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5 Things That Have (or Have Not) Changed in the Last 3 Years

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar and welcome to the Friday Five. March 9 marks the three-year anniversary of the market bottom. Joining me to discuss what has changed since then as well as what stayed the same is Morningstar markets editor Jeremy Glaser.

Jeremy, thank you so much for being here.

Jeremy Glaser: Christine, it's my pleasure.

Benz: Jeremy, we are marking the three-year anniversary of the market hitting bottom. We've had a really good rally since then. What do want to talk about?

Glaser: Well, these three years certainly have gone by pretty quickly, but today I want to talk a little bit about how private-debt problems have really become public debt problems, about consumers, about the tech industry, the Federal Reserve, and finally valuation levels.

Benz: Let's start with the first point--private debt. Consumers being overextended was really at the epicenter of the housing crisis. How does that relate to what's been going on in the public debt market?

Glaser: Three years ago I think we really were focused on consumer debt. We were worried about the debt that was on banks' balance sheets--from consumer lending to mortgages, credit cards, student loans, or whatever it could be. The idea of sovereign debt being a big issue wasn't really on a lot of radar screens, and I think that's something that has really changed in the last couple of years. Instead of worrying about banks' balance sheets--in the U.S., they have really raised enough capital to ameliorate a lot of those concerns--we hear a lot about debt in Europe; we hear a lot about debt in the United States and across the world and what that's going to mean for investors.

A lot of that was that governments guaranteed a lot of that bank debt. They guaranteed a lot of that credit debt and took it from a private issue into a public issue. A lot of it was just the spending that went on for so long in so many countries, well beyond what tax revenues were coming in and what the countries could really afford to spend. I think we've really been seeing that reverberate for a long time. And in this week, in particular, we're still completely focused on Greece. The country has been able to get its private creditors to agree to bond swap and wipe out EUR 100 billion of debt on its balance sheet, but obviously, Greece is not out of the woods yet. We still have to see if this deal is really going to stick and if it is really going to stabilize the market. If that contagion is going to spread to larger and more important economies such as Italy and Spain, I think that sovereign debt and kind of the idea of public debt is something that we're going to be talking about for quite a long time.

Benz: So, in terms of Greece, how do the markets seem to be reacting to this latest deal to do a swap with the bondholders?

Glaser: They seem to be a pretty happy with that. I think it is mainly because it reduces a lot of the uncertainty and really pushes out any prospect of a disorderly Greek default. Don't mistake this as anything but a default. They're saying, "Instead of getting 100 cents on a dollar, you're going to get $0.25 on the dollar." They are coercing, through collective action, some bondholders to take losses even if they didn't want to. Certainly, this is Greece admitting finally that it cannot pay all of its obligations, but there are still a lot of other problems. So, I think the markets have some cautious optimism here. The markets see that it gets just past that March 20 date when Greece has a lot of debt coming due. But certainly this is not the last time you're going to hear about the Greek debt crises.

Benz: I'm sure you are right. How about consumers? Do you think consumers have made strides obviously since the financial crisis and the housing market crisis? But you know that recently there have been some indications that consumer debt is creeping back up.

Glaser: Deleveraging was a big story that we've heard a lot about from before the market bottom. The worry was that consumers had built up all of this debt, either in their homes or through credit cards, and they were going to need a long time to pay it back. They're going to have to work extra hours. They're going to find money wherever they can to really get rid of this crippling debt load instead of being able to just refinance their homes and kind of use that as an ATM to pay off those debts. They are going to have to really go through that long process of slowly paying it off while still having pretty big interest charges coming in. That makes those balances more difficult to really pay down.

For the first time since really the start of the great recession, the Federal Reserve said that household debt actually ticked up again, and that the deleveraging has really slowed down a lot. I think this speaks to the fact that a lot of that debt was paid down. Consumers who really couldn't afford their homes anymore have gone through the foreclosure process, and that debt is no longer with them. People are feeling a little bit more confident about the job situation; they're feeling more confident about their ability to earn money and therefore are willing to put some more purchases on credit. They are able to buy both durable goods and consumable goods with some of that credit. So I think that's a sign that consumers are certainly feeling more confident. Could we have another period of deleveraging? I think absolutely, but I think the fact that that debt is starting to inch up shows that consumers are feeling a little bit better.

Benz: One thing consumers appear to be wiping out their wallets for are iPads or other consumer-electronics devices. You know that that's something that has remained somewhat steady during the past three years, that there has been a strong appetite for getting new gadgets. What's the latest news there?

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Glaser: It's been somewhat surprising that the consumer-electronics category has done really well over the last three years, and tech more broadly has done very well. Consumers have gone from seeing the smartphone as maybe a luxury item to an absolute must-have necessity as part of their lives; they wouldn't think about not having that $100-a-month smartphone plan. The iPad is only two years old, and already it's this incredibly large driver of Apple's growth. It's a driver of the tablet category; it keeps growing. People really want to spend the money to buy these gadgets, and I think it really speaks a lot to the utility that people find in them and the fact that there is a little bit more confidence, like I was just saying earlier, to open up the wallet for indulgences that might cost a little bit less than a new house or a new car yet are things that people feel like they are getting a lot of value out of.

Benz: And Apple introduced its latest iPad this week. Are you hearing that consumers will continue to be excited about this product?

