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More Pain, Then Pleasure (Maybe)

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Hindsight may always be 20/20, but in these market and economic times, the cognoscenti seem to agree that even perfect vision and an understanding of the past may not help us see through the blurry present into the future. In fact, the consensus of the market gurus who contribute to Investment Advisor’s monthly Asset Allocation page is that this environment is not at all similar to other historical financial crises–at least not similar enough to take lessons learned from the past and apply them now.

“All happy families are happy in the same way and all unhappy families are unhappy in their unique way,” notes David Kelly, chief market strategist for JPMorgan Funds, quoting a line from Leo Tolstoy’s Anna Karenina. “That’s kind of how it is with this financial crisis–if it was comparable to another, then we’d know how to get out of this, and then people wouldn’t be so scared about what’s happening in the short run.” Mark Balasa, principal at Balasa Dinverno & Foltz LLC and spokesman for the elite Alpha Group, agrees, “The S&P numbers are comparable to 1973-74 and 2001-02,” he says. “But what’s not comparable is how broad it is outside of that–even bonds are down.”

Faced with rising unemployment, corporate bankruptcies and fire sales, the credit freeze, seemingly unprecedented market volatility, a recession that’s finally been formally acknowledged, and plunging portfolio values, our intrepid panelists were asked to share with us their top worries, offer some sensible solutions, and suggest how to handle portfolios as we begin a very uncertain 2009.

More of the Same?

“The perfect storm of financial market meltdown, credit freeze, and economic contraction are meeting head-on in a period of political transition and regulatory overhaul,” the Securities Industry and Financial Markets Association (SIFMA) said in its latest economic outlook in mid-December. The upside is that some combination of cheaper credit, increased government backing of corporate debt, and an economic stimulus plan (or plans) that President-elect Barack Obama has pledged might lead us out of the recession as early as the third quarter of 2009, as many of our panelists believe. However, uncertainty looms large. “My biggest concern is that it’s not at all clear how big and wide this recession is going to be,” says Lincoln Anderson, chief economist of LPL Financial. “Anyone who says they are on top of it is out of their minds.” So what should advisors and their clients be watching? What should they still be worrying about?


“Very often you can measure the depth of any recession by the level of unemployment that you suffer through,” says Gail Dudack, principal of the Dudack Research Group. “My fear is that the unemployment rate will get higher and fall on top of what was not really a strong employment market–that is behind a lot of the consumer fear that you see.”

Government Ineptitude

My biggest concern is that the continuing stream of the financial crisis will not be contained by Washington’s efforts,” says Gary Shilling, president of A. Gary Shilling & Co. Balasa takes it a step further. “There have been mistakes,” he argues, “and government involvement is one of them.” With the rescue of Bear Stearns, many in the industry assumed that any troubled financial services firm larger than Bear would be considered by the Treasury and the Federal Reserve as too big to fail. “But then within a month or two they allow Lehman Brothers, which is much bigger in size, to go under,” laments Balasa. Like many advisors, Balasa was left wondering what the “rules” are. “They are clearly being made up as we go along, and it’s hard to make decisions–I don’t know how to apply the lessons yet,” he says.


Kelly compares his current worry–deflation–to an insidious disease. “It makes monetary policy pretty powerless and also leads to higher unemployment, but the biggest problem is that it encourages a ‘Wait and see’ mentality; we are in danger of becoming a ‘Wait and see’ economy,” he explains. With high unemployment rates and falling prices, consumers are waiting to buy that new house or car, and corporations may be delaying a decision to hire someone. “When everyone wants to wait and see, what they see is no good–it’s the perils of procrastination,” Kelly says. “You get rewarded for waiting.”

Lack of Trust

Every panelist interviewed mentioned mistrust as a worry. “The credit markets and the lack of trust have bled everywhere,” Balasa points out. “And it’s not only a mistrust of those on Wall Street that created a lot of this carnage, but it has spread into the Big Three [auto makers], and even Congress and how they handled the legislation around TARP.” Anderson says such fear is justified. “Consumers need to be shown a much more transparent and legitimate set of business models with a lot lower leverage and they are likely to get that,” he says. “And secondly, a financial structure and regulatory environment that gives investors confidence and a sense that this is not likely to happen again is needed–I think they are likely to get that, too.”

Dudack believes that once the psychological aspect of mistrust shifts, the recession will be even more likely to end. “The one thing about recessions is that they can feed on themselves, or they can be reversed in terms of consumer psychology, so it’s pretty important,” she says.


Shilling believes excess home inventories are a major problem at this point. “We estimate that there are 1.7 million extra in inventory still out there and they are the mortal enemy of prices. In other words, as long as you have that excess, you have downward pressure on house prices, which puts more people under water, with their mortgages exceeding their house values,” he explains. This, in turn helps to lower consumer confidence and spending. Shilling estimates that house prices that are now down 21% will be down 37% peak to trough, putting U.S. homeowners under water on their mortgages to the tune of $1 trillion. “The point is,” says Shilling, “when people are under water they have tremendous incentive to walk away from their houses and then those houses are resold at huge write-downs, which depresses prices even further.”

Looking Ahead

If that’s the bad news, and the indicators to watch for signal that the recession may linger, are there signs of hope on the horizon that the recession may be shorter and milder? Here’s what our gurus said could facilitate a return to growth.

