In my January article, Time for a Checkup, I cautioned that financial markets were beginning to see the back half of the storm because the recovery of 2009 and 2010 depended on government spending which was set to fade. This withdrawal of government stimulus has caused financial risk markets, like stocks and high yield bonds, to decline since year end through September 30.
So, where are we now? There have been reports of a double dip in the economy. The Economic Cycle Research Institute (ECRI) announced on September 30, that the economy has entered a new decline. The most knowledgeable researchers regarding the aftermath of a housing bubble, Professors Reinhart and Rogoff, authors of “This Time Is Different: A Panoramic View of Eight Centuries of Financial Crises” would argue that we never had a recovery.
Fortunately, we can now look forward to some good news. Returning to our model of the economy as being made up of the consumer + investment + government spending + net exports, a shrinking government implied lower future growth. As government stimulus has begun to fade, we are seeing the expected effects, particularly a decline in the price of oil. Oil is the largest import for the U.S., so in our model, the net exports offset some of the falling government spending. As gasoline prices ease, consumer spending should be redirected. Regarding the investments part of the model, corporations, are sitting on the record pile of cash, which earns them nothing. Eventually, this cash should turn into investments.
Reinhart and Rogoff estimate that real estate-led downturns take five to six years and chop about 35% off of the price of real estate. The Case-Shiller Home Price Index topped in June 2006 and is down 32.3% through May 2011. We may have one more poor selling season but if history is a guide, we are closer to the end than the beginning.
If the ECRI is correct, then it is important to understand the average duration of a decline. According to the National Bureau of Economic Research, recessions typically last 16-21 months. If we are in the back half of the storm, what are some portfolio actions you might want to consider? Historically, equity prices have bottomed during recessions, generally somewhere after the midpoint. Equity indices topped in May, but some sectors like financials topped in April 2010, so they are already 18 months into a decline.
Generally, more credit sensitive bonds bottom before stocks. Therefore, high yield bonds, particularly floating rate bank debt instruments, may be giving investors another opportunity. Even distressed European government debt, known as the PIIGS (Portugal, Italy, Ireland, Greece and Spain) may offer an opportunity once the market overreacts and goes after a fourth victim. Remember, like the three little bears, it takes three to make a pattern, but once everyone knows the pattern it is priced into the markets.
The final important piece of a well-diversified portfolio is rebalancing. Rebalance within asset classes. In a reversal of situations from my January article, if you are holding foreign currencies and they are down and the dollar is up, send some money abroad. Also, rebalance between asset classes. Stocks have been going down and bonds up recently. The reverse may hold true in future quarters.