Courtesy of Knowledge@ Wharton

Shaken Confidence -- for Now

Short term, there are a number of issues creating uncertainty in the markets -- including public perception of the markets themselves. "Confidence is shaken," McNabb said. Market volatility has driven many investors away from stocks and into other investments that are perceived to be lower risk. Equity purchases "basically came to a halt" on May 6 with the "Flash Crash," when the stock market plunged 900 points in a single day --  an event McNabb attributes to concern about the emerging debt crisis in Greece. "The Flash Crash didn't all of a sudden cause equity investors to get skittish," he said. "We think the Flash Crash was just a catalyst. It was probably the Greek debt crisis that was actually getting people to be a little bit more cautious."

Investor skittishness is nothing new. A look at market volatility in the S&P 500 over the past few decades shows a number of peaks and valleys, with the crash of 1987 and the global financial crisis emerging as "the two most volatile times in the history of the equity markets," according to McNabb. The Russian debt crisis in 1998 saw a level of market volatility that was lower than those two, but in comparison looks very similar to recent investor reactions surrounding the Greek debt crisis, he suggested. "So to say confidence in the markets has been shaken is fair, but at the same time, it's something we have seen before and we will see again. These things tend to be pretty cyclical."

Confidence could erode further depending on how Europe fares financially in the coming months. A possible European debt crisis "is one of the uncertainties as we move forward over the next six to 12 months," he said, noting that economists and market watchers at Vanguard are paying attention to credit default swaps for clues to Europe's financial health. "Greece does not look great," McNabb added. "The market is pricing that in as we speak. Ireland is not doing very well. You could argue that Ireland is really not solvent today. You hear a lot about Spain, [but] the market is treating Spain as though it will get through."

Back on this side of the Atlantic, housing news continues to rattle the market and put a drag on the economy. "The big question is: Has it bottomed?" McNabb said. Based on a comparison of housing prices and the consumer price index (CPI), housing may still be somewhat overpriced. "In the long run, housing prices have tracked CPI almost perfectly. There's a very, very strong correlation," he noted, referring to a chart showing the uptick of both over time. The two lines danced closely on the same slope for decades, until the housing boom in the mid-2000s sent housing prices steeply upward. "What you see here is this massive bubble, where housing prices got way, way ahead of what inflation predicted they should be, and obviously that fueled a lot of consumer behavior. Often when you have this kind of bubble, the reversion, if you will, doesn't stop at that nice little inflation line. It tends to go below it. So there's probably still some room for housing prices to fall further."

State and local government finances are another cause for concern over the next few months, but McNabb calls it "probably overblown" and mostly "headline risk." Many state and local governments are struggling with budget gaps as obligations rise and revenues fall. Fears have been growing that widespread defaults could cause another subprime-style crisis. McNabb disagrees with independent analyst Meredith Whitney, who has predicted up to $100 billion in defaults. "In 2008, the worst year of the crisis, there were only $8 billion of municipal defaults. So we don't think Meredith Whitney is correct," McNabb said. The debt burden does not make up a large part of state budgets, he added.

The last of the short-term risks McNabb identified is the shifting regulatory landscape resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law in July. A response to the financial crisis, the reform act is the most sweeping financial regulatory overhaul since the Great Depression. "Dodd-Frank [is] 2,300 pages, and none of us has a clue as to what to do," McNabb said. "There are literally 270 studies contemplated over the next 18 months as a result of Dodd-Frank.... There's a whole bunch of uncertainty, and that's going to [influence] the markets." He is "particularly worried" about the future of money markets, the way derivatives are traded and the notion of systemic risk. "If Dodd-Frank allows this oversight committee to designate anybody as 'systemically risky,' then you have no idea what you're going to be subject to. The Fed is going to come in and essentially dictate how you operate. That's obviously a concern."

McNabb's biggest worry about the future -- what he calls the "single biggest overhang to long-term economic health" -- is the rising level of U.S. debt, which is roughly $13.5 trillion and predicted to double by 2021, according to the Congressional Budget Office (CBO). It could grow even higher than that, given that the CBO uses what McNabb calls "very optimistic" assumptions to arrive at this estimate. "The CBO has unemployment dropping to 5% in the next three to four years. And if you believe that's going to happen, we've probably got some really bad muni bonds we'd like to sell you."

Another way to analyze U.S. debt levels is as a percentage of gross domestic product (GDP). By that measure, U.S. debt is projected to surpass 100% of GDP. "So it kind of looks like Greece, looks like Ireland, looks like Portugal and so forth," he said. "This is the thing that haunts me the most.... This has to be solved."