What's Next for the Economy: Stocks vs Bonds (Marketwatch)

Bonds and stocks diverge on U.S. economy
By Nick Godt, MarketWatchLast Update: 4:20 PM ET Sep 9, 2009


NEW YORK (MarketWatch) -- For those investors who believe the stock market works perfectly at discounting risks and rewards, the U.S. economy and corporate profits must seem to be on track for a stellar recovery.

After a spectacular 50% surge since March, stocks on the S&P 500 Index ($SPX) have continued rising through the summer and into September.

Yet, the market for U.S. government bonds, considered among the safest assets around, seems to be telling a different story."There is a growing group of people following the view that we'll have a jobless recovery in the economy," said Bill O'Donnell, head of Treasury strategy at RBS Securities.

"They're asking what comes after the sugar-high from the government stimulus measures, and what they see is rising joblessness, consumers spending less and lower inflation. All in all, good conditions for bonds."

On Wednesday, U.S. stocks continued to advance after the Federal Reserve's so-called Beige Book of current economic conditions. The central bank said the economy is improving across most U.S. regions but that consumer spending remains sluggish.

The Dow Jones Industrial Average ($INDU) finished up 49 points, or 0.5%, at 9,547. The Nasdaq Composite (COMP) was up 22 points, or 1.1%, at 2,060, while the S&P 500 gained nearly 8 points, or 0.8%, to 1,033.

Separately, Treasurys turned higher after the Beige Book and after the government's auction of $20 billion worth of 10-year notes was met by ample demand.

Demand for benchmark 10-year Treasury notes surged over the past month, sending their yields (UST10Y) down by about 40 basis points. Bond yields move inversely to price.

Government bonds provide fixed income over periods of time. This means that longer-dated bonds, such as the 10-year note, are more susceptible to inflation as fixed income loses value if prices rise in general.

When bond prices rise and their yields fall, it generally means that the chance of rising inflation is waning -- along with the outlook for economic growth.

Who's right?

Unfortunately for stock investors, bonds have often provided a better gauge of economic trends than equities. A recent example was when Treasury yields began sliding in June of 2007, as defaults on subprime mortgages surged and deteriorating credit conditions led fixed-income investors to seek safety.

Yet stocks continued to rally for another four months, reaching record highs by the middle of October 2007 before taking the big plunge. In those four months, the yield of the benchmark 10-year Treasury bond had already slumped by about 70 basis points.

Perhaps similarly, yields rose sharply for most of this year, as investors abandoned the safety of bonds and jumped into the massive equity rally. But over the past few months, yields have started to slump again.

Strong demand for even shorter-dated maturities, such as the 3-year notes sold at a government bond auction on Tuesday, is now raising doubts about the economic outlook among a number of market strategists.

"What does it say about the view on economic growth that there is such big demand for the 3-year note?" asked Peter Bookvar, equity strategist at Miller Tabak, in a research brief.

"Why isn't this money going into riskier assets? Again, it's another data point of the disconnect between the U.S Treasury market and equities," he said.

The visible hand of government

"The government has got a heavy hand in this recovery," says Jack Ablin, chief investment officer at Harris Private Bank.

Ablin does believe the economy and stocks are still running on the "sugar high" provided by government spending. However, while the bond market may be looking further ahead when the economy might run out of momentum next year, he doesn't believe stocks have to come down.

"There's still 10 donuts in the box [out of 12]," Ablin says. "We've only spent about 10% of the $800 billion or so committed. "The government is still spending a lot of money and that's going to be reflected in the economy and profits at least for the next couple of quarters."

And corporate bonds also continue to improve steadily, he noted.

Meanwhile, government bonds may simply have become a good bet again because of the lack of inflation in the outlook for the economy.

With the government raising close to $2 trillion to help shore up the economy, and as markets took the view back in March that those measures had helped avoid the worst, Treasurys seemed to be a bad bet for most of the year, and yields surged along with stocks.

Some of the hesitations on the way up were that government spending would pressure the dollar and boost inflation, and that raising money might become harder as buyers of U.S. debt, including foreigners, would become more scarce.

But while the dollar has returned to its lows of the year, few believe inflation is in the cards as long as the economy continues shedding jobs, and consumer spending, which makes up for about 70% of the economy, remains muted.

And judging by the results of this year's auctions, demand for U.S. government bonds remains strong.

For Ablin, if there's one area where a weak dollar has led to too much speculation, it's commodities, including gold topping $1,000 an ounce.

"I'd think twice before melting down your Rolex," Ablin said.

Stocks - some realistic expectations (WSJ Opinion Page)

MARCH 30, 2009

How Long Until Stocks Bounce Back?
Even the best-case scenarios will require years.

By PETER J. TANOUS
Investors have breathed a world-wide sigh of relief in the waning weeks of March as equity markets have shown signs of upward vigor. The question now being bruited around the financial centers of the world is: Have we hit bottom?

