Does the Country Need the Stock Market to Crash?

In this segment of The Motley Fool's financials-focused show, Where the Money Is, banking analyst David Hanson is joined by Motley Fool One analyst Morgan Housel to discuss the day's headlines. Among the newsmakers they discuss are the nomination of Janet Yellen as the next Federal Reserve chairman and how the government shutdown is affecting the housing market.

A full segment transcript follows.

David Hanson: We're all set to have a new chairwoman. We tell you why Treasuries are important. You're in the right place, folks, because this is Where the Money Is.

Welcome to the show, folks. I am David Hanson, normally, joined by Matt Koppenheffer -- but he is in Senegal or some African coastal country, so I'm joined by Morgan Housel, a Fool One analyst now. You are now in-house, no longer just a writer for us. Got a busy day of headlines. Let's throw up the first one. Got to start with Janet Yellen, of course. From The Wall Street Journal: "Yellen Is Obama's Choice as Fed Chief." Not a huge surprise here, right?

Morgan Housel: Yeah, I mean, this is already priced in by the market. We've known it for several weeks. Since Larry Summers bowed out of the race about four or five weeks ago, it was pretty much assured that Janet Yellen was going to get the nod and it's almost certain, I think, that she will be confirmed by Congress as well. Although who knows what Congress is going to do.

David: Do you think that this was -- I mean, Summers pulled his name out, what, three weeks ago -- something the administration was kind of holding onto this? The market's been down a couple percentage points -- "Hey, let's give them something they like, let's give them Yellen."

Morgan: You know the consensus several weeks ago, before we were talking about the government shutdown, when everyone was still focused on who was going to run the Fed, consensus was that the White House was going to announce around Oct. 1. Maybe this is a little delayed, but they've had other stuff on the plate last couple days, obviously.

David: Moving on to the second headline of the day, we've got this one from MarketWatch: "Congress Posing 'Grave' Risk to U.S. Economy, Mortgage Banker Chief Says." So we're talking about the shutdown, the debt ceiling -- the Mortgage Bankers Association's president comes out and says, hey, this is going start to have an effect on the housing market, because if IRS income verification, people not having their paychecks coming in that are federal employees ... do you see this as kind just a blip on the radar and the long-term economics, supply and demand housing market, that's what's going to win out, or something like this, could that really pose a grave risk to the housing market?

Morgan: Right now, the government shutdown is a blip on the radar. I think it will affect the housing market in the short run. You know, the single largest variable that drives housing, very obviously, is people's income. If you lay off 800,000 government workers, that's going to pose somewhat of a problem in the short run, and then, as you mention, there are things with income verifications -- there are a huge portion, effectively all, of the residential mortgage market is government-controlled, in one way or another. When you start throwing wrenches in that system, it's going to slow things down a little bit.

In the long run, as you said, it really comes down to the supply and demand of household formation, the strength in the economy. If we were to not raise the debt ceiling, and default on Treasuries sometime in the next couple days, that would have a very substantial long-term impact on the housing market.

David: Mainly because of its potential effect on mortgage rates?

Morgan: On interest rates, right. If interest rates rise because the economy is growing faster, that's a good thing. If interest rates rise because the market is putting in a risk premium on it because they're more dangerous now, we don't know if the government is going to pay back, that's a bad thing, and that will slow down the economy

David: All right, we're going to talk a little bit more about that later, but going on to our final headline. This one is from The New Yorker: "Why America Needs a Stock Market Crash." And in this post, John Cassidy is saying that with all this indecision in Washington, we need the stock market to go down a couple percentage points here, and that will really be the impetus for them to actually make a decision. Is this something you really think would work?

Morgan: Yeah, I think that absolutely would work. And something that John Cassidy talks about in this article is, he goes back to October 2008, when Congress and the Fed were debating the TARP bank bailout program, and its first pass in Congress -- when they were voting on TARP -- Congress voted it down, they said "No, we're not going to do TARP." Immediately within seconds, the Dow fell 800 points. That day I think it closed down 777 points, which is one of the worst days in history. Congress got the message, and then they went back in and then passed it.

I think whenever you're in these negotiating situations, coming up to a point where there's an obvious downside and there's some heat under their rear ends to get things done, that's what we're really pushes people.

David: You talk about the potential for a crash, though. I think it's important to put it in perspective. Say the market drops 10%, which, 10% over the course of three days, that would be pretty huge. I think people would be running around like their heads are cut off, but even if the market goes down 10%, we're still going be in the green for the year as they get, shows you that, one, you can't try to time these "market crashes" and try to get in right at the floor, and if you would have just been holding through even with a 10% "crash," if it happens, you'd still be positive.

Morgan: This is something that we talk about a lot. The track record of individual investors being able to time the market, get out before it crashes and get back in before it rallies, makes slot machines in Vegas look attractive. I mean, no one can do it, can time it like that. So what we also see is that when the market does crash, historically, that's also when you have some the market's best days.

So you go back to late 2008, when the economy is falling apart and stocks are crashing, you had some of the best days in the stock market in history during that period, and if people try to get out to avoid the downside, they almost invariably end up missing the upside. In 2009, when the economy was still really bad, stocks went up 25% that year. If you try to get out before that, a lot of people missed that upside, and in the end, by trying to tweak your portfolio -- get out now, getting then -- they really just end up whittling their wealth away.

David: I think the way you have to look at it, and now you've done some work on this, is don't try to time the market, but have your cash in your portfolio available to take advantage a big market swings. So not necessarily keeping it all on the sideline and saying, now, here's my chance to go 100% equities, 100% stocks, but keep appropriate cash balance, and when those opportunities are there, you put some put the money in the market, let it work.

Morgan: When you have some spare cash and the economy is freaking out and investors are panicking, selling everything, that spare cash is your best friend, and that's when you're really going to go in and get some great buys that you're really going to appreciate five or 10 years down the road.

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