Fed builds confidence by facing liquidity issue

Hank Herrmann, Chief Executive Officer, Waddell & Reed Financial, Inc.

April 2008

The opening quarter of 2008 brought more daily price volatility than we've experienced in the U.S. since the 1930s, according to a recent study by Standard & Poor's. The U.S. financial markets dropped 9.45 percent, as measured by the S&P 500 Index. Foreign markets were not immune, dropping 8.91 percent, as measured by the MSCI EAFE Index.

As we begin the second quarter, things are less bad than they were at the beginning of the year. I use the term "less bad" intentionally, as the problems we face have not gone away. However, the Federal Reserve now appears to have gotten things right in its approach to our challenges. That's good news. The Fed has cut interest rates aggressively since last September, with the federal funds rate going from 5 percent to 2.25 percent. Prospects for further cuts remain.

As rates were cut, it became apparent to the Fed that we weren't just facing a credit issue, but a liquidity issue. Simply cutting interest rates wasn't enough, as money was not going where it needed to go. The Fed then introduced several unusual mechanisms to address illiquidity, allowing major banks and brokerage houses to exchange mortgages for treasuries at the Fed. The so-called "bail out" of Bear Stearns was, at least so far, the final innovative action. This event likely ended the crisis; however, the problems remain.

As of yet, European governments and the European Central Bank have not been sufficiently proactive in response to their credit problems. Additionally, in the U.S., we have not adequately addressed the housing crisis. Some recent developments, however, are encouraging. On the first day of the second quarter, UBS AG took aggressive action to improve its capital base by announcing its intention to raise $15 billion, staving off concerns of a Bear Stearns-like collapse. The Swiss government strongly encouraged that action, which was another good development. Other foreign financial firms are raising capital and cutting dividends as well, thus reducing survival risk. Globally, it now seems to be understood that we need to improve transparency and accountability at financial services firms. Transparency has been a major concern on the part of the investing public, leading to a lack of confidence, which has exacerbated problems.

So, one worry, pro-activity, is improving. What about housing? We've heard a lot of talk from politicians, presidential candidates, the Treasury Secretary and the Bush administration. But so far, it is mostly talk. Housing remains a very complex problem, as we're seeing the worst supply/demand fundamentals in a generation. Encouraged by the Fed's recent creativity in addressing the credit issues, we are hopeful that we'll see aggressive action on housing as well. This will require congress and the Bush administration to act, a requirement complicated by election year issues. Until we get programs, rather than proposals, the housing challenge will remain. But we are going in the right direction, so housing, too, is less bad now than it has been.

As financial firms shore up their capital positions, confidence will improve. However, consumer spending has been supported by credit and home-equity extraction for some time. This will now change. Consumption in the U.S. likely will slow this year and the savings rate will rise. Gross domestic product (GDP) growth likely will decline this year. Corporate earnings will be moderately lower. It is important to remember, however, that stock price direction is dependent on two things: price-to-earnings ratios (P/E), and corporate earnings. Two thirds of all bull markets have come about due to P/E expansion; only one third comes from actual earnings growth.

So a big question for investors is what are P/E multiples going to do? Today, P/Es are historically low, especially relative to interest rates. The probability that P/Es will expand is pretty good. The reason P/E multiples are low is a lack of confidence. If we see improvement in the credit markets, which appears to be happening, then P/Es have room to move higher.

How much expansion can occur? That's a good question. A helpful way to respond is the "rule of 20." Subtract the current inflation rate from 20, and that will tell you what the forward-looking P/E multiple could be. Currently, inflation is approximately 3 to 4 percent, so P/Es should be 16 to 17 times, in a normal environment. They are currently about 13 times. As confidence improves, we will move back toward normalcy. Stocks are cheap and there is ample room for appreciation.

Past performance is no guarantee of future results. The opinions expressed in this article are those of Mr. Herrmann and are current through April 2008. Mr. Herrmann's views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. Waddell & Reed Financial, Inc. is the ultimate parent company of Waddell & Reed, Inc.