Lately, the financial markets are burdened by numerous contradictions and conflict, resulting in serious head-scratching and risk-aversion on the part of investors. The latest round of volatility is causing many to consider throwing in the towel completely.
Consider these head-scratchers:
• Mortgage rates are at a 50-year low, yet the housing market is still severely depressed.
• Ten-year Treasury yields hit a record low last week even though the government just experienced a downgrade in its credit rating and it is running trillion-dollar annual deficits.
• Gold prices hit a record high last week even though gold pays no interest and the core inflation rate is running below 2 percent.
• The value of the dollar fell to a record low against the Japanese yen last week even though Japan has been mired in a slump for 20 years and “Japanese government debt is more than double the Euro Area average and more than double the US,” according to Jim O’Neill at Goldman Sachs.
Sources: Bloomberg, MarketWatch
The situations described above suggest there are “distortions” affecting the markets that may not be explained by modern portfolio theory.
One distortion that has clearly impacted the markets is government policy and intervention. In just the past three years, we’ve seen the $700 billion Troubled Asset Relief Program (TARP), the $787 billion American Recovery and Reinvestment Act, the Federal Reserve’s zero interest rate policy, and the Fed’s QE1 and QE2 bond purchases. All these have generated numerous market side effects.
In addition, a major argument is unfolding between politicians who believe government intervention is necessary to prevent an even worse downturn and those who believe the free market should be left to fend for itself. Some politicians are even calling for the abolishment of the Federal Reserve.
A similar situation is playing out in Europe. For more than a year, European governments have scurried from one bailout strategy to the next in order to prevent a sovereign default.
All these distortions and philosophical debates are, not surprisingly, causing confusion in the financial markets. The result — a stagnant economy and falling stock prices.
The denouement of these interventions and political squabbles remains unknown. What we do know is, we can continue to plan wisely and do all we can to keep our individual goals and objectives on track.
As stock prices decline, does overall risk go up or down? The answer may surprise you.
Let’s start with a definition. For our purpose, we’ll define risk as the probability of losing money. With that shared definition, let’s look at the S&P 500 index. On October 9, 2007, it closed at an all-time record high of 1,565. On March 9, 2009, it closed at 676, which was a 12-year low, according to CNNMoney.
Now, was it riskier to own stocks when the S&P 500 was at its all-time high in 2007 or its 12-year low in 2009?
Intuition and hindsight tell us owning stocks at the all-time high was much riskier. Why? Because stock prices proceeded to fall by 57 percent over the next 17 months, while prices rose about 100 percent over the next two years from the 2009 low.
Money manager John Hussman framed it this way in a May 23 commentary, “As valuations become rich, risk increases, and as valuations become depressed, risk declines. At the same time, rich valuations imply weak long-term prospective returns, while depressed valuations imply strong long-term prospective returns.” In plain English, he’s essentially saying as stock prices go up, risk goes up, and as stock prices go down, risk goes down.
Warren Buffett was even more succinct. In an August 11 Fortune Magazine interview, he said, “The lower things go, the more I buy.”
It may go against human nature, but the lower prices go, the less risky they become and the more likely you are to experience strong long-term prospective returns, according to Hussman and Buffett.
For investors who are saving for retirement or simply trying to preserve their wealth, seeing lower stock prices is no fun. However, assuming you don’t need to sell today, what matters is what prices will be in the future when you do sell. And, with prices dropping now, it may be setting the market up for better returns down the road.