The
calendar on your refrigerator door may be new, but nothing much changed
in the stock market in the first month of 2009. Extreme volatility remained
the order of the day and stocks continued their slide, with the S&P
500 recording its worst January ever.
Late in the month, after President Obama's inauguration,
the market rallied for four consecutive days amid hopes for a
quick passage of his stimulus bill. Spirits seemed to be lifting
and the market appeared to have a decent chance to eke out a
second consecutive monthly gain. But the good feelings didn't
last as stocks fell sharply in the month's last two trading
sessions. Though one out of three stocks finished higher in January,
the S&P 500 Index lost over 8%, while the Russell 2000, which
represents small cap stocks, lost 11%.
You don't have to look hard to find a culprit for the
continued weakness in stocks as a steady flow of extremely negative
economic headlines has consumers and investors in a black mood.
So black, in fact, that many seem to be convinced that the global
economy is headed for the "Next Great Depression." We
are not members of that camp.
In this month's report, we'll detail why we believe
the economy is in better shape than many think. We will also
discuss the role of expectations and how they impact stock prices.
Lastly, we will highlight an asset class we find particularly
appealing in the current market environment, and which we believe
is well positioned to generate an attractive risk-adjusted rate
of return.
Economy Not As Bad As It Seems
Given recent headlines such as "World Economic Growth Worst
Since WWII" we may sound slightly daft to argue that the
economy is not as bad as currently perceived, but there are several
reasons for our view.
First, while Obama and his financial brain trust have been front
and center in talking about the severity of the current economic "crisis," we
have to remember that to gain enough public support for a nearly
$1 trillion stimulus package, they need to convince everyone
that it is absolutely essential if the economy is to avoid collapse.
In that regard, a little bit of overt pessimism (possibly over
done) is deemed necessary and that's what we're getting
right now.
Second, in the end, even if many observers feel the package
isn't the right size, or isn't targeted enough, or
will take too long to implement, the passage of a stimulus bill
should be a net positive, at least in the short term.
While we think the direct economic impact of the stimulus is
probably over-stated, at the very least it should have positive
symbolic value. It will mean that "something is finally
being done;" it will get investors out of their "wait
and see" mode; and lastly, once the bill is passed, the
talk from the administration will switch from why the package
is needed (i.e., the terrible state of the economy) to why the
package is working and the economy is improving!
Third, in addition to whatever effect the stimulus package may
ultimately have, there are a few tangible signs that the economy
may already be bottoming. Though most indicators still disappointed
in January, there were some important positive surprises.
The beleaguered housing market got some good news last month
as existing home sales rose 6.5% in December, when a further
decline had been expected. Granted it took lower prices to spur
the sales (the median price fell 15.3%), but importantly, inventories
are beginning to clear, falling to a 9 month supply (from 11
the previous month). We expect that this trend will continue
over the course of the year as consumer confidence improves.
Also supportive for housing is that the affordability index reached
a record high of 158.8 going back to 1971. This reading means
that a household earning the median family income of $61,058
would have 158.8% of the qualifying income needed to purchase
a median-priced existing single-family house ($174,700) with
a 20% down payment.
Also in December, the Conference Board's Leading Economic
Indicator (LEI) Index was positive for the first time in many
months. The gain in the LEI was mostly driven by the "continued
and very large positive contribution from real money supply." This
is a direct result of the Federal Reserve's lowering of
its target for short-term interest rates along with "quantitative
easing," that is direct buying of debt instruments. This
interest rate environment suggests a better economy ahead.
Freight traffic also seems to be improving, albeit still from
depressed levels. The Baltic Freight Index, which provides a
measurement of the price of moving major raw materials by sea,
has been steadily improving for weeks now. In addition, North
American railroad car loadings also suggest a potential rebound
(again from very low levels).
Situations can obviously deteriorate, however, in our view,
the question to ask here is not how much worse is it likely to
get, but when does pent-up demand become so strong that a floor
to economic contraction is established? Let's look at two
of the hardest hit industries: housing and autos. These industries
have been a major source of the economic problems of late, but
it could be argued that the worst times for these two pivotal
areas may be behind us.
First Trust economist Brian Wesbury (an extremely thoughtful
and accessible economist) had this to say about auto sales recently:
"Figures from the Federal Highway Administration
suggest there are now about 240 million light vehicles in the
US, including those owned by individuals and businesses. In December, light
vehicles sold at a 10.3 million annual rate. At that pace, it
would take 23.4 years to replace all the cars and trucks now
on the road in the US. Normally, the replacement rate for auto
sales is about 13 years, and even at the bottom of the recession
in 1981-82 it was only 16.3 years."
Wesbury takes a similar approach to housing with the following:
"Take home building: There are about 130
million homes in the US, according to the Census Bureau. In December,
the latest
data available, home builders started houses at a 550,000 annual
rate. In other words, at the current pace of housing starts,
it would take 236 years to replace all the homes in the US. To
put this in perspective, homes are normally built at a pace that
would replace the existing stock of houses every 75 years. Unless
you can imagine everyone living in Thomas Jefferson's Monticello -- first
lived in 239 years ago -- this is impossible to sustain."
While it's possible for the auto and housing industries
to still trend downward in the short-term, it seems highly probable
that we're at least nearing the bottom, and eventually
demand -- even if it remains below long-term averages -- will
start creating positive growth in these sectors again.
On a personal note, when my family and I went shopping this
past weekend we found the customer traffic at every store we
passed to be surprisingly heavy -- even heavier in some
cases than what we saw during the holiday season. Even our favorite
family restaurant had a line out the door. Maybe it was just
the respite of nice weather in what has otherwise been a tough
winter, but whatever the reason, the mood (and the lack of parking!)
surely did not match the gloom we have been reading about in
the news.
