October 10, 2008 - "What now?"
Summary: The market has been on a roller coast ride downward over the last week. In fact, the Dow Jones is down over 1,800 points this week and is down more than 18.7%. What should we, the average investor, do next? Are we headed into the second Great Depression?
Should you be scared? I don't know about you, but anytime the market loses nearly 20% of its value in one week, you have a right to feel scared. Anyone who is in the market is in effect 20% poorer than they were a week ago.
The S&P 500 has been up or down at least 1% everyday for the last 2 weeks. The market is trading in integer percentages. The VIX, an index that measures volatility and fear, are at record highs.
Treasury Yields went negative for a short period of time two weeks ago. Essentially, someone paid the government 0.08% to lend them money. The level of fear this indicates is absolutely astonishing.
I started investing in 1998. I saw the dot-com bubble. The level of fear now; the action and volatility of the market; is something not seen in at least 25 years (the last time the Dow Jones declined 18% in one week was 1933 during The Great Depression).
What is going on? The $700 billion bailout package passed. Hank Paulson today announced a plan that my Public Finance and Fiscal Policy teacher, Michael Boskin (he served as Chairman of the Council of Economic Advisors to the first President Bush from 1989-1993 during the Saving and Loans crisis), has been advocating. Many banks are insolvent, and the government is going to give banks money in exchange for preferred shares of stock.
Why is it important to get rid of every insolvent bank? First, 'bad' banks are very detrimental to the banking system. Bad banks are FDIC insured, and thus can offer any interest rate to secure deposits. Since bad banks are offering these high rates and they are FDIC insured, people are willing to give these banks money. Good banks are forced to compete for deposits by offering high rates, but this greatly increases the cost at which they can lend at and hurts their profitability. The government needs to get rid of these bad banks so good banks don't have to unfairly compete and pay unfairly high rates for money.
Second, banks are afraid to lend, because they are afraid of the market-raiders who are knocking down their share prices and potentially causing them to go bankrupt. As long as this continues to happen, banks refuse to lend because they need to hold onto as much money as they can to remain solvent in these tough times.
Third, as long as the government can seize any bank at any time-like they did to Wachovia last week-and can force them to sell at shotgun prices, no private sources of capital are willing to buy into banks. Why buy into a bank that the government can seize for any reason tomorrow and lose billions of dollars?
As long as banks are unwilling to lend, it doesn't matter how low the Federal Reserve lowers rates. The Federal Reserve needs banks to lend out money. As long as there is no way in which banks are going to lend out money, the Federal Reserve could lower the Federal Funds rate to 0%, and it would still have very little effect.
What else is happening? Many companies cannot access their money market accounts. Many companies cannot get short term loans. General Electric and Goldman Sachs, two blue chip companies, just raised money at 10% rates. These rates are very costly prices to raise money at, and are rates that many companies cannot afford.
What happens in recessions?
What happens in recessions. Equities go down indiscriminately, irrespective of any value the company may have. Fear is so rampant, opportunities are created. Warren Buffett said, "Be greedy when others are fearful, and fearful when others are greedy." Is this the time that Warren Buffett was talking about? I think this is finally when the fear buying can't start. You are buying stocks 35% lower than in January. EVERY stock has gone down, including traditionally defensive names like tobacco and health care.
Do you have a right to be scared? Absolutely!, but if you have money right now, you should start averaging into mutual funds you like or buying into the market. Notice, I said START averaging. Don't buy all at once.
What should you do if you have money in the market? I feel your pain. If you can, start taking additional money and averaging into your funds, if you can't, I can't guarantee the market won't continue to go down, but it is awfully difficult to tell someone to sell their positions down 30-40%.
