In recent months, the equity market has experienced extraordinary volatility. A steady dose of gloomy economic indicators, combined with outright fear, have led many investors to flee the stock market in favor of treasury securities and cash.
The best strategy investors can deploy during uncertain financial times is to remain patient, stick to long-term objectives and mitigate risk through diversification.
“Long-term investors should focus on maintaining a broadly diversified portfolio that reflects their specific investment goals, risk tolerance and investment time horizon,” says Richard Cunningham, managing director of investment consulting services for Comerica Bank.
Smart Business spoke with Cunningham about the current state of the equity market, the effects of the credit crunch and how to best strike a balance between risk and return.
What are some of the primary factors behind the equity market’s recent volatility?
From a fundamental perspective, the recent dislocation in global equity markets can be attributed to the increasing recognition that the major developed economies are contracting and the fact that financial sector crisis will lead to a massive deleveraging process. Both factors will ultimately create a negative feedback loop for the growth in corporate profits, which is the primary driver of equity prices. A key concern for investors is that the enormous debt levels in the U.S. will continue to suppress economic growth for some time. In particular, with consumers seeing a significant decline in the wealth due to falling home prices and stock prices, there is the potential for a significant retrenchment in consumer spending, which represents 70 percent of GDP. Credit expansion has been a primary driver of economic growth this decade, pushing private sector debt to record levels. Credit as a percentage of GDP in the U.S. is currently about 180 percent. In 2000, that number stood at 120 percent. Even a mean reversion would have a significant impact on credit, debt and spending.
In terms of what’s driving the recent day-today volatility, both the hedge fund sector and mutual fund complex are experiencing significant redemptions. For example, hedge funds, which control about $1.8 trillion in assets, have experienced close to $200 billion in redemptions in the past month alone. Some experts think that by the end of this year we could see one-half trillion dollars in redemptions across the hedge fund complex.
What specific moves led to this crisis?
The financial crisis was created by a perfect storm of mutually reinforcing trends and policy mistakes that have been in place for several years. The epicenter of the credit crisis was the bursting of the housing bubble, which led to the collapse of Bear Stearns last March and subsequently resulted in solvency risks across the entire financial sector. In July, we saw the ‘nationalization’ of the two GSEs Fannie Mae and Freddie Mac. However, the catalyst for the recent turmoil in the financial markets was the decision by the regulators to allow Lehman Bros. to fail, which served to expose the systemic risk across the global financial sector.
From a macro perspective, the Federal Reserve’s monetary policies have been a contributor to multiple asset bubbles in the U.S. We saw a technology bubble in the late 1990s, a housing bubble that collapsed in 2005 and 2006, a bubble in commodities in 2008, and a super-debt cycle over the past 20 years that has created significant leverage.
Another contributing factor is that many financial institutions, both in the U.S. and overseas, made the decision to leverage up their balance sheets supported by real estate assets and securitized mortgage portfolios. This was very profitable when home prices were rising, but when the subprime market collapsed, financial institutions suffered massive losses.
How do you anticipate the bailout plan will affect the market?
Short-term, the $700 billion bailout plan combined with the related guarantees of deposits and money markets was a necessary step to address the immediate solvency concerns and bring confidence and stability into the credit markets. The capital markets were essentially closed to the financial sector. Long-term, whether the funds will be sufficient to address the capital impairment of the financial sector will depend upon the economic outlook and asset prices. To the extent credit markets begin to function normally, that will be a net positive for equity markets.
In the current environment, how should investors go about striking a balance between risk and return?
A successful long-term investment plan should be based upon a disciplined strategic (and tactical) asset allocation plan, including diversification across multiple asset classes, high-quality investments and tax efficiency. Typically, we recommend stocks for long-term growth, bonds for income and capital preservation, and alternative investments for an absolute return strategy. Also, adequate cash balances should be maintained. Right now, as of late October, we believe that the risk/reward profile for U.S. equity markets is more attractive than it has been for several years. However, at the end of the day, each investor needs to consider his or her overall strategy and goals.
RICHARD CUNNINGHAM is managing director of investment consulting services for Comerica Bank. Reach him at (415) 477-3234 or email@example.com.