No one really knows, but that is likely the wrong question. More important to investors than the date we hit bottom is how long the recovery will take. How long will it take for investors to recoup the losses they suffered since October 2007, when the S&P 500 index reached a record high of 1565? Here's a clue: It will take longer than you think. Let me explain.

Let's assume that we have already seen the market bottom and that it occurred on March 9, 2009, when the S&P 500 sank to 676. A return to the lofty level of 1565 reached 18 months earlier requires a stock market gain of 131%. How much time might that take? What if it took five years? I can hear the cries already: "Five years? To recoup the losses we sustained in only 18 months? That's terrible!"

We should be so lucky. You see, if we were to get back to the old high in five years, that would suggest an annual return of over 18% for that five year period. There are few periods in stock market history when the market rose 18% for five years. The last such period was in the late 1990s at the tail end of the Internet boom, which was followed by three years of consecutive stock market declines in 2000, 2001 and 2002. Given the history, a five-year recovery period, far from being terrible, is probably wishful thinking.

More realistically, what if, starting now, we began a munificent period of rising stock prices over a multiyear period of, say, 11% a year? If that happened, it would take eight years to get back to the October 2007 highs. To put all this in historical perspective, the average annual return for the S&P 500 over the past 83 years, since 1926, has been 9.7%. If the market rose at that historic rate, it would take more than nine years to get back to the October 2007 highs.

What is the lesson from these sobering statistics? The recovery in stock prices is likely to take much longer than we had hoped, and investors should taper their expectations accordingly. Raising the risk level of your investments to accelerate gains will set you up for even greater losses if your risky investments don't work out. Instead, allocate your assets wisely and be mindful of the risks in the different asset classes you choose.

The good news is that stocks will recover. It just may take longer than we expect.

Mr. Tanous is president and CEO of Lynx Investment Advisory LLC in Washington, D.C. He is the author of many books including "The End of Prosperity: How Higher Taxes Will Doom the Economy -- If We Let It Happen" (Threshold Editions, 2008), co-authored with Arthur Laffer and Stephen Moore.

from Sunday's NY Times - A Long Term Investment Perspective

January 11, 2009

The Way We Live Now
Go Long

By ROGER LOWENSTEIN

In October, Columbia University’s business school honored its most famous investing guru, Benjamin Graham, with a series of panel discussions loosely connected to the market crash, which was then accelerating. The panelists, of which I was one, had contributed to an updated version of Graham’s 1930s textbook, whose signature themes are caution, avoidance of speculation and — at all costs — the preservation of capital. The day we met, the Dow Jones industrial average fell 350 points en route to one of its worst months ever.

J. Ezra Merkin, a Wall Street sage, noted philanthropist and professional money manager, seemed to embody more than any of the other panelists the fear that was gripping traders. When it was suggested that the government should stop intervening in markets and bailing out banks, Merkin rejoined that the system had cracked and desperately needed help. As the world now knows, Merkin had entrusted close to $2 billion of his investors’ money to someone even less dependable than the Dow — that is, the accused Ponzi artist Bernard Madoff. I have no reason to think that Merkin, at the time, had any knowledge of the fraud that was soon to secure his 15 minutes of fame, but that afternoon at Columbia now seems pregnant with latent connections. Perhaps Madoff’s investors lost a greater percentage of their money, and lost it more suddenly, than the rest of us. But beyond these mere matters of degree, is there really any difference?

At least for investors of attenuated time horizons, there is not. Public-securities markets are a wondrous artifice precisely because they offer permanent capital to industry and short-term liquidity to investors. Think about it: a General Electric or a Google sells stock to the public and then retains the proceeds — the capital — indefinitely. Even if the companies earn a profit, by selling more light bulbs or Internet ads, they are under no obligation to pay out the gains in dividends. How, then, do the shareholders claim their reward? Why, by selling their stock to other investors, of course. This means that, in the short term at least, each investor is dependent on the willingness of other investors to hop on board. If other investors go away, prices (even of solvent companies) plummet, to devastating effect on those who sell.

In a Ponzi scheme, there is no G.E. or Google underneath the pyramid: only air. Outgoing investors are paid from the money put up by new ones. And the game for Madoff ended, as Ponzi schemes always do, when he ran out of suckers.

In theory, stocks and bonds are more valuable than air. But when investors get hooked on trading securities (as distinct from owning them), especially ones that are overvalued, they are courting disaster. In retrospect, this was true of the legions that invested in mortgage-backed securities and in the banks that owned them, not to mention the many other companies affected indirectly. Nobody was thinking about what these companies were worth, only about the next quotation on the screen.

This was doubly true for the banks that held those wearily complex and difficult-to-value mortgage bonds. Look at the post-mortem issued by UBS, one of the world’s largest banks, which has suffered mortgage-related losses of some $50 billion (enough to bail out the auto industry several times over). Discussing one particular write down, the bank admitted, “The super senior notes were always treated as trading book (i.e., the book for assets intended for resale in the short term), notwithstanding the fact that there does not appear to have been a liquid secondary market.” Legally, UBS was a bank; conceptually, it was investing with Bernie Madoff.

