Perception & Reality
The S&P 500 declined 9.1% since year end and the NASDAQ declined 14.2% over the same period. The 75% S&P 500/25% Lehman Government Bond Index lost 6.3% over the same period. Stocks delivered the worst 4 month return since 2002. However, volatility in the US stock market is declining, with the S&P 500 in a trading range between 1300-1400 (last 1330) and above the 52 week low of 1310 set January 22nd.
Americans are beset by deep pessimism about the state of the US economy. Consumer sentiment plunged to a 16 year low, lower even than during the 2000-2002 bear market, which included the 9/11 terrorist attacks. The previous low, in 1992, corresponded to the last housing slow-down in 1989-92. The most recent report from Case-Shiller shows a decline of 8.9% in home prices in the year ending December 31st, down 10.5% from the peak of July 2006. The peak to trough decline in 1989-1993 was 8.2%, and new highs weren't made until 1998. Housing prices increased 127% between January 2000 and July 2006, but that's cold comfort to anyone who bought property since, or who borrowed against the equity in their home and now find themselves underwater. Combine worries about housing with an uptick in unemployment, stagnant wage growth, high energy prices and a low rate of savings, and it's easy to see why consumers would be concerned.
In banking, nearly $200 billion has been written down against the value of CDO (collateralized debt obligation) bonds. In the context of a US economy growing at the rate of $14 trillion/year, with financial assets of $30 trillion, these losses are sustainable (the 9/11 attacks and Hurricane Katrina each cost $100 billion, and the economy survived those hits.) However, it's widely perceived among consumers and businesses that the damage is severe. People are literally talking themselves into a recession. The reality is that US economy is experiencing a modest slow-down, and that economies outside the US continue to do well.
As we have noted, 50% of earnings of S&P 500 companies come from non-US operations. In the most recent reporting period (Q4 2006) earnings grew 10.5% according to Zacks. Backing out financials, which showed a decline in earnings of 9.5% and a decline in net income of $3.3 billion versus year ago gains of $50.9 billion, and earnings grew 14.9%. The technology sector did particularly well, with year over year gains of 28.5%, record revenues and net income at Microsoft, IBM, Intel, Cisco and Oracle. None the less, these stocks are down 25-35% from recent peaks.
Federal Reserve Policy
US stocks were poised to close higher in February, but gloomy comments from Federal Reserve Chair Ben Bernanke knocked stocks down 4.2% in the last three days of the month. In testimony, he indicated that the Fed was more worried about growth than inflation and would continue to cut rates. A mild recession is almost universally expected for part of 2008. Markets expect another 0.50% cut on March 18th to 2.5%, and rates could drop as low as 2% by mid-year. Lowered rates will cushion the downturn, especially as the LIBOR rate, which is the benchmark used to reset most adjustable rate mortgages, has followed Fed Funds lower. However, capital destruction among the banks and sharply increased lending standards means that credit is hard to come by.
Also, with perception by international investors that the US would continue to cut rates, the US dollar promptly gave up the gains of the last two months, dropping to a new 30 year low, which pushed oil to an all-time high of $102.59/barrel, gold to an all-time high of $974.17/oz and commodities in general to an all-time high. Commodity prices generally track the ebbs and flows of the US economy. The last time commodity prices rose despite a US recession was during the "Stagflation" period of the 1970's, and that word has certainly revived in the public consciousness.
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Gold 20 years through 2/29/07
NASDAQ - 20 years through 12/31/02
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We wonder, however, whether the current rally in, for example gold, is based primarily on "fund flows," cash coming in from investors chasing price momentum. The Gold chart on the left shows an ever accelerating rate of increase through Friday's close, which looks awfully similar to the chart of the NADAQ heading into the March 2000 peak, which was followed by an 85% sell-off. Commodity prices certainly are not guaranteed to fall so dramatically, but it's not a place we would rush to invest in.
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US Politics
As late as January 2008, we were confident that Hillary Clinton would win both the Democratic nomination and the Presidency, but primary results of the last two months have cast that analysis into doubt. It's possible but not likely that Barack Obama picks up enough delegates in Texas and Ohio on March 4th to force Hillary Clinton out of the game. Obama has 1,369 delegates, Clinton has 1,267 delegates, 2,025 delegates are needed to win, but only 444 delegates will be awarded next week (and on a proportional basis.) Obama could "win" all four states and still not secure the nomination. It's possible that the Democratic nomination drags on through the Pennsylvania primary on April 22nd, the Indiana/North Carolina primary on May 6th, or even that neither candidate can achieve enough delegates in the primaries, throwing the decision to the August convention. McCain, meanwhile, will probably secure the Republican March 4th (he has 1,033 delegates, 1,191 are needed to secure the nomination, and 265 delegates are at stake with few likely to go to Huckabee.) Although the Republicans are massively disadvantaged coming into the general election, if McCain can start his general election campaign in March, while the Democratic candidates continue their primary campaign through the Spring, or even until late August, McCain just might pick up enough independent voters to win.
A historical side note: the last time a US senator was elected president was John F Kennedy in 1960. Johnson, Nixon, and Ford all came from the Senate, but only after serving first as Vice-President. Historically, US presidents have been governors, which gave them experience at the state level with managing large bureaucracies. Our biggest worry is that whichever candidate wins, the Bush income, dividend and capital gains tax cuts get rolled back (effectively a tax increase) - the US economy is weak enough already.
Strategy
We expect US stocks to remain range bound through the end of March. Although the stock market is currently undervalued by at least 25%, we need to see what banks say about their credit losses in April. As Merrill Lynch, Citigroup, Bears Stearns and other banks and brokers have new management teams as of the 4th quarter, those teams were incentivized to stuff as much bad news into the January earnings reports as possible. If losses diminish for the 1st quarter reports coming out in April, we'd feel comfortable that the worst was past. However, if the losses accelerated in April (a 10% probability we estimate), then there would be no support for the stock market whatsoever.
The scenario we don't expect is for stock prices to fall 55% as we saw during the 2000-2002 bear market. In 2000, the stock market was roughly 110% overvalued. As company earnings fell sharply following the end of the tech bubble, stock prices fell faster. At present, stocks are undervalued, and earnings, outside of financial services, are growing, with a median projection of 11.0% in 2008. Bottom line is that stocks look pretty cheap. If we had any confidence that the credit crisis was moderating, we'd put our cash to work. Meanwhile, we're certainly not selling the stocks we already own.
Yours sincerely,
David Edwards
President
