Exactly one year ago, the unexpected failure of Lehman Brothers set off a horrific 6 months for US and world securities markets. Between September 15th and Thanksgiving of last year, daily volatility of the S&P 500 quadrupled. Americans fixated on the "Dow bug," that useless data-point at the lower right corner of every television in every bar, health club and shoe shine stand in America, which swung intraday hundreds and on some days over a thousand points. Merrill Lynch, Washington Mutual, AIG, Fannie Mae and Freddie Mac all fell into the arms of rivals or were essentially taken over by the US government, while Goldman Sachs, Morgan Stanley, Citigroup and Bank of America teetered on the edge of insolvency.
By mid-March, sufficient liquidity had been restored to the system so that even the bankruptcies of General Motors and Chrysler in June could not deter the monster bull market, which, after 6 months, has lifted the S&P 500 59.5% from the March 9th 13 year low. For the year, the S&P 500 is up 20.3%, the NASDAQ is up 35.9%, European markets are up 18-23%, and emerging markets are up 53-90%.
Was it all a bad dream?
Unfortunately, no. Trillions of dollars of wealth was vaporized in the last 12 months, mostly the equity of leveraged investors who were forced by margin calls to sell during the crisis. Many banks remain undercapitalized and are at risk if liquidity dries up again. Citibank for example survived only by massive capital injections from the US government, which currently shows a paper profit of $10 billion on Citibank preferred stock that it owns. Citibank stock quadrupled from the March 5th low, but would have to increase another 1,224% to take out the December 2006 high. Millions of Americans have negative equity in their homes, primarily those who bought since 2006, or those who took out lines of credit against their property.
The wealth destruction couldn't come at a worse time for the leading edge (born in 1945) baby boomers who turn 65 in 2010. For most, Social Security will be inadequate. Many took their investments and 401K's to cash in March, only to miss the rally. Meanwhile, plans to sell their homes to fund retirement are on indefinite hold. Bottom line is that most Americans will work 10 years longer than they planned.
Where are stocks now?
After being massively over-valued through most of the 1990's, the S&P 500 spent most of the current decade undervalued. This model shows the whether the S&P 500 is over or undervalued given
forward expectations about earnings and the ten year treasury yield and includes 20 years of data. The overvaluation peaked at 97% in December 1999 as the "Internet bubble" burst and peaked again in March 2002 at 152% as earnings collapsed faster than stock prices. The trough of undervaluation was a decline of 56% in March of this year as stocks fell to 13 years lows, far beyond what would have been expected even with the sharp decline in earnings in that time frame.
This model is based on a comparison of Morningstar analysts' cumulative estimate of individual stocks fair value versus actual stock prices and includes 10 years of data. Both the Fed model, which is top down, and the Morningstar model, which is bottom up, indicate that stocks are fairly valued after the big rally of the last 6 months. This doesn't imply that we should sell stocks, merely that the easy returns have already been achieved. Future returns will be based on growth in earnings, which will rise slowly.
The Lost Decade
Hard to believe, but a dollar invested in the S&P 500 on January 1st, 2000, is currently worth, including dividends, 83 cents. The S&P 500 would have to gain another 20% between now and year end just to break even on the decade. The same dollar invested for the decade starting January 1st, 1990 was worth $5.32 by December 31st, 1999. If we examine the two decades together, the average annual gain was 7.8%, not far from the 8% we would expect and a classic example of "reversion to the mean" where a period of out-performance is followed by a period of under-performance.
If we look at all the data we have available for US equities (14 decades running back to 1870, Robert Shiller data 1870-1949, S&P 500 from 1950 forward) we see:
Including the current decade, there were 4 decades in 14 where the simple price appreciation of the stock market was negative. In only two decades, the current one and the decade of the 1930's, which encompassed the Great Depression, were returns negative net of dividends. For 140 years stock returns have averaged 9%/year, and since 1950, 11%/year. Half to a third of that appreciation came from dividends, however. The dividend yield on the S&P 500 is currently only 2.3%, so our "best guess" of stock market returns for the decade to come is only 8%/year. Even at that lower than average rate of return, an invested dollar should be worth $2.15 after 10 years.
What's the implication for the next decade?
It's truly remarkable that in a time of unprecedented prosperity and relative peace (not just in the United States but world-wide) we could come so close to "the Great Depression V2.0." The fault lies squarely in the financial sector of the economy. We have long observed that finance is like the 5 quarts of oil in your car's engine; pretty much you don't notice it unless the lubricant is not there, at which point the engine seizes up and the cylinders smash through the block. We got down to about a quart of oil by November of last year.
For a couple of months, the engine of the world economy smoked and vibrated as world central bankers frantically added liquidity (lubricant) to the system to offset the liquidity draining rapidly out through the private sector. The banks have regained equilibrium and the non-financial sectors (manufacturing, services) are expanding again for the first time in a year. However, even though interest rates remain low, credit rationing is the order of the day, and neither individuals nor businesses can easily get the loans they need. Meanwhile, central banks need to reduce their intervention in the financial system. If done too slowly, inflation will surge; too quickly and the recovery will stall.
For the decade ending June 2007, which included the mild 2000-2002 recession, US GDP grew
at an average 3% annual rate. Over the last two years, GDP shrank at an average annual rate of 1.1%, including a dramatic decline of 6.4% in the quarter ending March 2009. Economists forecast that US GDP will gain 2.7% for Q3 2009, with the preliminary estimate to be released September 29th, and to grow in a 2-3% range for 2010 and 2011. Our expectation is that US GDP grows in the 2% range for the next decade for the simple reason that US consumers over-borrowed and over-consumed in the last decade, and will contribute less to growth for the coming decade. However, 40 million people are being added annually to the ranks of middle class consumers in China and India. As a result, those economies will become more focused on domestic consumption, less on production for export. Net, we expect world GDP to expand, but with Europe and the US growing more slowly than emerging economies in Asia and South America.
For the time being, we're not making major strategy changes. Between now and year end, we will check whether our client's sector allocations have drifted from our targets given that technology and materials stocks have gained over 40% this year while energy, consumer staples, utility and telecomms stocks have barely budged. Financials are only up 23% on the year, but up 149% from the March low, so we'll look at those also. As always, we'll try to balance gains with losses to minimize the tax impact of realized gains. We wonder whether there will be "buying panic" between now and year end, as most money managers are under-invested and under-performing this year.