There is, of course, an alternative to this madness. Which is to invest for the long term, independent of the market action on any given day or year. This is what most small investors pretended, and maybe believed, they were actually doing.

Robert Barbera, the chief economist at ITG, an investment firm, says there are really three schools of investing. There are people who think they can identify superior stocks and bonds over the long term and selectively invest in those that they deem to be undervalued. Second, there are people who recognize that they don’t have this ability and resolve to salt away a fixed portion of their savings, month after month, in a generic and diversified portfolio. Though the first approach requires considerably more talent and is not recommended for novices, both should work.

What does not work is believing you are following either strategy No. 1 or 2 when you are actually engaging in the third approach — which is, essentially, following the crowd, day by day and hour by hour. At the top of the market, investors told themselves they were disciplined and in for the long haul. Now they are selling or refraining from investing. Some misjudged their liquidity needs and have come under pressure to raise cash; others have simply lost heart. Either way, they are dependent on new money to come in for them to get out.

Benjamin Graham’s premise (which he did not abandon, even in the depths of the Great Depression) was that, sooner or later, markets will reflect underlying corporate values. Thus, he wrote, long-term investors had a “basic advantage” over others, because they could ride out bubbles and crashes rather than be gulled during such highs and lows into, respectively, buying or selling. In other words, for those who invest with prudence and an eye toward long-term values, the market need not be a Ponzi scheme. While stocks periodically go for roller-coaster rides, the earning power of the U.S. economy, albeit with serious fluctuations, endures. The people who chased unrealistic returns at the top, like those who are selling now, have simply cashiered their “advantage” to play a game that more nearly resembles Bernie Madoff’s.

Roger Lowenstein, an outside director of the Sequoia Fund, is a contributing writer for the magazine. His most recent book is “While America Aged.”

Outlook for 2009 from RGE monitor - predicting a LONG Recession

RGE Monitor - 2009 U.S. Economic Outlook

Christian Menegatti, Arpitha Bykere, Elisa Parisi-Capone and Mikka Pineda | Jan 7, 2009

It is clear that 2008 was not a very good year and it is official that the current U.S. recession started already in December 2007. So how far are we into this recession that has already lasted longer than the previous two (1990 and 2001 recessions lasted 8 months each)? We believe the U.S. economy is only half way through a recession that will be the longest and most severe in the post war period. U.S. GDP will continue to contract throughout 2009 for a cumulative output loss of 5% and a recession that will last close to two years.

One last look at 2008 will reveal a very weak fourth quarter with GDP growth contracting -6%, in the wake of a sharp fall in personal consumption and private domestic investments. We see the real GDP growth contraction playing out through the year as follows: Q1 2009 -5%; Q2 2009 -4%; Q3 2009. -2.5%; Q4 2009 -1%, adding up to a yearly real GDP growth of -3.4% for the U.S. in 2009.

Personal Consumption

The resilient U.S. consumer started to give up in the third quarter of 2008, when for the first time in almost two decades, personal consumption contracted. With personal consumption making up over two-thirds of aggregate demand, the outlook for the U.S. consumer is at the center of the dynamics that will play out in the real economy in 2009.

In our view, personal consumption will continue to contract throughout 2009 quite sharply as a result of negative wealth effects from housing and equity market losses, the disappearance of home equity withdrawal from the second half of 2008, mounting job losses, tighter credit conditions and high debt servicing ratios (the debt to income ratio went from 70% in the 90s, to 100% in 2000 to 140% now). This retrenchment of the U.S. consumer will result in a painful rebalancing in the economy that will eventually restore the saving rate of a decade ago.

The wealth losses for households related to the fall in home prices are roughly $4 trillion so far, and are clearly bound to increase further as home prices continue to fall –eventually reaching the $6-8 trillion range (compatible with a 30-40% fall in home prices peak to trough). With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500bn. And negative wealth effect from fall in equity prices – on the wake of a bleak 2009 for corporate profits – will also contribute to the contraction in personal consumption by an estimated $100bn (compatible with a 25% contraction in the stock markets).

This adjustment is consistent with a rebalancing of the economy that will over time bring the saving rate to a positive level of roughly 5-6% where it was a decade ago, for this to happen consumption has to contract by an amount close to $800bn.

Housing Sector


The 4th year of housing recession is well on course.

Total housing starts have plunged from the 2.3 million seasonally adjusted annual rate (SAAR) peak of January 2006 all the way to the 625 thousand SAAR of November 2008 (the last data point available), an all time low for the time series that started in January 1959. Single-family starts built for sale are down 75% from their Q4 2005 peak (seasonally adjusted data are not available, we performed our own seasonal adjustment).

On the demand side, new single-family home sales are down 65% from their July 2005 peak. Both demand and supply of homes are therefore still falling very sharply which does not bode well for inventories. Inventories are the mortal enemy of prices for any goods-producing sector, including housing.

