"The Week That Was"

Sydney M. Williams

Thought of the Day

“The Week That Was”

August 16, 2011

While much has been written of the similarities between last week’s roiling stock market to those frightening weeks when the world’s financial markets seemed on the verge of collapse in 2008, what separates them is far more important. Over the course of five days, the DJIA traveled 2133.69 points (18.6% from the previous Friday’s close,) yet ended the week down a mere 175.49 points (down 1.5%.) It was like a trip through a maze, about twelve times longer than it had to have been.

During the tumultuous days of almost three years ago, weekly volatility was almost as marked as the daily. Over a period of nine weeks – September 29 through November 28 – the market never rose or fell less than four percent on a weekly basis. In one horrendous week, the one ending October 10th, the Dow Jones closed down 18.2%. What the two times did have in common is that they were man made, with Washington playing a major role in both.

Three years ago, the nation, and in fact the world, faced an unprecedented collapse of confidence in the global financial system. The TED spread (the difference between the U.S. Three-month Treasury and LIBOR had widened to 485 basis points, from its pre-crisis level of 50 basis points. High Yield Bonds were priced to yield 25%. By the end of December 2008, a month after the peak of the crisis, the spread between High Yield and Investment Grade Bonds was still at 1108 basis points. The spread between Investment Grade Corporates and the Ten-year Treasury was 419 basis points. The concern was not just bank liquidity, but bank solvency. The VIX during that fall traded over 85.
Today those spreads are, respectively, 24 basis points, 368 basis points and 231 basis points. The yield on the FINRA-Bloomberg High Yield Bond Index has backed up to 8.3%. We are nowhere near close to the fear that gripped markets back then. Bank liquidity is no longer a serious question. On August 8, the VIX traded at 48. What we are now facing is a collapse in confidence in a political system and the ability of the economy to overcome hurdles thrown in its path.

In the aftermath of the credit crisis, Congressional fingers had no shortage of targets at which to point – particularly at bankers and mortgage brokers, who certainly played a role and deserved censure and more. Unfortunately though Congress, which played a critical role in creating this environment of little or no accountability, served as prosecutor and had little interest in seeing itself in the docket. Additionally, they deemed it impolitic to blame something so amorphous as “society,” which would include the electorate. Yet Washington was a leading factor in terms of creating the conditions that caused the crisis – homes for everyone, funded by government sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac. The relationship between Congress and the GSEs was not only cozy, it was symbiotic. Worse, in their determination to make life as “fair” as possible, Washington created a denouement of irresponsibility. And the people followed their lead, taking on debt they could not afford.

Once the crisis began to fade, people noted that bankers were rewarded, not punished; many consumers who had overextended themselves were saved, in part by those who had lived within their means. As well, the prudent were “rewarded” with unusually low interest on their savings – the lowest in memory. Observers, watching this tale unfold, may well ask: what is the moral of this lesson?

Today the country is torn between two unattractive political alternatives: On one side, we have liberal Democrats who choose not only to maintain entitlements, but to extend them, as we saw with the unilateral passage of the Affordable Health Care Act and with the attempt to pass Cap and Trade. On the other side we have Christian Fundamentalist Republicans who leave no doubt that God is riding shotgun on their side, as they repeat their mantra – no increase in taxes.

The current tax system is an atrocity. It is far too complex. It is too narrow in its base. It favors the very wealthy and large business. It needs reform – it should be broadened and flattened with lower marginal rates. Deductions should be limited, which would cause the “coddled” Warren Buffett to pay higher taxes, assuming he doesn’t voluntarily make a contribution to reduce the deficit. (In 2010, the IRS received $2,840,466.75 in such voluntary contributions.) The tax system should encourage investment and discourage marginal consumption. The sanctimonious Mr. Buffett has enough money, but most of the estimated 80 million people expected to retire in the next several years do not. In my opinion, that factor will be the most serious problem the nation will face over the next couple of decades. Additionally, entitlements, left unreformed, will bankrupt the country.

Like those who were urged to look upon the works of Ozymandias, the stock market views the schizophrenic responses of politicians to this situation with despair. Assuming S&P 500 operating earnings estimates for 2011 of $100 are accurate, the market is selling at twelve times, indicating an earnings yield of 8%. That yield is slightly lower than that of High Yield Bonds, but substantially higher than Treasuries or Investment Grade Bonds – suggesting to those who measure such statistics that stocks are attractive. However, given that current interest rates have less to do with the free flow of capital and more to do with an activist Fed, one would have to discount that analysis, at least somewhat. To me the market seems fairly valued, getting pushed or pulled not so much because of fundamentals, but because of changes in perceptions as to what is happening in Washington. That is not to say there are no attractive stocks. There are. Many large multi-nationals sell at reasonable multiples with attractive and growing dividends.

Markets have been in purgatory since that collapse of the tech-internet bubble almost a dozen years ago. Each crisis assumes its own characteristics. But what we are now going through pales in comparison to 2008. Nevertheless, markets are likely to remain in a trading range, until a sense of confidence in the U.S. and our capital markets are restored. Given the current Administration’s actions (as opposed to speeches) and the crop of Republicans vying for the job, it seems likely to me that over the next few years we will continue to experience periodic repeats of the “week that was.”