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« Market Risk, Part II; Barriers to International Trade | Main | Annuities: Their Uses and Abuses »
Saturday
Mar012008

Market Risk: It's Everywhere! It's Everywhere! Part 1

So, you have a little money saved for retirement and are not sure what to do with it.  Join the crowd; many of us are in the same boat.  One reason that this issue is so confounding presently is that the way ahead seems so unsettled.  Perhaps at no time in my life has the future seemed so cloudy with so many p0tential risks to financial markets.  But then again, perhaps it has ever been so, and these times are not so different for today's investors.  Thus, in an upcoming article I will share some ideas that I have regarding where to invest our retirement funds, but first I want to examine some of the risks, or perceived risks, to the financial markets as I see them.  

 

Market risk is, and always has been, with us.   The very nature of transferring purchasing power from today until tomorrow requires accepting some risk, because the future is uncertain.  Two major types of risks afflict financial markets:  systematic and unsystematic risks.  Systematic risk is associated with the market fluctuations that afflict all investments; unsystematic risk  refers to individual events that affect a particular security.  Unsystematic risk can be minimize by holding a diversified group of investments.  Systematic risk affects entire markets and is harder to avoid.  This is the type of risk on which I want to focus, those manmade events/conditions that increase the overall market risk for us investors and savers.1  There are plenty of big, bad things currently looming that may give us worry, and not all of them are George Bush's fault (to the surprise of many).

1The Recession:  Recessions, defined as two or more consecutive quarters of a decline in the gross domestic product (GDP), have been a part (some would say a necessary part) of our economic landscape for many years.  Contrary to what you may be hearing from the financial press and various political candidates, recessions do not signal the end of the world as we know it.  There have been four such economic downturns since 1975, and the American people bore up admirably during all of them.  To hear many financial pundits tell it, we are already in the midst of a recession, and you had better put your money under your mattress and kiss your figurative financial butt good-bye!  Our economy may, or may not, be in a recession, and whether is it or is not should affect little our decisions regarding what we do with funds we will not need for four or five years. In any case, these pundits have about as much insight into the recession as do you or I.  Most economist cannot predict with any accuracy the direction of interest rates, much less the direction of the stock market, and I will certainly not trust them to tell me if, or when, our economy will go into a recession, or what to do if it does.  (If you are concerned with money you may need in the next year or two, put it into CDs, savings accounts, or money market accounts; end of that story!)  By the time a recession has been identified, our economy may very well have moved on, and the recession may be in the rear-view mirror.  Even the stock market, that great predictor of future events, cannot predict recessions with any accuracy.  Paul Samuelson, America's first Nobel Prize winner in economics, was reported to have observed, "The stock market has predicted nine of the last five recessions!"  In other words, Wall Street, along with Main Street, is prone to worry more than it should.  Besides, stocks do not always decline during recessions.  In the four recessions since 1975, stocks declined in only two of them.  Let me emphasize that point:  the recessionary status of the US economy is not an accurate predictor of whether stock prices are likely to rise, decline, or move sideways.  The one thing the past does tell us is that stock prices move up and down but eventually higher over time; they may stagnate or decline for a year, or two, or three, but eventually broad stock indexes move higher.  Thus my assertion that whether or not our economy is in recession should not influence what we do with our "long-term" money, other than to insure that we are reasonably diversified so that the effects of any recession (and there will eventually be one) will be minimized. 

2. The Upcoming Presidential Election: Presidential elections do pose a special challenge for financial markets, if for no other reason than that they present the market with uncertainty.  Regardless which party it is, the party out of power will always emphasize how bad things are under the present regime and how nirvana can only be achieved under their so much wiser guidance.  They perceive that this tactic gives them a political advantage, and it has ever been so.  The press then reports all of the senseless accusations politicians are prone to make during campaigns, and this is bound to frighten some folks.  Heck, sometimes it even scares me, and I am one of the most optimistic people I know.  I am convinced that the candidates themselves know many of their accusations to be untrue.  Things are rarely as bad as politicians trying to get elected make them out to be (unless of course, they are talking about the long term health of either Social Security or Medicare; in which case, it is likely worse), but their endless quarreling and criticizing is not without effect.  If one were to completely believe the press and some campaigning politicians, our financial future looks pretty bleak.  This message may very well have an effect on consumer spending and may even affect plant and equipment investment in our economy.  But history gives us reason for optimism.  Our country and economy has survived forty-three presidential campaigns, and I have no doubt we will survive this one as well.  I suspect some of the volatility that we are seeing in the markets this year (2008) can be attributed to the upcoming presidential election, but hopefully next year will give us a chance to catch our collective breathes before the next election process begins.