New Administration

Barack Obama’s election and inauguration later this month will have an effect on the markets and the economy, our panelists suggest. “I think that so far he’s done a very good, pragmatic job and the markets have responded accordingly,” notes Dudack. “You can tell by the response in the markets to his Cabinet appointees.” Kelly believes that Obama’s new Cabinet members are a promising bunch. “Clearly the people he’s chosen are very experienced, intelligent, serious people,” he says. “I think everyone in the country wishes them well in this endeavor–we’re all in this boat together.” Anderson concurs. “I think he’s made good choices. I think Geithner was a very good choice for Treasury Secretary, especially since you need continuity and he’s been working hand and glove with Bernanke and Paulson.”

Stimulus Package

The catalyst for making the current economic situation better is the next stimulus package, which will be focused on improving the country’s infrastructure, according to Dudack. Kelly also sees its importance, but cautions against just pouring money at the problem. “I think the right way to do this is to give people incentives to spend money themselves,” he says. “I have nothing against infrastructure spending, but I think we need a balanced approach. It’s got to be designed to give people incentive to spend money now, specifically on cars and houses.” In fact most of our panelists say that they will know we are coming out of this recession when car and home sales begin to rise.

Reworking the System

“I think we’re going to be redesigning the financial system to have much greater transparency, much lower leverage, and much more conservative financial structures,” Anderson says. Although these fixes may be part of the solution, they also come with a price. Anderson says the downside with those changes would include the loss of several innovative investment techniques, and the fact that a lot of useful hedging strategies will become much more heavily regulated, which may cause some of those strategies to go away. “The lower leverage means that it will be more difficult to get financing for sometime, as well,” he adds.

When Is the Pain Going to End?

About half of our panelists believe the recession will start to turn around by the third quarter of 2009 with a return to positive GDP. The other half are split between the economy reversing course by nearly 2010 and uncertainty over when the recession will end.

“Next year we may see some improvement in the first half of the year related to the [effects of the] stimulus package, part of which may be implemented as soon as the end of January,” Dudack says. “In other words, they are looking to give the economy a shot of adrenaline early in the first half, so I think that we may see better economic activity again in the first and second quarter.” Her forecast, however, is not a steady stream of negative GDP. “It’s more complicated than that and we’re not likely to come out of it until early 2010.” Between now and then, Dudack says we may slip into negative or flat growth again in the second half of the year. “And that’ll be very disappointing to a lot of people, but it is all part of the cleansing process to get rid of all the excesses.”

Anderson predicts a deep recession in the first quarter with about a 5% GDP decline. “Then we’ll start to maybe moderate into a 2% to 3% decline in the second quarter, and we may get back to zero in the third quarter,” he says. In the fourth quarter of this year, he expects to see some small growth.

Kelly breaks up his predictions into a best- and worst-case scenario. Here’s the best case: “The new Administration gets in, puts out a stimulus plan, which causes housing and auto sales to pick up and GDP begins to grow in the second quarter of the New Year,” he says. “The unemployment rate peaks out at between 7.5% and 8%, but by the second half of the year the economy is growing rather rapidly.” The worst case is predictably bleak: An all-year recession throughout 2009 with unemployment rates going up to 10%. The ever-bearish Shilling believes that if the current problems of unemployment and the housing market can be contained, we might begin to see the economy stabilize by 2010. “If not, then this could continue through 2010 and who knows how far beyond that,” he says.

Finding a Safe Haven

Although there is no “safe” place to be right now in terms of investing, absent those low-yielding Treasuries and managed futures, there are some places that are somewhat safer than others. Dudack says that in an environment where earnings are at risk, investors want to go for the most predictable revenue streams, such as dividend yields, “so that tends to focus my attention on healthcare, utilities–as long as they are not energy-trading companies–consumer staples, and some technology service companies.” She thinks the best investments are stocks that have a dividend yield greater than the 10-year Treasury bond, and where the dividend is safe. “Clearly, that excludes all the financials and the auto stocks–you shouldn’t be going for the biggest yields when they are at risk,” she adds. Balasa recommends “the obvious Government bonds” as a safe place to be, adding “if I were a long-term investor still saving, I think the markets are a safe place to be going forward.” In Shilling’s portfolios “we’re short commodities, long the dollar, and short stocks.”

Kelly takes a different view and says looking for a “safe place to be” is a dangerous action. “People have to look at what their goals are when they think about safety,” he says. “A lot of people have lost a tremendous amount of money in their 401(k)s and real estate, and if they are one of the fortunate few to live to a ripe old age, they don’t have enough money to make it.” Although he pegs the least volatile sectors as cash and Treasuries, “those may be the most dangerous sectors for somebody who doesn’t have enough money and has to find a way to grow their money over the next few years.” Instead, he advises to look carefully at the time frames. “If the money they are investing today is money they don’t intend to touch for the next five years or more, then I would be over-weighted in stocks–national and international, high-yield bonds, and maybe high-quality corporates.” He also suggests investing in some of the very things that have gotten beaten up recently. “Eventually the economy will turn and markets will stabilize and these will do the best,” he adds. As for retirees, Kelly suggests having some money in equities and high-yield bonds, as well as maintaining some money in a more stable fixed-income area.

All in all, the panelists agree that if clients find themselves short on cash, they have to make lifestyle changes to accommodate the shortfall, and those are the toughest. “Part of being a good advisor is telling people when the numbers don’t add up, and for many people, the numbers don’t add up,” Kelly says. The changes could include working longer before retiring, dialing back their lifestyle, selling off a second home, or leaving less money to their grandchildren. “The job of the advisor is to help people make logical decisions on how to invest in this environment, but also, if need be and the numbers don’t add up, to help people make logical decisions about lifestyle choices to enable them to make the best of a bad situation,” Kelly concludes.


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