In my article from one month ago ("Some encouraging news"), I came up with a list of 10 things I thought policy actions should achieve to deal with the crisis and the various measures that had already been taken.
Back then the situation could be summarized as follows: while much had been done to deal with the financial crisis, nothing had been done to deal with the economic risks. This was understandable given that in the first half of October, the priority was clearly to contain the banking crisis.
Things have changed since then. Even though the situation in the money and credit markets is still far from normal, the risk of a systemic financial meltdown now seems remote.
The economic situation has deteriorated substantially in the last 2 months, however. From an economic point of view, there is a pre- and post- Lehman Brothers world, with the world economy basically having fallen off a cliff since the US investment bank went bankrupt. It is not so much that Lehman Brothers was so important for the economy but that since its demise (and the drama surrounding Fannie Mae, Freddie Mac, AIG, etc), all confidence has fallen out of the system. Without confidence, economic activity can't function and the economic news of the last weeks is truly frightening with developing countries on the verge of falling into what could be their worst recession since the 1930s.
The good news is that the authorities have started to implement aggressive measures to revive growth. In Asia, China has just announced a stimulus programme amounting to more than 10% of GDP. Similar programmes have been announced in South Korea, Japan, Thailand and Malaysia. Europe and the United States will soon follow suit. The drop in interest rates should also begin to have a positive impact on the economy once confidence returns and the banks start to lend again. Finally, there is the fall in commodity prices. Make no mistake: we are still in a process of deleveraging and there remain very strong headwinds for economic growth and especially for consumer spending in the Anglo-Saxon countries. Also as stated above, the financial crisis is still far from over. Between the occasional financial scare and very grim economic news, there is still much to worry investors and equity markets can be expected to remain very volatile. However, just as when you drive through Luxembourg, there is no sign telling you that you have left the south and entered the north, there will be no announcement that the credit crisis is over and that the economy will start to improve again (even though there are indicators to watch).
Which brings me to equities. Equity markets are known to be precursors of what happens in the economy. Stock prices today are determined by what the market thinks earnings will be in a few months. Investors know that many companies' earnings will be substantially lower a year from now. That, however, is precisely the reason stock prices have come down so much and not a reason for them to decline much further. It is only if the decline in earnings will be even stronger than what is anticipated today that equity markets will continue to fall.
In my October 15 article, I wrote that the time had come to turn somewhat more positive on equities again. Since then, markets have been extremely volatile but despite very bad economic news, most are not much lower than when I started that article. I still think that the right strategy today is to buy equities on weak days. These purchases should however be limited to companies with proven business models and strong balance sheets. This is not the time to own companies with high debt levels and/or major refinancing needs.
A final point I want to make is that investors generally underestimate the speed with which equity markets recover. In 1968-70, a 36% decline in stock prices was essentially recovered in less than a year. In 1973-4, a 45% drop recovered in 22 months. In 1987, a 25% crash recovered in 2 years. Even in the Great Depression, when the market fell 89% between 1929 and 1932, stock prices rose again by 372% between 1932 and 1937 (to be fair, that rise still left them some 50% below their 1929 high). This last example might be the most telling with regard to what I wrote in the previous paragraph given that in 1932 the stock market recovery started in the face of persistent disastrous economic news. (1)
For a long-term investor, not being in equities after one of the worst stock market declines in history is therefore also a risk.
(1) The numbers I use in this paragraph are from John Dennis Brown's book "101 years on Wall Street" (ed. Prentice Hall)
