In the first week of March of this year, millions of Americans opened their February statements, saw that their accounts were down another 20% on the year after falling 38% in 2008, and sold out their stocks for good. Through March 9th, the S&P 500 fell another 8%, leaving the S&P 500 down a sickening 57% from the October 2007 high - the steepest decline in stock prices since 1929-32. Unfortunately for those Americans who sold, March 9th marked not only the low for the current bear market, but the lowest price for stocks in 13 years. Through May 1st, stocks rallied 30% in one of the steepest rallies ever for US stocks.
The S&P 500 still remains down 2.8% for the year and down 43.9% from the high. However, the NASDAQ is up 15.5% YTD as technology stocks soar 17.6%. Materials stocks are up 13.2%, and consumer discretionary stocks are up 8.3%. These sectors typically rally ahead of economic growth, which means that more and more investors are anticipating the end of the recession. We note that emerging stocks markets are particularly bullish - China up 50.0% YTD, India up 15.3% and Brazil up 25.9%. Those economies were not particularly damaged by the financial meltdown that swamped the US and Europe. Hundreds of millions of consumers in those countries moved into the middle class earlier this decade, driving current economic growth for those countries and ultimately for the world.
Sustainable rise or bear market "trap?"
The S&P 500 rallied 7 of the last 8 weeks, and the NASDAQ gained in 8 out of 8 weeks, the best "streak" this century. The one month gain of 9.4% and two month gain of 18.7% are consistent with rallies we've seen at the end of previous bear markets. However, the current rally is almost universally derided as a bear market "trap," which entices investors to invest in stocks, only to dash their hopes weeks later.
We have a bit more confidence in the current rally than most of our peers. As we have remarked in recent letters, valuations as seen in P/E ratios, Price/Book ratios and dividend yields are the best since the early 1980's. With one third of S&P 500 companies reporting, earnings are down 9.4% from a year ago. Excluding financials, which have rebounded significantly from last year's catastrophic results, earnings fell an average of 22.4% from a year ago. Stocks, however, have rallied on earnings reports because most companies have beaten the worst case expectations of analysts. The overall psychology of the market seems to have turned. In December, discussion of the bankruptcy of General Motors or Chrysler drove stocks sharply lower. Last Thursday, Chrysler declared bankruptcy, yet stock prices barely moved.
In recent years, institutional investors placed substantial percentages of their portfolios in real estate, hedge funds and private equity deals. Turned out, those investments were illiquid during the financial crisis, so institutions were forced to raise funds over the winter from the liquid parts of their portfolios, mostly by selling US stocks and investment grade bonds. Now institutional funds are flowing back to those sectors to restore asset allocations. Individual investors were heavy sellers of stocks in February and March (-$29.5 billion,) and barely bought stocks in April (+$1.6 billion.) Eventually, individuals will play catch-up. Hedge fund trading, particularly short-selling, which totally dominated markets from September through January, is diminished. We suspect that quite a few have closed doors for good, and those that remain are sharply constrained in taking on leverage and risk. The volatility indices on the NYSE and NASDAQ, while double the levels that prevailed from 2002 through 2007, are half the peak levels achieved in Q4 2008. Other technical indicators such as the solidly positive Advance/Decline line and the few stocks making new lows (16 on May 1st versus 1,220 on March 9th and 3,377 on October 10th) show net buying.
We see continued strength in all commodities with the exception of gold. Prices rise for copper, oil and farm products because demand is increasing, which speaks to a rebound in worldwide economic activity. Gold prices reflect industrial demand for jewelry and electronics, but are also affected heavily by "flight to safety" purchases. Gold prices peaked February 20th at $993/oz. but subsequently sold off 10%. The prices of US Treasury Bonds, another "flight to safety" investment class, are also lower over the last two months by about 5%. One of the most sensitive economic indicators, the Baltic Dry Index, which tracks the worldwide average cost of shipping, tripled from its December low after falling 94% from the May 2008 peak.
Bottom line: staying out of US stocks is becoming increasingly uncomfortable for many strategists. When that sentiment turns, will a "buying panic" ensue?
Recession continues in the US
1st quarter US GDP declined at 6.1%, hardly a cause for celebration after the decline of 6.3% in Q4 2008. Shrinkage of inventories reduced GDP by 2.8%, while a 38% decline in capital expenditures (construction, heavy machinery, computer hardware and software) subtracted 6.0% from GDP. However, increased consumer spending added 2.2%, and exports added another 2.0% to GDP. Last month we opined that "doom fatigue" had set in among consumers; rising consumer spending is mirrored by rising consumer confidence. The numbers are still way down compared to as recently as 2007, but trends are turning in the right direction. The charts below represent three of dozens of economic indicators that are higher including Consumer Confidence, the Institute of Supply Management-Manufacturing Index, and the Economic Cycle Research Weekly Leading Indicators.
At the same time, current conditions remain grim, with housing prices still falling at an 18% annualized rate, jobless claims still rising at historic rates, and personal income flat to negative.