Starts need to fall substantially below sales so that the excess supply in the housing market is reabsorbed. Inventories persist at record highs and the gap between one-family starts (for sale) and one-family sales (-92K annual rate in Q3 2008 according to our estimates) is at levels that cannot promote a fast work–off of inventories. To put these numbers in perspective, compare this with a measure of vacant homes for-sale-only. Vacant homes for-sale-only were at 2.2 million in Q3 2008, an all time high. In the decade between 1985 and 1995 it oscillated around 1 million units on average and 1.3 million units between 2001 and 2005. This implies that we have to deal with an excess supply that ranges between 0.9 and 1.2 million units, of which roughly 85% are single-family structures.

The sharp and unprecedented fall of starts might not have reached a bottom yet. In this economy-wide recession, weakness on the demand side is bound to persist and we believe that supply will have to fall further, given also the great wave of foreclosures that is adding to the excess of supply in the market. We see starts falling another 20% from current levels.

We believe that home prices will not bottom out until the middle of 2010. Our target is a 38% peak to trough (so far prices have fallen 25% from the peak) but given the worsening conditions on the real side of the economy, we see a meaningful chance for over-correction that would bring prices down 44% from the peak reached in the first half of 2006 (Case-Shiller is the reference index for these predictions.)

Labor Markets

With continued credit crunch and significant cut down in consumer and business spending, the monthly job losses will continue in the 400-500k and 300-400k range during the first two quarters of 2009 respectively, bringing the unemployment rate to 8% by mid-2009. The severe contraction in private demand until early 2010 will keep lay-offs high and the unemployment rate elevated over 8%.

Economy wide job cuts are expected, with big corporations and small enterprises, residential and commercial construction, financial services and manufacturing continuing to shed jobs at a strong pace. Moreover with structural shifts in the economy since the last recession, job losses this time will be more severe in the service sector, including retail, business and professional services and leisure and hospitality. Unless the fiscal stimulus addresses the deficit problem for state and local government, job losses at the government level will also gain pace. In turn, income and job losses will further push up default and delinquency rates on mortgages, consumer loans and credit cards. Moreover, the loss of high paying corporate and financial sector jobs will be a big negative for tax revenues over the next two years.

Lay-offs are bound to continue thereafter as cost-cutting gains pace with the beginning of the (sluggish) recovery period in early 2010. Even as consumer demand might show some signs of recovery, firms, like in the past, will begin by hiring only part-time and temporary workers initially. The unemployment rate might peak at close to 9% in Q1 2010, almost two years after the recession began. However, the hiring freeze across industries that began in late 2007 will continue at least until 2010 causing discouraged workers to leave the work force and containing the extent of the spike in the unemployment rate. Further, the decline in labor utilization will add to the deflationary pressure in the economy. An aging labor force, lower capital spending and potential growth over the next few years might also result in lower productivity growth and an increase in the natural rate of unemployment (NAIRU).

Capital Expenditure

Firms have been drawing down inventories beginning in Q4 2008. As the slump in domestic and foreign demand and difficulty in accessing short-term credit persist over the next four quarters, business investment is bound to contract in double-digits throughout 2009. Industrial production, spending on equipment and durable goods will also remain in red through 2009. Moreover with a sluggish recovery in private demand even during 2010, firms will start building inventories and contemplate capex plans only at a slower pace.

Trade

Exports contraction that began in late 2008 will gain pace in 2009 as more and more emerging economies slip into slowdown following the G-7 countries. On the other hand, easing oil prices and secular downward trend in consumer spending and business investment will help imports to shrink. In fact, this might cause the trade deficit to contract in 1H 2009 since the contraction in imports might well exceed the decline in exports, thus containing any negative contribution of trade to GDP growth.

Dollar Outlook

The fate of the U.S. dollar in 2009 rests on the global growth outlook. After profit-taking on long USD positions ends and trading volumes pick up as investors return from their holidays, the dollar may temporarily recover its relative safe haven status in H1 2009. Since markets have yet to fully appreciate the impact of the commodity slump and financial crisis on the rest of the world, risk appetite may collapse again on signs of a deeper- or longer-than-expected recession outside the U.S.. Further de-leveraging of USD-denominated liabilities could provide an additional boost to the dollar as a funding currency. The bond yield outlook could be a further source of strength: while the Fed is already at ZIRP, other central banks will cut rates further to stimulate growth, putting downward pressure on currencies like the Euro. Alternating with these upside risks to the dollar may be downside risks from 1) a supply crunch in commodities that lifts commodity prices and producers' economies, 2) inability of the market to absorb increased Treasury supply at low yields.

Downside risks to the dollar seem more likely to outweigh upside risks in the latter half of 2009 and in 2010. Yet at the same time, similar downside risks exist for other currencies – growing fiscal deficits will weaken a range of currencies. With emerging markets continuing to have trouble attracting capital and Asian economies, hammered by export contractions, will be reluctant to allow their currencies to appreciate against or with the dollar – China allowed some depreciation of the RMB at the recent euro-dollar peak.