Glaser: Yes. The new iPad that came out I think broadly met the expectations, at least of the analyst community, of what Apple was going to do, and I think it just helps further cement Apple's lead in this segment of the market. I think certainly as we saw with the iPhone 4S, Apple doesn't need to make huge changes in order to get people to upgrade or to get new people into the ecosystem. The products have that network effect that really works to Apple's advantage. So, I think that Apple is probably going to have another hit on its hands here.

Benz: Switching gears, Jeremy, the Federal Reserve has been working feverishly behind the scenes during these past three years. But some people say, "The Fed's out of tools in its toolkit." What's your take on that question and is a third round of easing possibly on the horizon?

Glaser: The Federal Reserve has certainly been a big driver of the economy and a big driver of the stock market since the bottom three years ago. Certainly one of its biggest tools has been quantitative easing. The Fed is printing money, it is keeping interest rates really low in an attempt to stimulate the economy and get investors--instead of staying in safe assets or perceived-safe assets like cash or short-term bonds--to look at risky assets such as dividend-paying stocks or other equities that people might find have better return potential. Really the purpose is to make sure that the capital is still getting allocated into those risky sectors, so that you just don't have a huge flood of people out of the stock market.

If you're able to get a really good return on cash right now and you are uncertain about economy, you might feel pretty comfortable just holding that cash and waiting and seeing. But the Fed is trying to make sure that those rates stay as low as possible. You have enough money in there that you could do mortgage refinancing. It has a lot of ways to stimulate the economy. But after the Fed did these two big rounds of quantitative easing, there were a lot of questions that they could continue. There were worries about it stoking inflation. There were worries about if it's really just kind of pushing on a string, that you could throw in money at it. But if there's no demand for products and no demand for mortgages, it's hard to get people to keep taking the loans out.

This week we got a rumoured report from the Wall Street Journal that the Fed is considering another round of bond-buying. But this time instead of just printing money, the Fed would both print the money and then sterilize it, which means borrowing some short-term money with the new cash that's coming into the system in order to make sure that it doesn't greatly expand the money supply and doesn't stoke inflation. So this is the Fed saying, "Look, we're concerned about inflation too. We're looking at these same price numbers. We're willing to go out to the marketplace and keep rates really low. And we have these other tools at our disposal to do so in a way that we don't think it's going to really keep price levels rising."

I think that's an interesting statement. I still think we're probably a long way away from the Fed actually pulling the trigger on this kind of plan, but these kinds of leaks tend to be the first step of laying out the groundwork for these tools just to let investors know and let the market know that that's something of a possibility. I think that if there's still some economic weakness and if the recovery that we've seen kind of accelerating starts to slowdown, I think this move is something that Fed chairman Ben Bernanke could very well do.

Benz: So when you say "a long ways away," what summer possibly or any conjecture there?

Glaser: Yes, I think trying to read exactly what the Fed is going to do at any given time is always a bit of a losing game. But I think it could be as early as the summer, if things really start to slow down. It could be a year from now if things are looking better. It could be never if things are looking a lot better. I think it really is going to depend on what the economic data looks like. I don't think the Fed has a pretty determined schedule for anything like that.

Benz: The last topic you wanted to discuss I think is really an important one, given the anniversary today: market valuations. Stocks obviously got quiet cheap back in late 2008 and early 2009. How do valuations look from where you sit today?

Glaser: Much fuller. Certainly it shouldn't come as a surprise that when you have just this incredible run over three years from the bottom, that stocks are not going to be as cheap today as they were then. We've gone from stocks being at 60% full value. So essentially they were at a 40% discount on the average stock according to our staff of equity analysts.

Benz: Fantastic buying opportunity in hindsight.

Glaser: Yes, you can look at that right there, and it says, "Just back the truck up." At that time you could really have bought almost any stock, and you would have done pretty well. Up to right now we're at 94% value. So it's a much more modest discount to stocks, and I think investors have to be a lot more careful about individual security selection and making sure you're gaining a company with great long-term prospects and buying a firm that is at a decent discount. You might not be able to get that huge discount you had three years ago; those buying opportunities don't come along very often. But certainly stocks are much more fully valued now than they were then.

Benz: So, I think for investors listening to this, it's hard to get excited about bonds that's for sure. And then if you're saying that stocks are trading pretty close to our estimates of their fair value, what should investors do?

Glaser: I think it's important to see that just because a stock is trading very close to its fair value, such as that we think the market is fairly valued, doesn't mean the return from stocks is going to be zero, that there is no return. I think stock investors still get to participate in those dividend payments. They still get to participate in the earnings growth of those companies that's going to expand the stock price over time.

Does it mean there is less margin for error? Yes. When you're buying a stock at a 40% discount, if your thesis doesn't work out exactly the way you thought, if things aren't quite as robust, you still are going to get a pretty good return because you bought it so cheaply. So, again, you have to really be focused on buying those high-quality companies and be focused on buying firms that you think are going to be able to expand their earnings at a really nice clip to get that nice return. But I think compared with some of the headwinds that bonds are going to face or the headwinds that cash could face, if inflation starts to pick up, I think stocks still look pretty attractive even at fuller valuation levels today.

Benz: Jeremy, thank you. It's a helpful review of the past three years. Thanks so much for being here.

Glaser: You're welcome, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.