The current recession is now about 14 months old. The average
recession since WWII has been 10 months and the longest has been
16 months, which happened once in the 1970s and once in the 1980s.
We are surely going to surpass that length, so in that respect,
this recession is going to be the worst since the 1930s. That
said, it doesn't mean it will be as bad as the Great Depression.
Money-manager John Hussman sums up our fellings quite well:
"This is not to minimize the prospects for a further economic
downturn, but to say that this is "the worst economy since
the Great Depression" is like blowing up a crate of dynamite
on the Nevada Proving Grounds and saying it is the worst explosion
since the detonation of the atomic bomb there. Even if the statement
is accurate, the comparison is absurd."
The current environment does not rival the Great Depression,
in fact, looking at the Conference Board's Composite Index
of Coincident Indicators, the severity of the economic weakness
in the current recession doesn't even rank in the top five
since WWII. In nominal terms, during the Great Depression, the
U.S. economy shrunk nearly 50% from its high in 1929 to its low
in 1930. Currently, our nominal GDP has contracted only 1% off
its all-time highs reached earlier in 2008. Today's generation
of economists grew up studying the policy mistakes made in the
1930s (Bernanke in particular is a student of the Great Depression)
and we have avoided repeating them so far (such as a failure
to add liquidity, backstop bank assets, or pro-actively increase
counter-cyclical government spending).
Investor Expectations Are Certainly Depressed
In terms of consumer and investor expectations, however, it certainly
feels like a depression. Even though confidence seems to be
improving mildly by some measures, it hasn't been enough
to prompt any significant risk-taking as people remain hunkered
down in anticipation of more economic losses. As a result,
investors have dropped their equity allocations to their lowest
levels in years. Cash levels meanwhile, are now at their highest
levels in many years. This is true not just of individual investors,
but institutional investors, such as hedge funds and private
equity funds.
Markets often bottom when the consensus outlook has been extremely
negative for some time. That's because under those conditions,
the bulk of the selling pressure is likely exhausted. Think about
the tremendous amount of negative news since the stock market's
panic low in early October. Despite weakening economies worldwide,
historic levels of government intervention, geopolitical tensions,
the Madoff scandal and more, nearly four months later, the market
is basically still at last October's level. In short, the
market has taken quite a few punches in recent months and hasn't
pushed to new lows.
Couple this market action with the tremendous amount of cash
on the sidelines now -- earning not much more than 0% -
and even marginal economic improvement (from very low levels)
will likely create the positive surprises that can begin to fuel
a market recovery.
Corporate Bonds Look Especially Attractive
Valuation measures are now suggesting above-average long-term
returns for stocks for the first time in a very long time.
In some respects though, there is an asset class even more
attractive from a potential risk-adjusted performance perspective
and that is corporate bonds.
Corporate bonds come in many varieties, but to simplify, corporate
bonds could be put into two buckets: investment grade or high
yield. Both are currently attractive, though each has their own
distinctive risk profile.
High-yield bonds, otherwise known as "junk" bonds,
tend to trade much more like stocks than bonds. High-yield bonds
are high-risk, non-investment-grade bonds with low credit ratings
which are much more leveraged to the economy and therefore have
a much higher probability of defaulting. Junk bonds need to offer
higher yields to compensate investors for taking on their higher
credit risk and higher price volatility. Historically speaking,
high-yield bonds have rewarded investors with attractive returns.
However, last year was their worst year on record. As a result,
yields were recently above 20%. While defaults are clearly on
the rise, those record-high yields provide what we believe is
a more than adequate margin of safety. With credit conditions
starting to improve and investor interest in this asset class
starting to come back, we are optimistic about its potential.
Investment-grade corporate bonds may not have the sizzle of
high-yield bonds, but they too appear to be quite attractive.
Recently, high quality (AA) credit spreads were trading at their
widest levels in 75 years. If stocks were pricing in a deep recession,
corporate bonds were evidently priced back at Depression-era
levels.
Depending on what the economy does, high quality corporate bonds
might just give the stock market a run for the money, especially
on a risk-adjusted basis. Over the past twenty years investment-grade
corporate bonds have generated returns similar to equities, but
with one third the volatility.
Corporate bonds, especially investment-grade, may also start
to perform better before the stock market does. There are a number
of reasons for this. First, the current credit environment should
continue to motivate many corporations to emphasize improving
their balance sheets over investing for growth. Second, many
government policy initiatives are likely to favor bondholders
before stockholders. Third, as many investors begin to warm back
up to riskier assets, a good starting point may indeed be investment-grade
corporate bonds.
Reasons for Hope
In summary, we think there are several valid reasons for hope
in 2009, and plenty of investment opportunities for the patient,
long-term investor. Several asset classes appear to be attractively
priced, with some at their most appealing valuations in decades.
Many potential leading indicators have improved in recent weeks.
And, once we get on the other side of the stimulus package,
we think the information cycle will begin to get a bit more
upbeat. That should in turn start to help lift the gloom and
doom that now seems to be so entrenched. Remember, it doesn't
take a lot to change expectations, even extreme ones; less
than a year and a half ago, in 2007, consumer confidence was
at an all-time high.
Thank You Again
Once again we'd like to express our sincerest thanks to
you for your continued support. Needless to say, it was a terrible
year for the stock market in 2008 and we all suffered emotionally
and financially. Many of our new clients came from referrals
and I'm proud to say that at the end of 2008, we had a
record number of clients. We will continue to work diligently
to maintain your trust and confidence.
Sincerely,