Once crucial support from deleveraging wanes, however, the dollar may be left with only foreign central bank reserve accumulation, which has already waned on the reversal of capital flows, to finance the large U.S. current account deficit. Continued repatriation of assets and higher enforced domestic savings rates will at least reduce pressure on the dollar in the short-term.

Inflation/Deflation



Annual U.S. inflation, as measured by official producer and consumer price indices, is likely to slow in 2009 and even fall into technical deflation despite increases in the monetary base and fiscal measures to boost spending power. Slumping commodity prices may drag down the average annual headline CPI inflation rate to around -2% - a technical deflation which may morph into genuine deflation if falling prices generate expectations that they will continue to fall. Meanwhile, the growing slack in product and labor markets will keep core consumer inflation subdued at an average year-over-year rate of 1-2%. Steep discounts to get rid of unsold retail inventory, rising job losses and lower wage growth will reinforce the trend of stagnant or falling prices. Loose labor markets and weak demand for commodities and goods/services will keep producer prices at bay. Risks to the outlook include 1) a commodity supply crunch or geopolitical shock that leads to a sustained rise in commodity prices and 2) an earlier than expected global economic recovery.

Credit Losses Still Ahead



Back in February 2008, Nouriel Roubini warned that that the credit losses of this financial crisis would amount to at least $1 trillion and most likely closer to $2 trillion. As of mid-November 2008, the threshold of $1 trillion in global financial writedowns was finally reached. Given that national house prices expected to drop another 20%, we expect credit losses of $1.6 trillion.

An in-depth analysis of current and expected loan losses per asset class and separately of mark-to-market writedowns per securities class based on current prices indeed confirms RGE’s initial loss range estimates (outstanding loan and securities amounts as in IMF GFSR, Table 1.1) For our calculations we assume a further 20% fall in house prices, and an unemployment rate of 9%. With respect to credit losses on unsecuritized loans, recent research by the Fed Board using comparable assumptions (but assuming high oil prices) concludes that over half of 2006-2007 subprime mortgage originations are going to default (i.e. $150bn out of $300bn). The loss trajectories for Alt-A loans are similar resulting in a 25% default rate ($150bn out of $600bn). Even prime mortgage delinquencies display a very high correlation with subprime loan delinquencies, implying an approximate 7% default rate when the potential for ‘jingle mail’ is taken into account ($266bn out of $3,800bn).

The cycle has also turned in the commercial real estate (CRE) arena with the traditional lag of around 2 years. Current serious delinquency plus default rates of 5.9% of CRE loans (net recovery, via Fed data) are projected to increase to up to 17% by Fitch assuming a 25% fall in prices ($408bn out of $2.4 trillion.) In the consumer loan area, we estimate credit card charge-off rate could increase to 13% in the worst case scenario. Adding a typical 5% delinquency rate during recessions, the total loan losses on unsecuritized consumer loans are projected to increase to $252bn out of $1.4 trillion (see The U.S. Credit Card Industry in 2009, by RGE’s Mathias Kruettli.)

The IMF warned that commercial and industrial loans (C&I) charge-off and delinquency rates are likely to climb to historical peaks and potentially beyond in this cycle. Compared to past C&I loan loss rates, we project charge-off and serious delinquencies to reach 10% or $370bn out of $3.7 trillion of unsecuritized C&I loans. With regard to leveraged loans, the latest research by Boston Consulting/IESE Business School based on the 100 largest PE firms engaged in LBOs calculates an expected book loss from default of about 30%. This translates into $51bn out of $170bn unsecuritized leverage loans.

Based on these calculations, RGE expects total loan losses to reach about $1.6 trillion out of $12.4 trillion of unsecuritized loans alone, implying an aggregate default rate of over 13%. The IMF assumes that the U.S. banking system carries about 60-70% of unsecuritized loan losses (and about 30% of mark-to-market losses on securitizations). Even assuming that future loan losses are fully discounted at current market prices, deploying the remaining TARP funds towards recapitalizing the banking system would still be warranted.

The Disconnect Between Bond and Equity Markets



U.S. government bonds were on a tear in 2008, while equities plummeted in a nasty bear market. Bond yields at the long end hit all-time record lows, while the short end even dipped into negative territory. Only TIPS suffered as deflation risks rose. Stocks, on the other hand, had their worst year since the Great Depressions: DJIA lost 34%, S&P 500 -38.5%. At its 2008 low on November 20, the S&P 500 was down 49% for the year and 52% from its October 2007 peak. Stocks rallied in December though, resulting in an apparent disagreement between the stock and bond markets over the outlook for the U.S. economy. Bond markets seemed to be discounting a recession in 2009 while stock markets have been gaining since late November. This disconnect may vanish in 2009 though if the stock market rally was really just a bear market rally due to portfolio re-balancing and thin year-end trade volumes.

