The S&P 500 financials sector, which includes banks, brokerages and insurance firms, fell 18% in February on top of January's 26.3% decline, for a total decline of 39.6% in the first 9 weeks of 2009. This sector is down 80.2% from its all-time high in February 2007 and is at the level last seen in December 1994. Within the sector, Citibank is down 97%, Bank of America is down 93% and AIG is down 99.5% from recent highs. However Morgan Stanley and Goldman Sachs, while well off 2007 highs, are up YTD, so at least some banks are doing better.
Last month, we asked the question, "Can the banks be saved?" The answer so far seems to be yes, but selectively. So far in 2009, about 19 smaller banks have been declared insolvent and taken over by the FDIC. Shareholders are wiped out, but for the most part the day-to-day operations of these banks are unaffected while the FDIC merges the remaining assets of the bank with another firm. Depositors and checking account customers are unaffected, borrowers still owe their mortgage payments, checks and credit card continue to work. 2800 banks disappeared in the 1982-1992 banking crisis, and most Americans don't even remember that period. 10,000 banks went out of business between 1929 and 1932. In that period, deposit insurance did not exist, so every bank failure entailed the wipe-out of all its depositors.
"Bank nationalization" was hotly debated over the last month. The Obama administration has made clear that it will only take ownership of banks as a last resort as we saw with Citigroup on Friday. Paying a 10% dividend on the US Government's purchase of preferred stock in Citigroup was not sustainable given its constrained capital situation. The preferred shares are converted to non-dividend paying , and Citigroup is required to find private investors willing to match the government's investment dollar for dollar, leaving the US owning 36%, new owners 36%, and current shareholders 28%. Still, 28% of something might be more valuable that 100% of nothing. Bank of America could be the next candidate for similar treatment. PNC Financial, US Bancorp and Wells Fargo are also potential candidates. As investors are afraid to own stocks that might be diluted by government ownership, they're frantically selling all banks. Given that quite a few smaller, regional banks avoided investing in toxic mortgages, that selling is overdone.
AIG is 80% owned by the US government and has already received $150 billion in aid of various forms, but may need an additional $100 billion to avoid the collapse that Lehman suffered last September, which placed the world's financial system on its current downward spiral.
When does a recession become a depression?
The Great Depression lasted 10 years with 25% unemployment, 24% shrinkage of GDP, consumer price deflation of 23% and an 86% decline in the value of the S&P 500. The current recession is 15 months old with unemployment at 7.6%, a decline in 4th quarter GDP of 6.2% and a 53% decline in the value of the S&P 500.
Economic forecasts for the US are at this point wildly divergent. The current recession could end as early as Q3 2009, or not until the end of 2010. Unemployment could rise to 9% or even 11%. Some analysts think that stock prices could fall another 15-20%, although even using the most pessimistic assumptions, stock valuations are at the lowest level since 1982.
The key issue is whether inflation, currently at 0.0%, becomes deflation (i.e. negative.) In that environment, nobody will buy what will be cheaper tomorrow. Given that retailers can only sell at massive discounts, cars and homes aren't selling at all, and commodity prices are down 45-70% from summer 2008, we're surprised inflation isn't sharply negative already.
In the 1930's, the money supply crashed 25% as banks shuttered. Without cash, consumers were simply unable to buy goods, hence the 23% decline in prices. In the current environment, consumers are cut off from credit (no more home equity loans or credit card offers). The fear of unemployment and the loss of trillions of dollars in paper value in home prices and investments accounts have caused consumers to become much more cautious about spending. The US savings rate, which was briefly negative in 2004 (consumers spent more than they earned, borrowing the difference) is now sharply higher at 3% of incomes and expected to go to 5-6%. The increased saving would shrink the money supply, except that the US Treasury is aggressively pumping money into the system by buying up securities from the banking system. The cash deposited into banks to pay for the securities offsets the shrinkage in the money supply. This may cause inflation in a couple of years, but it's worth taking the risk to avoid deflation now.
The worst recession of the post war era was in 1980-82. Reacting to high inflation rates caused by adjustment to higher energy prices after the Iranian Revolution of 1979, the Federal Reserve shrank the money supply and raised Fed Funds rates to 20%. The rate on home mortgages peaked at around 23%. Unemployment peaked at 10.8%, inflation at 13.5%, and economic growth shrank 7.8%. Subsequent recessions in 1990-91 and 2001-2 were both short and mild.
The Fear of Fear Itself
To quote from Franklin D. Roosevelt's inaugural address, "the only thing we have to fear is fear itself-nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance." The new Obama administration is moving aggressively to shore up the banking system, to stimulate the economy with deficit spending, and to reduce the rate of foreclosures by getting cash to those home-owners most at risk. However, as fast as these programs are rolled out, hundreds of commentators rush to the airwaves and blogosphere to explain why they won't work. Furthermore, every day when average Americans get off work, whether at their gym, their bar, at home, on their cell-phone, the Dow "bug," which has mostly been negative for months, is right in their face. No wonder Americans are scared to death. Until that fear dissipates, spending is limited to necessities and investing is out of the question.
The stock market closed February 2.3% below the lows of November 20th and is 6% below the lows of the 2000-2002 bear market. However, the volatility is way down. In one week last October, the S&P 500 fell 14.9% over 5 days, then rallied back 11.6% on the following day. Hedge funds lost about 1/3 of their assets last year, and are trading with reduced leverage, so their ability to "gun" the market is sharply reduced. Retail investors have unfortunately taken up various leveraged and sector exchanged traded funds with a vengeance. In particular, heavy trading in ETF's related to the financial sector has caused that group to jump around 7-10%/day in recent weeks.
Eventually the problems of the banking system will dissipate. Despite the current recession, corporate profits of non-financials are 158% higher than at the low of the 2000-2002 recession, and 48% higher than June 1997, the last time the S&P 500 was at this level. Even if we assume some shrinkage in corporate profits through 2009, the stock market remains very cheap and massively oversold. We don't know what will turn investor psychology around or when. We do know that when this bear market ends, the first few quarters deliver the largest returns. So we're holding the stock positions that we have and waiting.