The complexity of events since Black Monday has made it difficult for investors to put developments in perspective and make intelligent investment decisions. Here is my attempt to do just that.
The collapse has changed the economic environment and the psychology of investors, especially those who focus on stocks. But to what degree? There obviously has been a loss of wealth, either real or on paper. The extent of this loss and how it affects consumer spending is at the heart of the two economic scenarios that seem to be guiding investors.
The first scenario -- and currently the prevailing one -- is that the loss of some $1.5 billion in wealth in the stock market will lead to a reduction in consumer spending, which in turn will cause a recession. A slow-growth economy means a lowering of corporate earnings, which will hurt stock prices. It also will lead to less inflation, which is good for bonds because interest rates must fall to revive the economy and move into a recovery.
The key to the other scenario is the belief that since only 15 percent to 20 percent of households own stock, lower interest rates are much more meaningful to consumers, and with rates having declined about 1.5 percent, the economy is in a position to improve rather than decline.
It would follow that corporate earnings should improve, and that investors who purchase equities will in time be rewarded. This view also believes that the economy was already slowing down prior to the stock collapse, that inflation is not a problem and that bonds are a good buy.
The only problem with this position is that rates have already declined 15 percent, so it is doubtful that bonds could appreciate much more. Consequently, you would purchase bonds maturing in five years or less to protect your principal in case interest rates reverse themselves.
Unfortunately, it will be December before we are able to get a good reading on the direction of the economy, and there are several other factors that have a significant bearing on the financial and economic future. They are the declining dollar, the anticipated budget-deficit reduction plan, economic and financial cooperation between West Germany, Japan and the United States, and, finally, the Federal Reserve's monetary policy.
It appears, then, that the economy is delicately balanced and that any one of these four factors could tip it one way or another.
If the deficit reduction package isn't meaningful, the dollar's slide could accelerate, adversely affecting the financial markets, which in turn could push the country into a recession. Or, if we or our trading partners turn protectionist in economic and financial policies, other serious problems will be created.
Critical in this equation is how the Federal Reserve responds. If it allows too much credit into the system, it runs the risk of fanning the fires of inflation, but if it provides too little credit it can force interest rates higher and cause a recession. The Fed isn't likely to provide too little credit; if anything, it probably will err on the side of injecting too much credit.
It will still be some time before many of these issues are resolved. Don't be too aggressive and keep some cash available until the smoke clears. James E. Lebherz has 28 years' experience in fixed-income investments.