However, there have been intimations that the bond market is in a bubble about to burst in 2009. Indeed, with ultra low bond yields, investors may be tempted to switch into higher-yielding equities - which are now considered by many to be undervalued. Valuation, however, is not the be-all and end-all of asset performance. The credit freeze needs to end before equities can see the end of the bear market. However, considering the likely economic stagnation ahead, bonds should be a better bet than equities for some time. We see meaningful downside risks to stock prices as bad macro news – worse than expected – continues to dominate in 2009. Using the S&P 500 as benchmark, earnings per share will stay in the $50-60 range – and earnings will fall further. If, and it is not unusual during recessions, P/E ratio falls in the 12-14 range, we could see another 25% slide in stock prices.

Fiscal and Monetary Policy

Fiscal Policy

A lot of hope is being placed on the expected fiscal stimulus package of around $750 bn spread over 2009-10 including 40% of the stimulus in tax cuts for households and firms. Around half of the stimulus is expected to kick-in starting Q2 2009 and through 2010. But this will fall short of the pull-back in private demand of close to $1 trillion during this period.

Infrastructure spending, in spite of being highly effective, might not be timely, stimulating the economy only in late-2009 and 2010 when it has well passed the severe recession phase only to exacerbate the ballooning fiscal deficit. Nonetheless, around $100bn of infrastructure investment might be able to kick-in during 2009. Moreover, job creation in infrastructure might be overestimated given limitations in moving laid-off workers from other sectors to the infrastructure projects. As such, any job creation via government spending and tax incentives for firms will significantly fall short of the ongoing lay-offs.

Given the drawback of the ‘spending’ component of the stimulus, the government may be enticed to implement more tax cuts. While tax incentives for households like payroll and child tax credit might be well-targeted at the group with high propensity to spend, tax cuts in general will be less effective in stimulating demand given a secular rise in the saving rate expected over the next few years. Likewise, tax breaks for firms hiring new workers or investing in new equipment will be rather ineffective since businesses see little viability in doing so during a slump in domestic and export demand. At the most, tax stimulus in spite of being timely and well-targeted will cause only a temporary rebound in the economy for a month or a quarter merely shifting the spending decision period just like tax rebates did in 2Q 2008.

Expansion of unemployment benefits, food stamps and other incentives will have a high bang-for-buck effect in 2009 and will only assuage the impact of the recession. The stimulus will also include up to $100 bn for state and local governments to meet their severe budget shortfalls including grants, Medicaid and unemployment insurance funds, preventing cutbacks in public services, investment and jobs in several recession-hit states. But again, fiscal aid for states often suffers from time lags.

Fiscal stimulus, TARP spending, GSEs-related expenditure along with further slowdown in corporate and individual income tax revenues will push the fiscal deficit to around $1.3 trillion in FY2009.

Monetary Policy

The Fed has enacted a wide and unprecedented range of measures to mitigate the credit crisis and stimulate the economy. It has already cut its target range for the Fed funds rate down to 0-0.25% (essentially ZIRP) but, more importantly, it has created currency swap lines and an alphabet soup of programs to provide liquidity to the financial system and clean out toxic financial assets. The Fed experimented with different forms of financing itself in order to enable a sharp expansion of its balance sheet to accommodate these liquidity facilities. In addition to rate cuts and quantitative easing, the Fed has directly aided failing financial institutions. Now, the Fed is considering issuing its own debt and/or purchasing long-dated Treasuries and Agency debt. Will the monetary easing work? So far, the increase in money supply has not been accompanied by an increase in the velocity of money. In other words, credit growth remains stagnant as banks are reluctant to lend back out the money provided by the Fed and, at the same time, borrower demand has fallen.

Business Week on Getting Out Now

Investing October 2, 2008, 5:00PM EST

Why You Shouldn't Bail on Stocks Now
Today's bunker mentality has the stock market looking cheaper relative to Treasury bonds than it has since 1978
by Roben Farzad and Tara Kalwarski

To many panicky investors, it feels like financial Armageddon. But decades worth of investing precedent suggest otherwise. And investors who bail on stocks now might come to regret it.

Make no mistake: The freeze in the credit markets is frightening. "People don't have any experience with this kind of thing happening," says Martin Barnes, managing editor of Bank Credit Analyst. "People can't look back at previous episodes and take comfort and say, 'I've been here before.'" And so, almost by default, we are given to extreme bearishness—invoking the Great Depression and Japan's lost decade is all the rage. "Sure, these things are possible," says Barnes. "But not likely."

Sept. 29's 778-point drop on the Dow doesn't even rank among the top 10 in percentage terms—it was 7%, compared with 22.6% in 1987. Yet the very system that rewarded risk taking for years is now holed up in the closet under a security blanket. Hedge fund traders, banks, individual investors, small businesses—you name it—have been piling into ultrasafe short-term Treasuries, which now yield close to 0%.

