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How bad will it get, ask investors? Here’s one answer

Are we in the midst of temporary troubles or the start of something worse? It’s really all a matter of managing risk, says this U.S. advisory.

“Investors struggle to answer this question: How bad will it get?” That question could have asked any time this week by many investors. In fact, it was asked just before this week’s shakedown on the markets.

It appears at the beginning of an article in Bob Carlson’s Retirement Watch entitled “Good News, Bad News.” While the bad news seems to have pretty much hogged the stage this week, nothing is more valuable now than taking a balanced, realistic view of the markets.

Before we continue with Mr. Carlson, we will pass on the advice of the experts we consult here. A realistic approach to the market does not consist of selling in the midst of a general panic. Investors who sell into the market now are almost sure to lose — and pay for the privilege, in broker’s fees, on the bid-ask spread and on any dividends they might have been collecting.

Remain calm and you have lost nothing. If you have stocks you really don’t trust any more, get rid of them in an orderly fashion. But hang on to your good stocks. They’re not going anywhere but back up. You may want to buy more shares while they’re cheaper.

That is the view from here. Trust us, this advice will not change the next time the market trembles, or the time after that.

Now on to Mr. Carlson who, remember, was writing just before this latest blow up.

The original culprit

In response to the “How-bad-will-it-get” question, Mr. Carlson reckons investors must struggle for an answer throughout the coming year.

The original culprit in this mess, the housing situation in the U.S. and its doleful trail of bad mortgages, is still causing trouble. Mortgage delinquencies are at 20-year highs and foreclosures are right behind. Credit rating agencies are busy downgrading both mortgage securities and the companies that insure mortgage-backed bonds and municipal bonds.

“The good news is the housing-related problems still have not caused serious problems in the rest of the economy,” says the editor. “GDP growth has declined but not enough to indicate a recession, at least not yet. Retail sales are holding up.”

There’s another bit of good news as well. There is still plenty of liquidity in the financial system. Many investors, says Mr. Carlson, are willing to purchase mortgages and other assets. They are simply waiting for prices to fall further.

Some sales have already taken place. E*Trade, which took an enormous hit in the market, sold itself to a hedge fund. Homebuilder Lennar sold itself to an investment group. “But most sellers are unwilling to sell at prices buyers are willing to pay. The bottom will occur when buyers and sellers agree on prices and make deals.”

A history lesson of sorts

History gives us an indication of where we may be just now, says Mr. Carlson. But we should be careful not to rely too much on historical precedents.

“Despite the rhetoric of the most bearish analysts,” he says, “the total losses from this crisis are unlikely to be worse than those of the S&L [Savings & Loan] crisis of the late 1980s or the financial crisis of the 1990s.” And there’s a significant difference. “In addition, the risks are widely dispersed among investors worldwide, not concentrated among major U.S. financial firms as in the past crisis.”

This may not be much consolation to the likes of heavily battered Citigroup, but it does spread the pain around.

Although history repeats itself, it doesn’t do so in cookie-cutter fashion. Things do change. “We cannot rely on history to analyze today’s situation,” insists Mr. Carlson. “Analyses of today’s market that rely on history should be followed skeptically.” The current crisis makes a liar of history.

Most credit crises occur when central banks raise interest rates and tighten credit. Then it eases rates to spur a recovery.

This time it was the other way around. This one started when consumers couldn’t pay their debts, even in a healthy economy. Right on cue, the Federal Reserve Board stepped in to lower interest rates. But the affect can only be described as underwhelming.

Even with lower interest rates, defaults and foreclosures kept on coming. “The financial situation deteriorated with unemployment low and wages growing at a solid rate.” Historically, this doesn’t make sense. Except in one way: even prime or high quality borrowers are starting to default on loans. People have simply taken on too much debt.

Will the usual tools work?

The other signs of a poor economy are not present, adds Mr. Carlson. The spreads between yields on corporate and high-yield bonds on the one hand and treasury bonds on the other are just average, not at the wide spreads that signal a recession.

In fact, the housing and credit crisis does not appear to be affecting the rest of the U.S. economy. But this raises an unsettling thought, because it also means “the Fed’s usual tools might not work if things get worse.”

Interest rates are already pretty low. If falling consumer spending leads to higher unemployment and other symptoms of recession, the Fed may be stuck sitting on the sidelines, its ammunition already spent.

At this point, Mr. Carlson observes that the major indexes have continued to trade at near record levels, bouncing back after 10 per cent corrections. This week’s events will test that assumption severely.

But there are several reasons not to expect the worst.

An odd rescuer

“There are two factors keeping a floor under U.S. markets and the economy,” asserts Mr. Carlson. “One factor is that the global liquidity boom primarily caused by savings in emerging market economies still is intact. The slowdown in the U.S. is not yet hampering growth in Asia.”

Then there is that rather odd rescuer, the weaker U.S. dollar. “The second factor is that the weak dollar is attracting foreign investors to U.S. assets, including stocks. They are starting to view the dollar’s decline as an opportunity to purchase assets cheaply.”

Since Mr. Carlson’s advisory is called Retirement Watch, we would not expect him to be fond of taking big risks. You would be right. “As always, we look at risks in the market and try to avoid those we do not want to take. We have benefited from investments based on the global boom, a declining dollar, and limited, hedged positions in U.S. stocks. These remain the best investment themes.”

Unlike some other analysts, the editor is not anxious to go bargain hunting during the current crisis. “There is a temptation to step in and buy investments that declined substantially in 2007. But we have to be aware of the potential for financial conditions to continue deteriorating, keeping investors seeking safety.”

The danger remains, he adds, that investors will unload all risks as they did this past July and August. As if on cue, we have seen a fair bit of unloading this past week. “We will avoid investments that do not have margins of safety in case there is another round of unpleasant surprises.”

A safe landing is a good landing

We will conclude with Mr. Carlson’s observations on the oft-debated question of whether a troubled economy can be brought in with a soft landing or a hard landing.

The editor’s response: “Pilots will tell you any landing you can walk away from is a good landing.”

It is simply too difficult to try and answer questions about hard or soft landings and try and trim your portfolio accordingly, says Mr. Carlson. Instead, try to manage risks in the market. Are you more concerned with avoiding risk now, or capturing gains in the next market rally? Either way, make your portfolio fit your aspiratioins. “The portfolio should be subject only to the risks you are willing to take.”

Think of it this way: if your portfolio has been carefully prepared to account for potential risks, all this market madness is somebody else’s problem.