I also said that if the economy was the patient, I view the Dow Jones Industrial Average (DOW) or the S&P 500 as the heart monitor. At 14000 the patient was doing just fine. I am sorry to inform you that the patient has suffered a stroke. The DOW dropped approximately 1500 points. So again, what happened?
The longer explanation of what happened goes back to the 2000-2001 recession. In order to bring the economy out of this recession, the Federal Reserve lowered interest rates. After 9-11-01 those rates were lowered even more, to a 46-year low of 1.0 percent, causing the price of money to be cheap. While this was a long time ago, I believe the seeds for this current situation can be found in that very cheap money, coupled with easy credit. If you were borrowing money, you referred to it as the “cheap cost of funds,” however, if you were investing, it was a “poor rate of return.”
If we think of those two views as one transaction, we can make sense of how someone who was trying to invest might be willing to accept a rate of return that was not equal to the amount of risk being assumed. Once again, risk should equal reward and to accept too little of a rate of return can have unfortunate consequences. An example of how poor credit, or junk, was priced in more normal times; think of U.S. Treasuries as the center of a bulls-eye. As you move further out away from the center, each lower credit rating should cost less and pay you more. Simple enough! Under normal circumstances, if you were investing in the poorest credit, referred to as junk, you would expect to receive 500 to 600 basis points in additional yield over a treasury with a similar duration. Prior to the recent market correction, that spread had collapsed to a range of 250 to 350 basis points. Considering these securities are rated as junk, and have the potential to default, shouldn’t you expect to receive a wider spread and a higher yield?
Now take into consideration the effect of the global economy. Not only are you looking at a ton of liquidity here at home, but also around the world. The addition of China and India to the roster, which already includes such players as Japan and Korea, has added a great deal of wealth to this global pool of funds. It becomes a matter of supply and demand. With this tremendous demand and thirst for more securities, an opportunity to gain favorable pricing for sub-prime mortgages, and lower quality corporate debt was created. As this demand continued, the pricing became even more favorable, resulting in the spread compression discussed in the previous paragraph.
Two emotions move markets, greed and fear. We have experienced the first, and now are experiencing the second. What never ceases to amaze me is the difference in the timing of both. Greed can last for years, but when fear takes hold it can cause destruction in a very short period of time. How long we will be engulfed in this emotion of fear is not an easy question to answer. It will definitely take time to sort out. However, in what can only be described as a surprise move, the Federal Reserve, in an attempt to calm the fear, lowered the discount rate to 5.75 percent. The overnight funds rate remained unchanged at 5.25 percent.
