Year 2008 started off poorly and has continued to get worse. From the beginning of the year through January 22, the S&P 500 (a measure of large cap stocks) is down nearly 11%, and the Russell 2000 (a measure of small cap stocks) is down more than 12%. In reaction to the sudden downturn in the equity markets, the worsening credit crisis, the fall in home prices, and, most importantly, the likelihood of a slowing economy, the Federal Reserve (the Fed) in an emergency meeting cut short term interest rates by three-quarters of a point on January 22 from 4.25% to 3.5% in an attempt to stem the tide. Based on activity in the futures markets, it is likely that the Fed will implement another 25 to 50 basis point reduction in short-term rates at its regularly scheduled meeting next week. In addition to the action by the Fed, both the President and Congress are working on an economic stimulus plan, but whether it will prevent a recession remains to be seen.
Key Points to Consider
We believe that the markets have probably over-reacted. And yes, the economy is slowing, but there are some positives that have been overlooked by many in the media:
Interest Rates Reduced
With lower interest rates, banks and other financial institutions, which have been hardest hit during the recent downturn in the stock market, will again be able to start making profitable loans by borrowing at lower short-term interest rates and lending at higher long-term interest rates. This is the classic profit model for banks. In addition, it appears many of the major domestic banks have written off most of their bad debt and cleaned up their balance sheets, which should translate into better stock performance. We expect to see hefty write-downs from non-U.S. banks. Financial stocks took a beating in 2007, and managers we know and respect are becoming excited about new opportunities.
Inflation continues to be benign. Most of the inflation that we have witnessed over the past few years has been in the form of commodity inflation, as demand from overseas has pushed up prices. The good news on inflation is that wage inflation appears to be minimal. With the threat of an economic slowdown, any significant wage inflation is unlikely anytime soon as companies will attempt to contain costs as sales may decline. The decline in the U.S. Dollar has translated into an increase in exports and has resulted in a slight increase in inflation. Also, the downturn in the housing market has acted as a counterbalance, keeping overall inflation in check.
Interest rates coming down precipitously may jump-start a stalled housing market as buyers will now be able to get loans at rates much lower than they were a year ago. In fact, mortgage refinancing has increased dramatically over the past two months. Additionally, with many adjustable-rate loans about to reset, the drop in rates means that the increase in monthly payments after the re-set may not be nearly as steep as it would have been just six months ago. In fact, monthly payments may actually decrease. Potential lower monthly payments may help an already overextended consumer.
Our Thoughts Going Forward
With equities nearing official bear market status (defined as a 20% drop from its peak), we remain cautiously optimistic as valuations are becoming attractive again. With the Fed committed to lower interest rates, long-term investors should not be panicked as a correction such as this actually creates new opportunities. For those with money on the sidelines, we recommend averaging into positions over time to lessen the effect of any short-term volatility.
If you have any additional questions, please don’t hesitate to give us a call at 303-694-1900. In addition, please see the links below for commentary from leading financial institutions on the current state of the markets.
Director of Research