Wilting in a Market Meltdown
As credit dries up, fears of recession spook investors
Still, investors need to take a deep breath. While some are bracing for an even bigger fall, as retailers like Wal-Mart and Home Depot offer dim earnings forecasts, few are predicting a bear market, usually defined as a 20 percent drop in value.
There have been six significant market drops since 2003--and none of them proved fatal to the bull market, notes James Paulsen, chief investment strategist for Wells Capital Management. And despite the concerns over exposure to subprime-related debt, "the U.S. corporate sector remains in very good shape," says Markus Schomer, global economic strategist for AIG Investments. Corporate balance sheets are sound, profit margins are near 40-year highs, and cash flows remain strong, he says.
Here are several things investors should watch for:
The globalization of the subprime sell-off. The one thing that the United States is still good at exporting is its financial products. And the U.S. credit mess now seems to be spilling over into the global financial markets. Recently, three hedge funds run by BNP Paribas, based in France, announced that they could not allow investors to cash out because of difficulties in valuing securities backed by subprime mortgages. And European central banks have done more than the U.S. Federal Reserve to inject cash into the market to shore up financial institutions. That suggests the subprime mess could be as big a problem abroad as in the United States. But the booming global economy might better withstand the credit shock.
Rising volatility as investors reassess their appetite for risk. Since the bear market ended in 2002, investors have been spoiled by an unusually long period of calm in the markets. But it now appears that volatility will persist. The Chicago Board Options Exchange volatility index shot up to more than 30 last week, more than twice as high as at the start of July.
Weakness in financial stocks. Financial institutions are announcing their exposure to subprime-related debt almost daily, and firms that work directly in the mortgage market are getting hit the hardest. Shares of Thornburg Mortgage were nearly cut in half last week after analysts downgraded its stock.
A traditional flight to quality. In times of financial turmoil, investors often sell the riskiest assets in their portfolios and head for the safest. The safe haven of choice for global investors is still U.S. treasury bonds. Not surprisingly, the flood of investments into U.S. treasuries has pushed the yield on 10-year notes down from 5.25 percent in mid-June to 4.65 percent last week.
For stock investors, this means two things: growing demand for shares of high-quality companies that lead their industries and those of dividend-paying firms. Between July 19, when the sell-off began, and August 14, stocks with an "A" grade from S&P (based on earnings quality and other fundamentals) fell 8.9 percent on average, while "B" stocks lost 10 percent and "C" stocks 12.9 percent.
So while dominoes are falling, prudent domino players may be repositioning their portfolios.