Dear Clients and Friends,
The 5 day period ending Friday delivered the worst
1 week return to US stock markets since 1940, exceeding the 1 week losses set
during the October 1987 stock market crash. The Dow declined 14.3%, the
S&P 500 11.7%, the NASDAQ 16.0% and the NYSE 11.2%. The major averages
are now below the lows for the year set back in early April and are back to the
levels last seen in October 1998 during the Emerging Markets crisis. The
S&P 500 is 36.8% below the March 2000 peak, the NASDAQ down 71.9%.
European markets fell an average of 16.5% and Asian markets an average of 12.0%
since the 9/11 attack.
Monday though Wednesday the decline was orderly,
but Thursday saw a huge wave of margin selling (including the forced sale of $2
billion in Disney stock from the Bass family of Texas) and Friday saw another
wave of selling related to position squaring in the Index futures and options
market. (To explain, many investors rushed to purchase index puts or to
short index futures earlier in the week. Friday was a "triple witching
day" which meant that many of these positions had to be settled, in large part
by selling the underlying stocks. The major averages opened down 6%,
rallied to break even by midmorning, but settled down 2-3% on the day.)
About $1.4 trillion in wealth was lost in the US, about $2.5 trillion world
wide.
Our forecast from a week ago was that "we expect US
stocks to be severely tested, falling perhaps as much as 10%. This may not
happen in the first day, but investors anxious to raise cash or facing margin
calls may well sell into rallies, taking stocks lower." We were
a little short on the magnitude of the decline, but otherwise the week turned
out as we expected. We completed a series of sales Thursday morning,
raising cash levels to an average 10% by trimming companies that we expect to be
hard hit over the next year or which we had already planned to take tax losses
on.
What happens next?
As we have said on many occasions, the two events
most likely to harm the stock market is a series of rate increases by the Fed
and the outbreak of war. We have had 8 rate cuts by the Fed since January
and a huge increase in the rate of money supply growth. Absent a condition
of war, we would typically expect to see economic growth surging with the
additional prospect of an uptick in inflation (too much money chasing the same
supply of goods and services.) The Fed cuts so far this year have had
limited impact in boosting output because businesses have been loathe to make
new investments in light of the current capacity under-utilization. Now
investors fear that the terrorist attack will harm consumer confidence, thereby
reducing spending, thereby tilting the economy into recession.
Indeed, the new consensus among economists is that the US will show negative
growth of -0.5-1.0% in each of the next two quarters. Corporate earnings,
which were expected to be flat to slightly lower in the 4th quarter (following a
likely loss of 17% in the third quarter) are now expected to decline 15%.
One positive development is that economists had
expected a U-shaped recovery (in the sense that without a catalyst to drive a
sharp increase in growth, the recovery would be slow) but now look for a
V-shaped recovery (stimulation to the economy from easier money, increased
construction spending and defense spending.) The unemployment rate, which
was moving up towards possibly 5.5%, may be held in check as
military reservists are taken out of the employment pool. Inflation
will be held in check for now as oil prices retreat below the levels of two
weeks ago.
Investor's biggest concerns right now is
determining the nature of the war ahead of us. It won't be a turkey shoot
like the Gulf War (Afghanistan has no tanks lined up in the desert, Afghan
soldiers have high morale and 23 years of guerilla combat experience.) It
won't be a war for territory. It will be a police action in which we try
to pick out individuals who are hidden in caves in hills and among civilian
populations. Carpet bombing won't be successful and indeed would
create a new generation of martyrs. US intelligence was caught flat-footed
by the attack, and there will be a huge catch-up effort accomplished, in part,
by sharing intelligence with some pretty unlikely allies. For example,
Iran, hardly a friend of the US, may well assist in this campaign because the
Iranian leaders fear being destabilized by the Taliban. The history of
fighting terrorism, whether Palestinians in Israel, Tamil separatists in Sri
Lanka or the IRA in Northern Ireland, is that low-level violence can
continue for decades. The US may well have to adopt a policy of
containment towards Muslim extremists as expensive and lengthy as the Cold
War.
What does this mean for stocks?
In April, when stocks had plunged 20% on the year,
we published an article entitled Stock Market
Valuations: Too High, Too Low or Just Right?. This article listed
several models for valuing the overall stock market. One of our
preferred models values the S&P 500 in terms of forward expectations of
earnings growth given yields on the ten year treasury bond. In April, this
model showed the S&P 500 to be overvalued by 12%. After the slide of
the last three months, the same model shows stocks to be undervalued by 17% -
details are at http://www.yardeni.com/stocklab.asp#smcalc -
assuming the ten year yields under 5% and earnings decline by
2.8% over the next year. Another model compares the value of total
stock market capitalization to the value of Gross Domestic Product. At the
height of the bull market, the ratio was 1.81 versus an average of 1.0 over the
last ten years. In April, the ratio was 1.35. After last week's
decline, the ratio is 1.0. In reviewing many factors including these
models, high rates of money supply growth, low interest rates, the high
probability of a V-shaped recession, and falling energy prices, we conclude that
stocks should be higher. How quickly stocks actually recover
depends largely on psychology at this point - the psychology of investors with
regards to this war and the psychology of investors who have been punished by
falling stock prices over the last year and a half.
Some questions from our clients over the last
week:
Should we buy gold?
No, gold rallied modestly over the last two weeks,
but the long term trend remains down as national banks continue to auction off
reserves, miners find ways to improve yields.
Should we buy treasury bonds?
No, yields on treasuries are at generational
lows. The two year yields 3.2% while the 10 year yields 4.7%. If we
buy those bonds and yields go higher (as is already happening in the longer
maturities) the values of the bonds will fall. We can get 3.24% in money
markets with no principal risk.
Before the markets reopened on Monday, we said that
we would only sell stocks to meet immediate cash needs. However, on
Thursday we "changed our mind" and raised cash levels 10%.
Why?
Part of our job is to be pragmatic in light of new
information. For the most part, we do not want to sell stocks at current
levels. However, as information became available during the week, it
became apparent to us that certain companies would be worse hit than we thought
prior to the market reopening. Also, this is the time of the year when we
usually clean house, taking losses on companies that aren't doing well to offset
gains taken earlier. Since it is highly unlikely that we can deliver
positive returns this year, at least we can make sure that clients won't owe
taxes. We will evaluate the market week by week to see when we should
reinvest the proceeds and we will also investigate adding companies to our
portfolios whose prospects and valuations seem reasonable.
We have spoken to about a third of our clients over
the last week. We will try to reach the rest this week and next, or you
can call us first with your questions.