It was another challenging month for stocks, with three month returns from August 31st through November 20th the worst in 80 years. On November 20th, US stocks closed at a level last seen in April 1997. However, stocks rallied 17% over the next 5 days, still leaving the S&P 500 down 7.2% on the month, down 22.8% on the quarter and down 37.7% on year. Economic news continues to be horrible, but stocks rallied simply because hedge funds appear to have stopped selling.
The #1 question our clients have asked over the last few weeks: "Can we sell all stocks now and step back into the market when things calms down?" The problem with that strategy is that, as volatile as the market has been to the downside in the last three months, we've seen 4 occasions where stocks have gained 10% or more in a very short time frame. So rather than protecting our clients against further losses, more likely we would sell stocks low, only to buy back later at higher levels.
From a technical point of view, the good news is that the Dow Industrials at 8000 and the S&P 500 at 800 seem to be the hard floor of this particular bear market. We've broken through those levels a couple of times, but each time the market rallies back hard the next day. As we have discussed in other recent commentaries, stocks remain exceptionally undervalued even if we discount next year's earnings expectations by a third.
Housing remains at the root of all the current problems. The rate of decline in home prices accelerated sharply in September and will also probably show a sharp decline in October as funds for mortgage lending dried up completely. The rate of decline should slow when November's numbers are reported (in February.) The hardest hit areas include California, Nevada and Florida, with prices down 36% from 2006 highs. Up to half of all sales in those states are foreclosure sales, which may overstate the total decline as foreclosure sales are generally at a discount to local market conditions.
The latest Treasury program, which addresses tight credit conditions by intervening directly in the home mortgage, car loan and credit card markets, caused mortgage rates to drop 0.75% in a day. This program purchases newly originated loans directly from the banks, which can make quick profits without worrying about getting stuck with depreciating securities. This is another step in the ongoing nationalization of the US financial system, but necessary as the banks are unwilling or unable to do the job themselves.
How to destroy investor confidence
If a hypothetical Dr. Evil wanted to destroy the US economy and investors confidence in stocks he would: underfund and understaff the regulatory agencies; dismantle 60 years of market safeguards such as the uptick rule, prohibition of naked shorting and separation of the functions of commercial and investment banks (Glass-Steagall); load up bank balance sheets with illiquid securities whose value balanced precariously on the assumption that housing prices (unlike any other asset class) would never fall; increase leverage ratios from 10 to 33 times among hedge funds and investment banks; promote borrowing over saving among average Americans; hire thousands of MBA's, CFA's and PhD's, equip them with state of the art computers and trading programs, and enable them to "bomb" the markets with millions of short sale transactions per hour (short stock sales, ETF-exchange traded fund sales, put option and credit default swaps purchases.)
Even as recently as August 31st it appeared to most investment managers and to the Federal Reserve that the stock, housing and credit markets were experiencing a modest correction. However, the takeover of Fannie Mae and Freddie Mac in early September triggered selling that completely overwhelmed market makers' ability to maintain orderly markets. Selling accelerated in October and into November as margin calls hit individuals and funds, and panicked investors rushed to unload mutual funds and redeem hedge funds. If the selling is truly finished, then we'd expect to see the stock market gain in December (first time in 4 months) and in the first quarter of next year (first time in 6 quarters.) The last time the stock market declined 5 quarters in a row was during the 1969-70 bear market, and before that during the 1929-32 bear market.
The Obama Administration
If Barack Obama can apply the same discipline to government that he used to beat first the Clinton political machine, then the Republican machine, he will do very well. So far, we are encouraged by the appointments he has made to his economic team and by his willingness to get out in front of cameras and answer questions. We hope that the new administration has the courage to establish minimum regulatory and maximum leverage standards for all market participants.