We've felt the sky was falling before. Recall that one-day panic on Oct. 19, 1987, or the savings and loan crisis of the early 1990s, or the Asian meltdown in 1997, when Koreans lined up on the streets of Seoul to donate jewelry to shore up their currency. The markets took big hits in all of those cases, but ultimately bounced back. By the beginning of 1989, for example, the Dow had returned to its pre-crash levels.

The smart money knows that banking crises are par for the course. According to the International Monetary Fund, the past quarter century has seen at least 124 banking crises around the world. "It is important to recognize that this isn't the first time the U.S. financial system has experienced—and survived—a financial crisis," says Eric Bjorgen of Minneapolis-based Leuthold Group, an investment research firm.

BARGAIN INTERNATIONAL STOCKS
The time to panic, if there ever was one, was a year ago, when stocks were hitting their highs—not now, when they are hitting their lows. Today's extreme bunker mentality has the stock market looking cheaper relative to Treasury bonds than it has since 1978.

That's precisely the environment in which savvy, patient investors make their fortunes. Case in point: legendary cheapskate Marty Whitman of Third Avenue Funds, an octogenarian who lives for volatile times like these. "Right now is a time when deep value investors excel," he says. "People like myself got rich in '74 and '87, unlike those who tried to pick bottoms." The common stocks of companies that need access to capital markets are "toast," he says. "The common stocks of companies that can finance themselves have never been more attractive."

Whitman says that many international shares in particular have never looked so cheap: "There are unbelievable bargains. It's terrific for us." Stocks he thinks are especially cheap include Hong Kong-based real estate investment holding companies, including Cheung Kong Holdings, Hang Lung Group, Henderson Land Development, and Wharf Holdings.

Even Rob Arnott, chairman of investment advisory firm Research Affiliates and a bear long before it became fashionable, says the current panic "is creating some really spectacular opportunities for those who are nimble and weren't overly aggressive." The reaction in financial-services stocks is overdone, he says. "We have an anti-bubble—when a sector of the market falls to levels that no plausible scenario would justify." Arnott also sees "great bargains" in convertible bonds and says the debt of "many emerging markets is more creditworthy than U.S. Treasuries". The broad U.S. stock market, however, has a chance of falling further as consumers begin tightening purse strings, he says. Arnott thinks investors should lower their long-term expectations of stock returns to about 6%.

Of course, bargain-hunting always sounds great in theory. But people have shown time and again a predilection to sell low—just as they tend to buy high. Princeton economics professor Burton Malkiel, author of the best-seller A Random Walk Down Wall Street, notes how much hot money piled into equity funds in early 2000, just as the market was about to peak. Then, as stocks were nearing the bottom in the third quarter of 2002, that money fled in droves. The timing couldn't have been worse. "One of the things we know about individual decisions in markets is that people generally do the wrong thing," he says. "I know money is coming out now. I don't know whether this is the bottom. But taking money out now, when things look horrible, is almost always the wrong thing to do."

The Long View - Ask a Seasoned Investor (from Portfolio magazine)

Talking to Chuck
by Portfolio Staff October 2008 Issue

Charles Schwab says investing is boring. That's why the practice has become a lost art—and a national emergency.


At age 71, Charles Schwab has seen his share of stock market slumps. In 2003, he stepped down as C.E.O. of the Charles Schwab Corp., the San Francisco-based brokerage house he’d founded in 1973, but returned to his role in 2004, when the company was getting pounded during a down cycle. Since then, not only has the company gotten back on track but its bottom line seems to be benefiting from the current turmoil as well. Schwab himself is almost evangelical about the importance of investing—despite an economic slump he says will still take months to run its course.


Where are we in this down cycle?The market probably hasn’t reached the bottom yet. I would expect that to happen between now and just past the election. The overall economic slowdown probably won’t subside until sometime in 2009. But that’s okay. Markets move in anticipation of economic moves. You can see the market beginning to reach its bottom—it’s going past the threshold. There’s still more ugly news coming out, I’m sure.

How will we know when we’ve hit the bottom?
That’s the challenge. You don’t know until you see it in the rearview mirror. There’s no way to know even when it’s arrived. That’s all the more reason successful investors have the confidence to stick to their plan and ride through the ups and downs—and even to invest when there is the possibility of a drop in the short term. It’s the long-term trend they’re after.

What do you expect will be the lag time between when the market turns and when the economy responds?
I expect it’s probably about six months. That would be consistent with other periods in the past.

Your company talks to thousands of investors every day. How scared are they?
They sound scared every time we have a market that’s going nowhere. It’s not pretty. Most people you meet live for today. Thinking and planning for tomorrow is almost impossible. Investing is such an abstract notion that most people really have a tough time grasping it until they’re way
far gone: “My God, I’ve got to save for my future—what in the world am I going to do?”

So you advise people to invest in a market like this one?
This is a fantastic time, frankly, for people who are just starting to invest. Prices are low.
In investing, you’ve got to have some confidence that stock market cycles will be no different in the future than they have been in the past. The market will recover.

