US stocks made a 1 month high on November 4th as the 2 ½ year long US presidential election finally came to a close with the widely anticipated election of Barack Obama. Stocks subsequently slid 15.3% over the next 5 trading days, ending near the lows for year set on October 27th, tracing out a 15-20% trading range in the S&P 500 with 1005 at the top, 850 at the bottom. Either the October 27th low of 848.92 holds, or it doesn't. If not, then market technicians look at 776 in the S&P 500 as the next floor - that was the low set during the last bear market which ended in October 2002. At the worst point today, US stocks were down 2.8% on the day, 14.3% on the month, 28.7% on the quarter, 42.6% on the year, and down 47.2% from the October 2007 high. However, at the close, the S&P 500 was up 6.9%, an intra-day swing of 11.3%.
Fundamentals haven't remotely changed in the last two weeks to justify these swings. We've discussed stock valuation at length in recent commentaries, but favorable valuations do not seem to drive investor decisions right now. So instead, let's detail what investors are focused on:
- The Credit Crisis
- Housing prices continues to fall
- Unemployment continues to rise
- Probable bankruptcy of General Motors, Ford and Chrysler
- Recession in the United States
- Media saturation of bad news
- Continued liquidation of hedge funds
- Can "Baby Boomers" retire?
- Is there any good news at all?
The Credit Crisis
All of our current woes tie back to the period of 2003-2006 when low prevailing interest rates caused investors to seek out high yielding, but "safe," fixed income securities. Wall Street responded by underwriting vast supplies of mortgage and debt based securities, which, when push came to shove in 2007 and 2008, were worth far less than stated value. US banks, and later European banks, were forced to write down the value of these securities, by $900 billion to date. Bear Stearns, Fannie Mae, Freddie Mac and ultimately Lehman Brothers all broke under the strain. The failure of Lehman impacted the commercial paper market and credit default swaps markets, causing banks worldwide to run away from lending to each other, let alone actual customers. Peak fears were seen in soaring LIBOR rates on October 10th; the normal spread of 0.75% between 3 month LIBOR and 3 month T-bills jumped to 4.8%. That spread is way down now at 1.9%, so still about 1.1% higher than normal. Overnight LIBOR is back to normal, about par with Fed Funds.
Spreads widened dramatically in other securities. For example, yields on investment grade corporates jumped from 6% to 9%, high yield bonds from 11% to 19%, municipal bonds from 4% to 5.5%, and preferred stock yields from 5% to 9%. Since the October peak, yields have fallen by a percent or so and thus remain well elevated compared to August. So even though the Federal Reserve Bank has dropped the Fed Funds rate from 5.25% as of September 2007 to in 1% as of October 2008, investors are only just starting to take advantage, preferring "safe" Treasury bills at 0.3% or Treasury bonds at 3.7%.
Meanwhile, it seems like the risk of additional large banks failing has dissipated. US and International central banks have placed trillions of dollars into the banking systems to replace capital destroyed by the credit crisis and forced weaker firms to merge with stronger. The capital injected into the banks, however, is only grudgingly making its way to corporate and individual borrowers, and borrowing rates remain high. As a result, bank profits are widely expected to surge in 2009; write downs on securities holdings will diminish, while profits on conventional lending will soar.
The $700 billion TARP program passed by the US Congress in October continues to evolve. The original plan was to use the funds to buy up illiquid mortgage backed securities and get them off bank balance sheets. As we expected, implementing such a program was far too cumbersome if the goal was to get cash into banks quickly. The straightforward purchase of preferred stock in the banks is faster, cleaner, and offers a clear path to the Treasury recouping its investment within 5 years. There is also discussion of whether to extend TARP funds to non-banks such as credit card and car loan companies.
Housing prices continues to fall
Housing statistics continue to look grim, with prices likely to level off only in mid to late 2009. Foreclosures are up, mortgage money is hard to obtain, many homeowners find that their mortgage is higher than the current value of their house. However, supply is starting to shrink relative to demand as new housing construction is at the lowest level in decades. JP Morgan, Citigroup, Bank of America, Fannie Mae and Freddie Mac have all announced programs to modify existing mortgages, either by reducing principal, reducing rates, or extending terms. The programs will reduce the foreclosure rate, which will put a floor under the entire market.
Unemployment continues to rise
US unemployment at 6.5% in October exceeded the peak of 6.3% set at the tail end of the 2000-2002 recession. Forecasts for 2009 range up to 8.7% (average forecast is 7.3%), which would exceed the 7.8% level set during the 1991-2 recession, and would close on the peak level of 10.8% set during the 1982-84 recession. Biggest contributing factor to the rise in unemployment is the decline in construction jobs, but now we're seeing spillover into automobile and retail jobs as consumer spending has slammed to a halt. The US economy has lost jobs in every month this year, for a net loss of over 1.2 million jobs. Unemployment usually trails the economy, so unfortunately we expect job losses to increase into 2009.