Personal income bumped up in May 2008 as tax rebates checks spread through the economy, and will bump up again this May for the same reason. Government stimulus spending in general will boost economic growth through year end. Meanwhile consumers and businesses alike have a certain amount of capital spending that can't be deferred indefinitely. Lastly, with inventories at the leanest possible levels, businesses have limited scope to further reduce production. Net, US unemployment should peak within the next 3-6 months, start falling slowly into 2010.
The vicious cycle of reduced spending leading to increased unemployment leading to reduced spending is nearly broken. The US economy will shrink one, perhaps two more quarters, but will turn higher by year end. Many commentators feel that current recession is the worst since the Great Depression.
We believe that recessions in 1958-59 and 1979-82 were worse. The recession that ended in 1983 was particularly brutal, with unemployment peaking at 10.8% versus the current 8.5%, Fed Funds peaking at 15.0% versus the current 0.25%, and mortgage rates peaking over 18% versus the current 4.7%. Note how the quarter to quarter volatility of economic growth moderated after the US shifted to a primarily service driven economy in the early 1980's. Compared to the relatively stable US economy of the last 30 years, the current economic situation feels like the worst conditions since the 1930's
World's financial system continues to stabilize
US banks including JP Morgan, Goldman Sachs and Wells Fargo handily beat earnings estimates, while even Citigroup and Bank of America turned in better than expected results. Although it can be argued that the entire US banking system is currently insolvent, the rate at which banks must write down assets values is sharply reduced while spreads on conventional lending are at the highest level in a decade, so banks are currently cash flow positive. The Federal Reserve will release details of the banking system "stress tests" next week. We expect some banks to fail, but most to get by with a grade of "good enough." Banks are far less eager to finance hedge fund trading or private equity projects and will cut back heavily on risky derivatives trading such as credit default swaps. We regard this hesitation as good news - less leverage means more stability means more confidence, which ultimately feeds back to economic growth.
Much whining among financial professionals about how the US government is setting bank policies including capping pay and selecting executives. These professionals have yet to grasp the fact that if you kill the Golden Goose, you don't get any more Golden Eggs. Bank managers are concerned that their "All-Stars" will jump to hedge funds or boutique firms. Indeed, a few will make that transition, but bankers are more replaceable than they think they are. With 200,000 unemployed financial professionals in the US alone, filling the ranks should not be a problem.
The current excitement over Swine flu reminds us that the television news programs are becoming ever more desperate to attract viewers, but also becoming ever less useful as a source of information. The dramatic graphics and breathless reporting implies that Bubonic Plague is on the march. Actual numbers tell a different story. Perhaps 150 people have died of Swine flu in Mexico City in the past month (we say perhaps, because the deaths occurred primarily in the slum part of Mexico City, where good healthcare and good health records are hard to come by.) By comparison, over the past year nearly 6,000 Mexicans have been killed in narcotics trade murders ("Bullet flu!") There's one confirmed death by swine flu in the US so far. In the last 9 months, 30,000 Americans have died from other strains of flu. Worldwide, 250-500 thousand people die of flu related symptoms annually, compared to about 3.9 million who die of pneumonia, 2.7 million who die of AIDS and 1.2 million who are killed in car accidents.
Net, the average person's chance of dying of Swine flu is slightly higher than being hit by lighting or killed by a shark. There's always a risk that Swine flu could evolve into a pandemic such as the Hong Kong flu of 19868-9, which killed 700,000-1 million people, or the Spanish flu of 1918, which killed between 20-100 million people out of a worldwide population of 2 billion. Disease control specialists should be concerned, but average people should be far more worried about smoking, obesity or careless driving.
Obama: the first 100 days
We find that the media's coverage of the first 100 days of the Obama presidency to be about as useful as their coverage of the Swine flu outbreak. Our primary observation is that the new administration is trying to make the best of a pretty poor set of circumstances. Hundreds of high level positions are still unfilled in the administration as nominees struggle to get through the confirmation process. Those that have been appointed hardly have had time to find their offices, get their phones connected and business cards printed up, let alone design and execute strategy. We know that the SEC, FDIC and Treasury are trying to hire hundreds of new forensic accountants, risk and compliance managers to supervise the vast array of programs implemented in the last 9 months. Our society has become accustomed to instant gratification, but we think that perhaps by the 1000th day of the Obama presidency, it will be possible to make a useful evaluation of the quality of this administration.
We began investing our cash balances in mid-March, starting with the clients who had the highest cash percentages, and so far have been rewarded. We continue the process of rebalancing all our portfolios, with about half done so far. We've pared back healthcare positions primarily, while adding to financials. We've also taken advantage of cyclical highs of dividend yields in energy, materials, utilities and telecomm stocks, and also added to preferred stock positions. After a 6 month period (September 15th-March 15th) where "normal" investing didn't work, the rules and strategies that have worked for generations once again apply.