every market and every asset category, but we are seeing that there is value being re-established.”
What’s happening is the emotional and irrational devaluation of some securities, Cohen notes, as fear and panic-selling kick in. She says rather than looking at the fundamental valuations on many securities, emotion is forcing sellers to make decisions on arbitrary factors, like who holds the security. She believes this was a big factor in the recent selling of a large swath of money market funds in the U.S.
“There wasn’t anything wrong with the money market mutual funds or the assets they held. Rather, there was pressure on the holders,” she explained. “One of the things we have been seeing is price-insensitive selling, and we need to explore that further.”
Jason Trennert, managing partner and chief investment strategist of Strategas Research Partners, agreed with Cohen’s evaluation of the economy. He said things will get worse on the economic front because this recession is different from past recessions. In the past, consumer spending has been a key drag on the rest of the economic environment. This recesson was sparked by a financial crisis, which usually occurs at a later stage in the economic cycle.
“Normally what happens is consumer spending weakens first, and bank profits are actually pretty good. That weakness in consumer spending impacts corporate profits, then impacts bank profits, which in turn affects accessibility of credit. Then capital spending and employment [erode],” he explained. “This cycle started with an almost exogenous impact on bank profits. Until relatively recently, there was not much of an impact on consumer spending. Most of those indicators were relatively strong compared to other recessions.”
Trennert says there is a silver lining in the current downturn in unemployment figures. If history is to repeat itself, markets drop well before a peak in unemployment rates.
“In the last three cycles, the unemployment rate cycle lasted about 40 months, and, on average, the market bottomed at 30 months in that. Right now, we’re in about the 26th month in the unemployment rate. I think we are getting very close to seeing the ultimate bottom in the market,” he said.
The market is currently pricing in a 21% default rate on corporate debt over the next few years, which exceeds that of the Great Depression.
Martin S. Fridson, CFA and founder and CEO of Fridson Investment Advisors, warned that there will likely be an unprecedented spike in defaults as deleveraging continues. He noted Moody’s has predicted that the corporate default rate will skyrocket from 3% to 11% over the next year.
At the highest risk level of the high-yield index are securities yielding a 1,000 basis points spread over treasuries. Traditionally, this group is a relatively small proportion of the index. Fridson highlights this group has exploded over the past year.
“In early 2007, the percentage of issues in the index of that category was 1%. It’s now gone over 80%. Default rates on bonds in that category are now at a one-in-four probability of default within 12 months,” he says. “The market is signaling over 20% default rate, over the next year. We probably are going to see higher levels of default, not because we’re going to see a depression, but because of the underlying mix of assets of the related securities. In the corporate area, as well, the quality of the mix of the high-yield index is much lower than it was as recently as 1990.”
Fridson says forced selling by institutional investors, like hedge funds, may put additional undue downward pressure on some higher-quality issues, but he believes the risk priced into the market is ultimately warranted.
“(The) market does a pretty good job in estimating the default rate of securities,” he says.
Casting a pall over the discussion was moderator and Wall Street Journal personal finance columnist Jason Zweig, who suggested there is really no historical precedent for how far and fast the U.S. stock market has dropped.
Zweig says his initial research showed that the drop in 2008 as of November 20 was the worst drop since 1926. In fact, if the November 20 year-to-date losses hold, 2008 would be the worst year in the New York Stock Exchange’s 194-year history.
“Earlier in November of 1931, the stock market was down about 16% on two weeks, about 40% in one year, almost exactly as it was in (November of 2008). The numbers were as close to identical as you can possibly imagine. For the rest of 1931, the market lost another 20%. Then it went on to lose another 48%, until it finally hit rock bottom on July 8, 1932. When you ask how bad can this get, (history suggests) it really could get a lot worse.”
 | Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com |