In recent months, the equity market has
experienced extraordinary volatility. A
steady dose of gloomy economic indicators, combined with outright fear, have led
many investors to flee the stock market in
favor of treasury securities and cash.
The best strategy investors can deploy during uncertain financial times is to remain
patient, stick to long-term objectives and mitigate risk through diversification.
“Long-term investors should focus on maintaining a broadly diversified portfolio that
reflects their specific investment goals, risk
tolerance and investment time horizon,” says
Richard Cunningham, managing director of
investment consulting services for Comerica
Bank.
Smart Business spoke with Cunningham
about the current state of the equity market,
the effects of the credit crunch and how to
best strike a balance between risk and return.
What are some of the primary factors behind
the equity market’s recent volatility?
From a fundamental perspective, the
recent dislocation in global equity markets
can be attributed to the increasing recognition that the major developed economies are
contracting and the fact that financial sector
crisis will lead to a massive deleveraging
process. Both factors will ultimately create a
negative feedback loop for the growth in corporate profits, which is the primary driver of
equity prices. A key concern for investors is
that the enormous debt levels in the U.S. will
continue to suppress economic growth for
some time. In particular, with consumers seeing a significant decline in the wealth due to
falling home prices and stock prices, there is
the potential for a significant retrenchment in
consumer spending, which represents 70
percent of GDP. Credit expansion has been a
primary driver of economic growth this
decade, pushing private sector debt to record
levels. Credit as a percentage of GDP in the
U.S. is currently about 180 percent. In 2000,
that number stood at 120 percent. Even a
mean reversion would have a significant
impact on credit, debt and spending.
In terms of what’s driving the recent day-today volatility, both the hedge fund sector and
mutual fund complex are experiencing significant redemptions. For example, hedge
funds, which control about $1.8 trillion in
assets, have experienced close to $200 billion
in redemptions in the past month alone.
Some experts think that by the end of this
year we could see one-half trillion dollars in
redemptions across the hedge fund complex.
What specific moves led to this crisis?
The financial crisis was created by a perfect
storm of mutually reinforcing trends and policy mistakes that have been in place for several years. The epicenter of the credit crisis
was the bursting of the housing bubble,
which led to the collapse of Bear Stearns last
March and subsequently resulted in solvency
risks across the entire financial sector. In
July, we saw the ‘nationalization’ of the two
GSEs Fannie Mae and Freddie Mac.
However, the catalyst for the recent turmoil
in the financial markets was the decision by
the regulators to allow Lehman Bros. to fail,
which served to expose the systemic risk
across the global financial sector.
From a macro perspective, the Federal
Reserve’s monetary policies have been a contributor to multiple asset bubbles in the U.S.
We saw a technology bubble in the late 1990s,
a housing bubble that collapsed in 2005 and
2006, a bubble in commodities in 2008, and a
super-debt cycle over the past 20 years that
has created significant leverage.
Another contributing factor is that many
financial institutions, both in the U.S. and
overseas, made the decision to leverage up
their balance sheets supported by real estate
assets and securitized mortgage portfolios.
This was very profitable when home prices
were rising, but when the subprime market
collapsed, financial institutions suffered massive losses.
How do you anticipate the bailout plan will
affect the market?
Short-term, the $700 billion bailout plan —
combined with the related guarantees of
deposits and money markets — was a necessary step to address the immediate solvency
concerns and bring confidence and stability
into the credit markets. The capital markets
were essentially closed to the financial sector. Long-term, whether the funds will be sufficient to address the capital impairment of
the financial sector will depend upon the economic outlook and asset prices. To the extent
credit markets begin to function normally,
that will be a net positive for equity markets.
In the current environment, how should
investors go about striking a balance
between risk and return?
A successful long-term investment plan
should be based upon a disciplined strategic
(and tactical) asset allocation plan, including
diversification across multiple asset classes,
high-quality investments and tax efficiency.
Typically, we recommend stocks for long-term growth, bonds for income and capital
preservation, and alternative investments for
an absolute return strategy. Also, adequate
cash balances should be maintained. Right
now, as of late October, we believe that the
risk/reward profile for U.S. equity markets is
more attractive than it has been for several
years. However, at the end of the day, each
investor needs to consider his or her overall
strategy and goals.
RICHARD CUNNINGHAM is managing director of investment consulting services for Comerica Bank. Reach him at (415) 477-3234
or [email protected].