Probable bankruptcy of General Motors, Ford and Chrysler
US car sales plunged nearly 40% in October relative to the year ago period. US automakers were not in robust health even when car sales were strong. In the current environment, General Motors burns through between $5-7 billion a month. With a cash cushion of just $16 billion the firm might be bankrupt as early as Q1 2009. We have long avoided this sector, even the relatively healthy Toyota, but should the US automakers go into bankruptcy, hundreds of thousands of workers will be idled, delivering another major blow to consumer confidence. There's some discussion that US automakers will get cash infusions from the TARP, but we think the probability of that is low. More likely, the automakers will experience what US steel makers experienced in the 1980's: bankruptcy, restructuring and emergence as much smaller but more profitable companies
Recession in the United States
Through August 2008, it looked like the US would skirt by recession. The credit crisis slammed economic activity to a halt. This chart from Economy.com shows how economic
forecasts evolved over the last three months. Previously, economic growth looked slow but positive in the 1% range from the end of 2008 and into 2009, rising back towards average by year-end 2009. Now we see Q4 growth declining sharply at a 2.8% rate in Q4 2008, working back to positive territory only late in 2009.
Media saturation of bad news
There was a time as recently as the 1990's when average investors checked their statements once a month, or possibly looked up stock quotes in their daily newspaper. Now, every health club, bar and shoe shine place in the country is tuned continuously to the business channels, with a camera focused on the value of the Dow Jones Industrials at all time. Americans see that Dow bug wherever they go and feel compelled to do something about it!
We've tried to educate our clients to expect 8-10% annual gains in the stock market. Meanwhile the markets are swinging up or down 15%/week, which doesn't instill confidence. On top of that, we have market gurus like Jim Cramer trying to educate the US public to become day-traders because "buy and hold is dead!" Jim Cramer is a very smart guy and a very successful investor. But the idea that millions of Americans can do their jobs, take care of their families AND day trade stocks is ridiculous. Over the last 10 years, the cost of trading has plummeted, the amount of information available to the average investor has surged, and all kinds of trading vehicles such as ETF's have been introduced to make investing as easy as a click of a mouse. Unfortunately, the results have been terrible - US investors bought high/sold low in technology stocks, bought high/sold low in housing, bought high/sold low in international funds and right now are liquidating their mutual funds at record rates for fire sale prices.
Continued liquidation of hedge funds
A minority of hedge funds have made phenomenal returns over the last two years. A third to a half of all hedge funds, however, delivered horrible returns, in some cases losses of 100%. We see daily announcements 2-4 funds going out of business, either from investment losses or investor redemptions. As each fund closes, it's forced to sell its investments at whatever the market will bear. We also see huge daily swings in, for example, the S&P 500 futures contracts, as funds desperately try to generate marginal returns to keep in business. Typically, we'll see the markets up reasonable levels at 3PM, or even 3:45PM, only to see massive shorting of the futures, which turns into stock declines, by the close (the hedge fund profits by shorting the future, which triggers sales by other investors, and then buying back the contract at the close for a profit.)
Today, however, massive hedge fund buying in the last hour lifted stocks dramatically. Nice, but what we'd really like to see is the market go up for more than 2 days in a row (once in the last two months,) or more than one week in a row (not since early September.)
As the hedge fund sector shrinks into 2009, hedge fund volatility will be reduced. Also, the surviving funds, which are mostly in cash right now, will eventually invest in stocks and other assets and that will help boost prices. We hope that the new administration moves aggressively to regulate these funds going forward.
Can "Baby Boomers" retire?
The leading edge of baby boomers born in 1945 is now 63. There can hardly be anything more demoralizing than being a year or two away from retirement only to see one's stock investments down 40% and house down 20%. Boomers will have to adjust to lower spending levels in retirement, or will end up working a few years longer. It may take 3-5 years, but stocks eventually will make new highs. Our retirement age clients are generally 30-40% in fixed income, from which we make monthly distributions. As stocks recover going forward, we will reload the fixed income allocation from stock sales.
Is there any good news at all?
The price of oil is down 62% since July; $4 gasoline is headed to $2. That decline alone is worth about $230 billion to American consumers. The decline in energy, commodities and food prices, ranging from 40-60%, along with falling housing prices and flat to lower wages, means that inflation is not an issue for several years. This will allow the Fed to keep interest rates low. Eventually the shock of this year's events will wear off, and businesses and consumers will start making up for deferred purchases. There may be some psychological benefit from having a new administration Washington. If Obama can bring the discipline of his campaign, beating both the Clinton machine and the Republican machine despite major initial disadvantages, to how he conducts government, he will be very capable in addressing the ills of the nation.
Judging by other bear markets which seem similar to this one, notably 1987 and 2000-2002, our best guess is that stocks will trade sideways over the next 3, possibly 6 months, held down by investor fear, but supported by company valuations, and then start rising again. The one year return in the S&O 500 after the final low in December 1987 was 23% and a new high achieved within two years. After the October 2002 low, stocks gained 34% over the next year, making a new high after five years. Market historians are well aware that maximum gains occur just as a bear market ends. So which will dominate investor decisions over the next three months - fear of all the factors above, or fear of missing the rally? If the latter, then perhaps, just perhaps, we've seen the final low for this bear market.