Millions of individual investors opened their February statements, saw that their stocks were down 19% on the year and sold out, driving the S&P 500 on March 9th to the lowest level since September 1996. As hedge funds already sold stocks last fall, and institutions sold stocks over the winter, individual sales marked the final exhaustion of the selling which began with the September 15th bankruptcy of Lehman Brothers. Financial stocks, which include banks such as JP Morgan and Goldman Sachs, insurance companies and REITS, fell as much as 52% between the end of last year and March 9th, but gained back half that loss by month end - the best performing sector in the S&P 500 for the month of March. Overall US stocks delivered the best return since October 2002, which coincidently marked the end of the last bear market. So far, the rally is continuing into April.
Why the sudden change of sentiment? With US stocks down 57% from the October 2007 peak, valuations were at the lowest levels since 1982. Many top down analysts feel that the S&P 500 is still overvalued at these levels, because losses in the financial sector crushed earnings estimates for the S&P 500. Outside of financials, however, the earnings picture is by no means as bleak. Technology companies, for example, are doing fine simply on replacement spending by companies and individuals - that sector is UP nearly 10% on the year. Worldwide demand for commodities has bottomed (oil for example is 30% higher than the low of $39.72/barrel touched mid-February.) Energy stocks are still down 7%/YTD but the Materials sector is up 3%. Also reflecting an uptick in demand for commodities and basic manufacturing, the Bombay (India) stock market is up 4%, Brazil is up 16%, and China is up 45% on the year. In the US, the NASDAQ is up 2.4% on the year, while the NASDAQ 100 (the largest cap technology and medical stocks) is up 7.4%. The S&P 500 is still negative on the year, but the loss is trimmed from down 25% to down 6.6%.
So bottom line, plenty of investors see opportunities even though the world's financial system is still mired in problems. Is it too late to get invested? At current levels, the S&P 500 is back to the level of January 31st of this year and has to rise another 7.5% just to get to breakeven on the year. Stocks must gain 48.9% to eclipse the level of September 12th, 2008, right before the financial melt-down, and rise 86.2% to break the October 2007 record. At the post 1945- average return of 10.4%, US stocks wouldn't make a new high for 6-7 years.
The World's Financial System
For months, the US and international governments have been grappling with a dysfunctional world banking system. As has been described "ad nauseam," US and European banks and hedge funds gorged on highly risky debt securities purchased with borrowed money through mid-2007. Once the selling started, these securities had to be marked down from par (100) to as low as 20 cents on the dollar. Nearly a trillion dollars in value has been written off so far, and the reduction in "regulatory capital" caused banks to suspend normal lending to corporations. For industries such as housing or car manufacturing, inability to finance customer purchases caused production to fall by 40% with corresponding losses of jobs.
Why has it taken 6 months for things to turn around? The current problems have their roots in bank deregulation enacted 12 years ago during the Clinton administration and accelerated during the Bush administration. Safety mechanisms established after the Great Depression were systematically dismantled. Regulators with a free market philosophy such as Alan Greenspan refused to regulate new investment products such as Credit Default Swaps. The banks themselves demanded an increase of leverage far beyond that which destroyed Long Term Capital in 1998. The rating agencies certified as investment grade securities which we now were junk all along.
Such a systematic failure, encompassing tens of thousands of public agencies and private financial firms, is not turned around in a heartbeat. The US government, primarily the Federal Reserve and Treasury, has at most a couple of hundred employees to address the issues. As fast as these individuals came up with plans to address the crisis hundreds of economists and portfolio managers rushed to the airwaves to explain why these plans wouldn't work. Even so, trillions of dollars in the US and in Europe are being brought to bear on the problem, pushing capital to the banks through, for example, the TARP program, while setting a floor for regulatory capital by buying up junk securities. Probably half that money will be return to government coffers over the next decade, while the rest is the cost of saving the system.
A hint of spring in economic reports
For the past year, hundreds of economic reports showed nothing but deterioration, taking most indicators to generational if not all-time lows. In the last month or two, many reports have leveled off and some have ticked higher. For example, US Factory production, which
fell off a cliff in the 4th quarter of last year, gained for the first time since July 2008. Even though corporation and individuals have cut spending to the bone, there's still a basic amount of replacement spending that must occur. Housing prices are still falling at nearly a 20% year over year rate, reflecting in particular foreclosure sales of 40-50% in total sales, but inventory levels are falling as total sales are increasing. Job losses unfortunately will increase through at least mid-summer with unemployment rates in the US hitting generational highs. Hiring and firing is expensive, so employers resist layoffs as long as possible; and then resist hiring back as long as possible. US GDP for Q4 2008 declined at a 6.3% annualized rate. Expectations for 2009 are: Q1 down 5.1%, Q2 down 2.0%, Q3 up 0.5%, Q4 up 1.9%. Stock markets tend to lead the real economy by 6-9 months, so the recent move up in stocks reflects anticipation of a return to growth in the second half of 2009. For the whole year, US GDP is expected to decline 2.5%, and gain just 1.8% in 2010.
Out of the woods yet?
No. It's hard to overestimate how much damage has been done to the world economic system over the past two years. Almost half of all paper wealth was destroyed in that time frame; we see the losses in our clients' accounts, in the endowments of universities and in pension plans, in the vast shrinkage of billionaires in the Forbes annual survey, in home owners made homeless by foreclosure. At the same time, we observe that "doom fatigue" has set it. People are tired of hearing that this is the end of the world, when plainly it is not. As a result of this crisis, the average American will probably have to work ten years longer than they'd planned before retirement, but they are fast adapting to the new reality by cutting spending and paying off debt. In recognition of how interconnected the world's financial system have become, the G-20 nations have announced at this week's conference the intention of creating a world-wide regulatory framework. Banks and hedge funds will chafe at new limitations on leverage and employee compensation, but that's the price they must pay for failing to regulate themselves.
In the past three weeks, we've rebalanced about 25% of our accounts, starting with the accounts with the highest percentage of cash to take fully invested. After US government bonds, healthcare stocks were the best performing asset class over the last year (healthcare companies perform independently of the state of the economy.) We're reducing our healthcare exposure, increasing our exposure to those financials that will come out ahead of the crisis, and also adding to technology, materials, energy and consumer discretionary. As there's a risk that we're early, we're concentrating our purchases on those companies with high and sustainable dividends. We will continue the process of rebalancing through Q2.