3.  Potential Changes to the Tax Code:  As the political winds have blown throughout our history, our tax code has been in a constant state of flux, and this will likely continue.  Regardless which party wins the upcoming presidential election, tax rates are likely to increase on someone, somewhere.  The Democratic candidates have pledged to increase tax rates on the "wealthy" and allow the Bush tax cuts to expire while giving a tax break to the middle class.  Any new Republican administration will likely face a Democratic congress and the reality of federal spending far exceeding revenues.  Since I have absolutely no confidence in the federal bureaucracy ever reigning in spending, the only alternative is to increase taxes in some fashion.  The tax rate on capital gains and dividends, currently at 15% for most of us, will almost certainly increase.  This will have an adverse impact on stock prices as the tax increase will in effect increase the risk of owning stocks.  The retired will bear this tax to a greater extent than others because the retired  rely on dividends for income more than do younger folks.  Historically capital gains and dividends have always enjoyed a tax advantage to encourage investing in new business, thus helping create new jobs and opportunities.  This has been the case regardless which party was in power.  Hopefully the new administration will see the wisdom in such a tax policy and will see that investors are not taxed too harshly for holding dividend-paying stocks.

Most economist agree that periods of economic weakness are particularly poor occasions to raise taxes.  This only takes money out of the hands of consumers, and consumers drive the economy.  This is a period of economic weakness, but given the current political climate and the state of federal spending, I fear that a tax increase is in the offing.  Again though, history gives me confidence.  Our economy is a huge, diversified business enterprise, and absent  an absolutely stifling tax environment, it will again adjust to a new tax environment.  The minute the new president is sworn into office, he/she will likely put the fantasies of the campaign in abeyance and face reality.  Reality is that a stifling tax environment will derail growth, inhibit new business development, weaken our competitive standing in world markets, and increase unemployment.  The fact that a number of European countries are struggling with just such a scenario lends credence to the need to avoid excessive government spending and punitive taxation.  Surely the current candidates for president are aware of these facts.

4.  Acts of Terrorism:  To the surprise of most of us, there has not been a major terrorist act on US soil since 9/11/2001.  I was flying that day and those events will ever be etched in my memory.  The fact that we have escaped another such  attack can be attributed in part to the fine job that our security forces have done, and in part, to luck.  Many believe that another major attack awaits us at some point.  A large part of the Islamic world hates us and our free and open society.  They just cannot get past the way we live, treat our women, and believe in religious freedom and tolerance.  No doubt many eagerly anticipate the next "Allah-inspired" attack against the "Great Satan."  But even with this inevitability  hanging over our heads, I have confidence.  I see the way the British carried on in the face of the IRA bombings, and the way the beleaguered Israelis go about their daily lives while under constant threat of suicide bombings, and I think that we Americans will do no less.  No, terrorist attacks cannot bring down our economy.  They may rock us back on our heals temporarily, but we are, after all, Americans!

In light of our vulnerability to terrorist acts however, I am amazed at Congress's reluctance to exempt the telecommunication industry's liability as it relates to the monitoring of potential terrorist communication.  All of our major security forces maintain that eavesdropping, wiretaps, etc. are vital to our national interests, yet Congress has so far opposed continuing this exemption.  Without this exemption, this industry is vulnerable to lawsuits concerning invasion of privacy, even from the potential terrorists.  They could face lawsuits that would threaten their very existence, all for cooperating with our security forces trying to keep us safe.  I don't get it; it is a trade-off I am willing to make in order to help keep our country safe.

5.  Unforeseen Geopolitical Events:  North Korea could invade South Korea.  Pakistan could invade India.  We could attack Iran.  In fact, Iran is the wild card in any number of unpleasant scenarios.  There could be a major disruption to the world's oil supply.  Some madman somewhere could set off a nuclear device.  But, in none of these scenarios do I see the US "going out of business," thus I am forced to be an optimist about our future.  I will not bet against us.  The world has long been a scary place, and we are, by the grace of an Almighty God, still here!  I suspect we will be for some time!

Enough of this for now.  I want to spend some time in part two on international trade, and its importance to financial markets.  Free trade is so important, as I see it, to our markets, and thus to our retirement money, that I want to devote an entire entry to it.  Following that, I will address the issue of where to put our hard-earned money in order to see it grow.

Investments: An Introduction, 7th Edition, 2002, by Herbert B. Mayo

 

Fly/Drive Safely!

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