Yet investors are reluctant.
We want to enjoy everything we see advertised, and there’s nothing about saving or investing that gets our juices going. Investing is a very abstruse, intangible concept. It’s what economists talk about. How many people have taken a class in economics? The literacy around this concept is woefully low, but it’s amazing how essential this boring concept is. We say the same thing about good health: You don’t really become aware of it until you’re sick. Then you realize there really is some limitation on the strength of your body. Being a saver always means the same thing: spending less than you earn. That never changes.

How did we end up here—with saving and investing being such a low national priority?When I was a kid, we were coming out of the Great Depression and World War II. All you talked about in families was the lack of money and the desire to save and make life better. The past 20 years have been bountiful, but we’re moving through a big crack now, from the subprime thing to everything else. I’d be willing to bet in five years’ time, maybe 10 years, the pendulum will swing back to a much more conscientious rate of personal savings. What we’re going through now is cathartic, but it’s very painful. One of the key things to understand in a free society, which I wish we didn’t have to face, is that there are cycles. It never goes in a straight line. It’s a fundamental fact that market systems go up and down. Life goes up and down. And that’s okay.
I’ve heard you call for a national effort to boost the savings and investment rate. Why is that?
We have a huge national problem. Our savings rate is zero or below zero. It’s a disgrace.

We have to have a national program to launch the savings rate to 10 percent. It almost has to be as important as going to the moon.

You’ve contributed money to John McCain. Does he support such an effort?
This isn’t a political thing. We’ve just got to get some shock component to this. I haven’t found a good way to awaken people at an earlier age to the fact that they have to save and invest.

What percentage of the ­population does what you suggest?
Between 2 and 5 percent of the population invests as it should. It’s shocking to meet people who simply haven’t put aside anything for the future, and they’re now approaching 50. You tell them it’s never too late to start, but, man, deep in your soul, you say, “What has this person been doing?”

Where should people begin if they’ve never invested before?
New investors should be assembling a diversified portfolio. An investor with a smartly diversified portfolio of stocks should expect something like a 10 to 11 percent return per annum. Your money should double every seven years.

All of a new investor’s money should go into stocks?
If you’re younger, it should all be stocks. If you’re over, say, 55, your portfolio should be more diversified—some international stocks, small-cap stocks, low-cost mutual funds, fixed-income investments, some money-market funds—and you should expect an annual return of 8 percent.

What’s an easy rule of thumb for how much to invest, as a percentage of income?
It depends on your age, how much you’ve already invested, and other factors. But a good rule of thumb, if you’re just starting out working, is to put aside 10 percent of your income each year and stick with that over your working life. If you wait until later in life, you’ll need to increase that considerably. At age 62, your life expectancy might be 30 more years.

How much should most investors be actively trading? How often should they rebalance their portfolios?
Certainly some investors trade very actively. There’s no formula for the right number of trades
in their case. But our average client trades only a few times a year. For most of us, the rebalancing is
the important part, and that should be looked at on an annual basis—but also if major changes
in the market occur or if your objectives change. With a portfolio of mutual funds, which is the best way to get diversification, the process is much simpler.

And you don’t advise going it alone.
No, you’ve got to get some professional help. No matter how much I have looked at this issue, I have to say with a great amount of discouragement that not more than 2 to 3 percent of our population wants to think about any of this. The rest of us need good, ethical, cost-effective assistance.
Why does your company do well when the market is down?
We’re a well-established, well-regarded company. People gravitate to us. At a time when people are very worried about the news on the front page and various economic crises, that tends to make them more fearful.

What’s the biggest miscon­ception about investing?
Many people confuse investing with big short-term hits, “the next great thing.” That’s not investing; it’s gambling. Bad advice feeds on that, by trying to sell us the next great thing. It’s okay if investing is a little dull, as long as it’s doing what it’s supposed to be doing, which is to help you build financial independence.

What should people be investing in?
I don’t believe that sector investing—picking investments by industry—is a wise move for the average person. If you were smart enough to move into oil, will you be smart enough to move out? Nobody’s really that smart.

Look, I’m the biggest advocate of entrepreneurial people making speculative moves. But you don’t want to be making those moves with your investment.

So if I call one of your advisers and ask which companies to invest in, they won’t give me names?
They’d better not. They’ll encourage you to have five to 10 sectors in your portfolio. When you buy a great index fund, that happens anyway.

You’ve been consistent about the need to stay the course, even in down cycles. In a market like this, should investors do anything different at all?
There’s no harm in taking the opportunity to think about whether your portfolio is structured the right way. If it is, and it doesn’t need rebalancing, it’s not a time to be making big changes. But again, down markets are an opportunity to invest at a discount. That’s hard for most of us to do, because the chances are good that we could go further downward. And that’s a tough emotional ride.

What’s the best piece of investing advice you ever got?
Start saving today and start investing tomorrow.

And the worst?
You should get out of the markets now.