Unless the damage spreads, let's not overreact to subprime's travails
"Meltdown" is a vivid word, isn't it? It must be, or market pundits and financial writers wouldn't use it so often. Meltdown conjures up images of Three Mile Island or Chernobyl, where all that remains in the aftermath is a useless radioactive hulk.
But financial meltdowns like the current subprime crisis have turned out to be far less long-lasting than the nuclear variety. That means the right move for the smart stock market investor with a broad portfolio may be the simplest one: Stand pat.
Yes, the Dow Jones industrial average has dropped by 5% over the past three weeks. But investors have suffered through 10 or so real or threatened "meltdowns" over the past 20 years, starting with the market crash of October, 1987, and continuing through the dot.com bust. Who can forget the Mexican peso crisis of 1994–95, the Asian financial crisis of 1997, or the Russian ruble crisis of 1998, which helped send the Dow plunging by more than 13% in less than a month?
In the end, all the meltdowns except the tech bust have been made up for by the upward trend line of the stock market. The 1987 stock market crash, so horrifying at the time, looks like a mere blip in retrospect. Even factoring in the long post-2000 bear market, the 20-year average return on Standard & Poor's 500-stock index, including invested dividends, is 10.6% per year. If you had invested in the stock market right after Alan Greenspan gave his "irrational exuberance" speech in December, 1996, and kept it there until now, you would have enjoyed an average annual return of 8% per year.
The long-term gains for investors over the past two decades come from two factors: strong productivity growth, which has propelled profits; and the lack of a financial debacle big enough to inflict a Chernobyl-type disaster on the markets. It's noteworthy that the one period with a stagnant stock market, the decade from 1972 to 1982, also happens to be the weakest decade for productivity growth since World War II.
The Big One?
So the real question to ask is this: How does the crisis in the subprime mortgage market stack up against previous meltdowns? Is this going to be the Big One?
The short answer is, not likely. In a Feb. 20 speech, Federal Reserve Governor Susan Schmidt Bies estimated that subprime adjustable-rate mortgages, which are the heart of the problem, make up just 7% to 8% of the total home mortgage market. Still, in absolute terms the size of the defaults could be enormous. Some estimates suggest that banks and other lenders could take a hit of $300 billion or more.
But remember, the tech bust devoured about $9 trillion in corporate equity; next to that, the subprime problem looks like an insect bite—unless it spreads to the rest of the mortgage market. But at least so far that doesn't appear to be happening: Mortgage rates for good borrowers have actually been going down. In early February, for example, the average rate for 15-year fixed rate mortgages was 6.06%, according to Freddie Mac (FRE). As of Mar. 8, that was down to 5.86%. If low rates continue, they should actually prop up most of the housing market.
I don't want to be too Pollyanna-ish about either the stock market or the economy. There are plenty of dangers, with the biggest one being the slowing of U.S. productivity growth in recent months. If productivity growth slides even further, it could undermine corporate profits, the economy, and the stock market. But at least for now, the subprime meltdown doesn't look like a reason for investors to dive for the fallout shelters.