Zaks Investment Advisory Service

Market Turmoil: out of the woods?

Today I will hold my third and, hopefully for the foreseeable future, last review of the preceding week’s market events. Why last? That should become clear by the end of this program.

I will remind you that Dow Jones started falling after climbing to the record level of 14,000 on July 19. The subsequent three weeks were remarkably turbulent. There were days when the spread between that day’s highs and lows reached nearly 500 points. Interestingly, between the start of 2007 and the moment this crisis began, the average daily spread was slightly above 100 points. Thus, the daily spread during the crisis was nearly five times higher than usual. This should give you a general sense of just how volatile the market has been for the past three weeks. On Thursday, August 16, the Dow Jones average fell to 12,500 at mid-day, or about 10 percent below where it was on July 19. A 10-percent fall may be officially called a correction. But the markets rose by about 2.5 percent over the past week and on Friday, August 24, Dow Jones closed at the 13,380 mark. This is some 4.5 percent below its record level, i.e. Dow Jones regained about half of what it had lost the previous month.

But that is not what is most important. Several indicators point to the possibility that the market has already survived the worst. There are grounds to believe that the scope of the problem associated with subprime mortgages has been more or less assessed, and that we should not be expecting any large-scale nasty surprises. I would like to underscore: the market by no means believes that all subprime mortgage problems have been resolved. Not at all – these problems will be with is for many months to come. But the markets were not “scared” by the subprime mortgage and bond problems alone. They were scared by uncertainty: a feeling that perhaps, after this, it will turn out the risk of numerous other securities was underestimated, too. The market for risky bond (high yield bonds, or as they are sometimes unkindly known, junk bonds) is enormous. And other risky financial instruments exist beyond these bonds. The possibility of risk for this entire segment being undervalued led to the market fall. Over the past month, thousands of analysts have been combing for skeletons in the bond market closet. It looks like nothing extraordinary has been found.

How do we know that the market has slightly calmed down? We have several telling indicators. Interestingly, they are all associated with bonds, even though from the point of view of investors, the crisis hit the stock market the worst. All of these indicators are linked to risk. The first one is the spread between high yield bonds and Treasury bonds, which we know carry no risk at all. The yield spread between these two instruments is a direct indicator of what compensation the market is seeking for additional risk. I have already mentioned that for the longest time, this spread was negligible, i.e. the market seemingly believed that the risk was insignificant. The crisis broke in the open when the market realized just how undervalued that risk had been all these months. The spread between the yields of risky bonds and Treasuries soared. However, it has eased back slightly and, most importantly, stabilized over the past few days. This indicator measures the risk of long-term bonds. Similar processes were occurring with short-term securities. Last week I mentioned commercial paper, a short-term financial instrument used by industrial and service companies (i.e. companies whose main line of business is not related to the financial industry) to borrow money over the short-term. I mentioned that the yield on commercial paper had jumped. It was the same old explanation: buyers decided that commercial paper was a riskier instrument than they had previously assumed, and started demanding higher returns. The yield difference between commercial paper and Treasury bills grew sharply. It has fallen back a bit over the past few days.

Both indicators we just mentioned – the difference in yields between risky bonds and Treasury bonds, and a similar difference between commercial paper and Treasury bills – are very important: this is how the market assesses risk on the whole. There are also more specific indicators. As we have already discussed, the crisis was unleashed by the so-called subprime mortgages. There is an index, created by London’s Markit company, called ABX. This index monitors the risk of bonds issued on the basis of subprime mortgages. It had been recently falling hard, but stabilized in the course of the past week, and has even rebounded a little.

The events I just described are in no way a prediction of the market recovering to its record levels in the coming few weeks. Nor does it mean that we may not suffer through another period of market losses: ups and downs are a historical market norm. Nevertheless, we may presume that the market is gradually pulling out of its current crisis. We will end our day on this optimistic note.

I would like to remind our listeners that we monitor the returns of three model portfolios, and compare them to the market, on our site’s Portfolios page. Despite the ongoing problems, the multi-year average returns for both the market as a whole and our portfolios remain very high. Compare the returns of your investments to our model portfolios. If you do not know what the returns of your portfolios are, contact us, and we will calculate them for you.

This was Sergey Zaks. Thank you for your attention and until next time.