New Year's rally fizzles on economic woes


US stocks rallied 24% between the low set November 20th and January 6th.  However, the release of universally dismal economic reports in the United States dropped stocks over 11%, leaving the S&P 500 down 7.4% on the year, and down 47.0% from the record high set in October 2007.  This chart of the S&P 500 since 1928 shows the violence of the current bear market.  At the far left, we see the 80% declines of the Great Depression.  At the far right, we see two major sell-offs - the first in 2000-2002 with the bursting of the tech bubble, and the second from 2007-present with the bursting of the credit bubble.  The 1987 stock market crash is minor by comparison.  We see that US stocks are net unchanged from 2003 and before that from 1997.  Between 1965 and 1978, US stocks were also stuck in a range.  Following the conclusion of the 1982 recession, stocks rallied for the next two decades.

The first estimate of 4th quarter US GDP showed a decline of 3.8% versus expectations of a decline of 5.5%.  These growth figures are the worst since a decline of 6.4% in 1982.  The first estimate includes minimal data from December, however, so we would expect lower revisions in the February and March estimates.  Soaring layoffs and jobless claims, and a rising unemployment rate bode ill for subsequent quarters, with GDP growth estimate at -3.0% for Q1, -0.8% for Q2, 1.1% for Q3 and 2.0% for Q4.  Unemployment, which usually trails economic growth, is expected to peak between 8-9% towards the end of 2009.  Considering that the US economy appeared to be on the mend as recently as August 2008, we're shocked at how dramatically the US and world economies have slowed.  In particular, we're astonished that the major interventions by the US Federal Reserve and Treasury, and by central banks worldwide, have had little or no effect on the continuing collapse of the world's banking systems.

Can the banks be saved?

The 75% slide in the financials index since June 2007, including a decline of 24% since the start of 2009, is unprecedented.  This decline reflects a write-down of $1 trillion in assets among banks world-wide AND the fear that another $1-2 trillion will be written down before the crisis is over (US banking assets currently total about $14 trillion.)  The "toxic" assets are tied primarily to US residential mortgages.  Housing prices, according to the Case-Shiller indexes, are down 25.2% across the US since July 2006, with the rate of decline accelerating in the two most recent reports at about an 18% year over year rate.  Prices are expected to level off by mid-2009 at the earliest, or could continue falling through year end.  So the value of mortgage backed securities must also continue to fall.  The ability of banks to lend is tied to the value of their assets which could range from simple cash deposits, to preferred stock issued to the TARP program, to various types of securities.  The $350 billion in TARP fund distributed so far has offset a third or less of the capital lost to write-downs, hence the net contraction in lending.

Although the situation is grim, there are some indicators that the credit squeeze is easing.  This chart shows the spread between the three month treasury and 3 month LIBOR - the rate that banks lend to each other.  After spiking to record levels in October 2008, the spread is near normal levels. 

Spreads between US treasury bonds and BBB corporate bonds, which also spiked to record levels last fall, have also eased, but have a ways to go to get to "normal." 

Rates for conventional mortgages (30 year fixed rate) are higher than the January 9th low of 4.2%, but, at 4.7%, are near the lowest levels in the last 40 years.

The US Treasury and Federal Reserve have struggled since March 2008 to contain the credit crisis.  Fannie Mae, Freddie Mac and AIG were effectively "nationalized" last fall.  Among the five largest banks, Citibank and Bank of America are on life support, and JP Morgan, Wells Fargo and US Bancorp are damaged but seemingly able to survive with TARP support.  Should Citibank or Bank of America fail, their depositors will be protected and there are plenty of healthier banks that can take over their operations.  The big question in Washington right now is whether a strategy can be implemented to segregate "bad" assets in a government sponsored entity (the "bad bank") so that declining asset prices will not further depress lending.  The problem is how to price the assets to be transferred - too low and bank lending is impaired anyway; too high and tax payers foot the bill for the difference.

Can the US economy be saved?

We receive several hundred economic reports each month, and most show the worst news since the 1982 recession, many the worst news in their entire history.  The statistic which captures the current angst most succinctly is the US

Non-Farm Payrolls report.  Not only have a net 2.6 million jobs disappeared in the last 13 months, but job growth from the end of the previous recession in 2003 was low compared to the end of previous recessions. 

The US unemployment rate is now higher than at the end of the 2003 recession and is approaching the peak of the 1992 recession.  Measures of US consumer confidence are at or near all time lows over job insecurity and wealth destruction in both housing prices and investment portfolios. 