At present, hedge funds are pretty much unregulated. As we have seen, these funds can do enormous damage to individual companies and to the stock market in general. Certain of those funds have made hundreds of millions of dollars by attacking, for example, Bear Stearns, Lehman Brothers and Citigroup, which were worth hundreds of billions of dollars. We would be the first to agree that managers were not doing their jobs at those banks. However, allowing speculators to destroy these banks is like smashing stain glass windows to salvage the lead.
Can the US economy, and by extension, the world's economy, be saved?
We have often described the US economy as an aircraft carrier, slow to turn and with enormous momentum. However, as we have seen over the last three months, even an aircraft carrier can stop on a dime if it hits a big enough reef. US consumers, who account for 70% of economic activity, are scared to death for their jobs, by their high levels of debt, and by the negative wealth effect of sharp declines in housing and stock prices.
Third quarter GDP was revised from down 0.3% to down 0.5%, which is not bad compared to expectations of down 1.0%. Economists are racing each other to paint the worst possible picture for fourth quarter GDP, with estimates ranging from an average of down 2.7% to a worst estimate of down 5.6%. Unemployment, currently at 6.5%, is expected to rise to levels of 7-7.7%, with one economist calling for 10.0% unemployment by the end of the 2009. If so, unemployment would exceed levels seen during the 1981-2 recession, which was far worse than current conditions. Car sales, which have a big impact on the economy and on employment, are running 35% below year ago levels as tight credit and consumer fear keep buyers out of the showrooms. Discretionary spending, for example on clothing or electronics, slammed to a halt, hurting retailers badly. Prior to September, it seemed that US would experience a couple of quarters of slow or flat growth, and then resume growth in the 2% range. Now it seems that we'll experience negative growth through the first half of 2009, and then slow growth in the 1-1.5% range through year end.
The one piece of exceptionally good news is that inflation is simply not an issue, either in the US or in most economies, with energy down 63%, commodities down 45-57%, wage pressure negligible and prices for housing, cars, and most goods under incredible pressure. The bigger fear is deflation, which clobbered the Japanese economy in the decade of the 1990's. Thus, the Federal Reserve and European central banks have no need to raise rates or reduce monetary expansion until late 2009-early 2010.
The biggest hindrance to recovery is the world banking system. As we see in sharply reduced LIBOR rates, banks are willing to lend to each other. However, banks aren't willing to extend credit to businesses or individuals as we see in exceptionally high rates in corporate and personal lending. Eventually, banks won't be able to resist the profits that can be obtained by borrowing from the central banks at rates as low as 1.0% (in the US) and lending to corporations at rates of 8% or higher, or to individuals at mortgage rates of 5.25%, car loan rates of 8% or more and credit card rates of 15% or more.
The #2 question of clients over the last month: "How can stocks rise while the economy is contracting?" Generally speaking, the stock market anticipates the economy by 6-9 months - peaking before the economy peaks, rallying before the economy rallies. Stocks were down 10.7% YTD on August 31st, which seemed consistent with a mild slowdown. The absolute collapse of stocks over the next three months would normally imply a substantial recession, which it looks like we're going to experience. However, the Treasury and Federal Reserve are going all out to mitigate the impact of the recession. If we make the assumption that GDP starts to expand in the second half of 2009, then stocks should start moving higher through the first half of 2009, perhaps as early as December. Of course, nothing this year has played out as expected, so we can't take that expansion for granted. On the other hand, the majority of economic indicators we follow are showing "unprecedented" negative readings, which tells us that the risk of further downward movement in stocks, while possible, is limited.
We remain net buyers of stocks over the past few weeks. We are buying US mega cap companies like JP Morgan, Microsoft, Hewlett Packard, General Electric and Coca-Cola, which we believe have the financial resources to ride out the current downturn and are priced at the lowest levels since the early 1980's. We're also buying companies with relatively high and predictable dividend yields, such as utilities, in case the recession last longer than our current forecast of three quarters. The riskiest sector remains financial services, which lead the stock market into the current decline and even now remains down 55% on the year. A rally in that sector would give us a lot more confidence about the rest of the market.