Our View of What's Going On In the Markets

The sharp sell-off in stocks last Thursday and Friday grabbed headlines and sparked anxiety among investors. We thought we’d take this opportunity to share our views on last week’s market action and what we think you should make of it.

To start with our conclusion: Unless the economy is headed for recession–and we don’t believe it is–the outlook for stocks remains positive. Now for our reasoning.

The sharp declines in the stock market last Thursday and Friday seem to us very similar to the declines in late February. Both followed periods of very strong gains in stock prices. February’s 3% sell-off followed a 7-month run where stocks gained 19%. The 5% decline last week followed a 4-month stretch where stocks gained 13%. Such sharp pullbacks in price do not seem unusual given the far stronger gains preceding them. This is the way the market advances: a few steps forward, a couple steps back.

Relatedly and from an investor-sentiment perspective, both declines occurred after investors had gotten a bit complacent following strong price runs. As legendary investor John Templeton said, “bull markets are born of pessimism, grow on skepticism, mature on optimism and die on euphoria.” Last week’s market action demonstrated–and insured–that investors are far from optimistic, much less euphoric. Keeping investor sentiment in check is, again, the way the market advances.

Fundamentally speaking both declines were prompted by problems in the housing and subprime lending markets. In February we got our first glimpse of these problems as mortgage defaults spiked and US housing prices registered their first year-over-year decline since the 1930s. Last week the scope of these problems expanded as the debt markets registered the weakness in mortgages. Same problem, different stage of development.

The crux of the matter remains the same: Will problems in the housing/mortgage markets pull the economy into recession? We think not.

It’s important to note that something like this always happens at this point in the economic cycle. Following the end of a Fed credit-tightening cycle, somewhere in the economy something cracks as a result of the pressure. Often that something was created earlier by money being too easily available. In the mid-1980s it was in the banking sector with Continental-Illinois Bank. In the mid-1990s it was the Mexican peso crisis. Both were true financial crises but neither led to recession.

So there’s always a weak link that cracks and this time it’s housing. Creative mortgages and the housing bubble were a natural if unintended result of the extremely easy-money policy the Fed put in place following 9/11. That they’re both now cracking following two years of Fed rate hikes is also natural, if equally unintended.

We doubt that the subprime lending implosion will stall the overall economy. Slow it, yes. But stall it, no. Most US homeowners and corporations enjoy the strongest balance sheets they’ve had in decades. The US economy is quite diversified with increasingly large exposure to a rapidly expanding global economy. Problems in the housing sector aren’t likely to overwhelm these strengths.

If we’re wrong about this, however, our ace in the hole is the Federal Reserve. Should the economy begin to show signs of faltering the Fed has plenty of room to lower short-term interest rates from their currently high level of 5.25%. Lower interest rates would in turn re-stimulate the economy as well as boosting stock prices. This is in fact the typical pattern, one we saw in the soft landings of both 1985 (after Continental-Illinois) and 1995 (post-Mexican peso).

Today we see investors very nervous and stock valuations lower by some measures than they were at the bottom of the last great bear market in 2002. That’s not the way things look at the end of a bull market. The time to be concerned is when nobody else is and valuations are stretched.

Against the current backdrop if you believe the economy will avoid recession (with or without the Fed’s help) and so expect earnings growth to continue it’s hard not to conclude that stock prices will be materially higher a year from now. Getting there could be a bumpy ride but that, after all, is the nature of stock investing. Successful investors tune out the short-term noise and stay focused on the long view. That’s what we’re doing.