Consumer income is falling, but consumer spending is falling at a faster rate, reversing a slide in the US savings rate which dates to early 1980's.  The increase in the savings rate, while a long term good, is a short term disaster.

Net, the recession in the US, which appeared to be short and mild a few months ago, will now be longer, deeper and more painful than many economists had forecast.  A return to the Great Depression, with 25% unemployment rates and a 30% decline in GDP, seems unlikely.  US recessions in the post 1945 period generally reflected increased interest rates and restrictive monetary policy in response to inflationary pressures, in particular the "oil shock" recessions of the 1973-5 and 1980-82.  However, US CPI is currently mild at 1.8%, excluding food and energy, or 0.1% including food and energy (reflecting the 72% decline in oil), and US monetary policy is exceptionally expansive so those examples don't apply.

From 1986-1990, Japan experienced a parabolic rise in both stock market and real estate prices, which peaked at valuations roughly 2.5 times higher than the US saw in the stock market bubble of 2000 or the real estate bubble of 2006.  By 2004, Japanese real estate prices had fallen about 90%, and the stock market (Nikkei,) which peaked in 1989, fell 80% from December 1989 through April 2003, increased by 137% through July 2007, but gave back all those gains through October 2008. 

We think that the Japan experience applies best to the US in the current situation - extremely low interest rates in the 0-0.25% range and expansive monetary policy totally unable to offset a collapse of consumer and business confidence.  The Japanese economy pretty grew at an average of 1%/year over the next 18 years, with four recessions along the way. 

The obvious question - is slow or no growth all that the US can expect over the next two decades?  Several important differences:  First, the size of the Japanese bubbles in real estate and its stock market dwarf the equivalent bubbles in the US.  Second, in Japan, the bubbles burst simultaneously, whereas in the US, the stock market bubble burst in 2000, and the real estate bubble in 2006.  Yes, stocks peaked in October 2007, but stock valuations were reasonable given earnings and prevailing interest rates.  Third, Bank of Japan resisted forcing banks to recognize loans as non-performing, which delayed taking necessary actions.  US banks have gone to the opposite extreme in marking down the values of loans and securities.  Fourth, the US is much less patient with the status-quo, moving aggressively months into the crisis to offer stimulus plans, while the Japanese government waited years.  Still, Japan's experience of the last 18 years suggests that the US will experience sub-par growth for at least several years.

Does investing in stocks make any sense at all?

From 12/31/97 through the present, including dividends, the net return in the S&P 500 was 0.2%/year.  From the end of the last bear market in October 2002 through the present, the net return of the S&P 500 with dividends was 0.8%.  However, the net return in stocks from 1945 through the present including dividends is 10.5%/year.  That 10.5% return includes not only the negative effects of  current crisis but also the 9/11 attacks, bursting of the tech bubble in 2000, 1987 stock market crash, assassinations of John Kennedy, Robert Kennedy and Martin Luther King, and the outbreaks of the Korean War, Vietnam War, Gulf Wars I and II, and the Cold War.  So we continue to believe in investing in US stocks.

January, with a decline of 8.3% for the S&P 500, hardly bodes well for stock market returns in 2009.  The decline is attributable to continued bad news out of the banks, which fell 26.3% in January and continued uncertainty about various bank bailout programs and stimulus packages.  Hedge fund selling not only of stocks, but also preferred stocks, bonds, securitized loans diminished sharply after the "Great Margin Call" of October and November.  Stock market volatility (the amplitude of daily swings in prices) has diminished as well.  This chart of the Volatility Index shows a surge of volatility last October-November to levels not even seen during the 1987 Stock Market Crash.

 Although the VIX has fallen by half, it remains at twice the levels seen during the 2002-2002 recession, when stock prices fell by an equal amount.  Investors remain extremely skittish about stocks, with mutual funds seeing net investments of $9 billion in January, versus net withdrawals of $221.4 billion in 2008 ($72.3 billion in October alone.)


A meaningful upturn in the US economy doesn't seem likely before the end of 2009 or the beginning of 2010.  The US stock market generally leads the economy by 6-9 months, so by the second half of 2009, stocks should be higher.  We've had several false rallies in the last 4 months of up to 25%.  Each time, the stock market falls back to around 8000 on the Dow Industrials and 800 on the S&P 500, which is about where stocks closed at the end of January.  We're going to sit tight with the companies we have, and continue to look for opportunities to get more fully invested.