Credit crisis dissipates

With each passing week, March 17^th looks more and more the bottom of the current stock market bear market (peak to trough, the S&P 500 fell 19.7%, the NASDAQ and most international indices fell over 20%.)  Although US economic reports are generally weak, many showing the worst values since 1991, the rate of decline has leveled off.  It's no surprise that housing statistics are terrible, with prices and volumes continuing to fall through 2009.  Consumer and business confidence levels are deeply gloomy.  Despite that, US export driven manufacturing surges as the dollar remains 20-25% undervalued against major currencies.  The risk of competition from overseas manufacturers (e.g. China) should not be underestimated, but the US still has the largest manufacturing sector of any economy, focusing on high value products such as MRI machines, while other countries produce commodity products such as toys or even personal computers.

What could happen over the next three years?

After 5 months of chills and spills, we're able to push back from the daily volatility and think "big picture."  In terms of magnitude of losses (anywhere from $300 billion to $900 billion, depending on the estimate used) and how rapidly the crisis unfolded, this crisis was unprecedented.  However, if we look back over 40 years of US economic history, we see that a major crisis occurs on average once every 4 years.  We well remember the October 1987 stock market crash and the "Tech Wreck" of 2000-2002, but how many remember the Penn Central bankruptcy of 1970 or the Mexican Default Crisis of 1995?  Yet, in hindsight, we see that investors who bought stocks when the situation looked grimmest made significant profits over the next three years.

We used a log scale on the S&P 500 price history (previous page) so that % price moves are scaled similarly (e.g. the 44.8% decline in 1974 looks the same as the 45.8% decline in 2000-2002 even the value of the index was 10X greater in 2000.)  On average, the stock market doubles every 8-9 years although there are some obvious periods of out-performance (e.g. 1996-1999) as well as two decade long periods where stocks did not gain at all (1969-1979 and 2000-2007).  By the Fed model, US stocks are undervalued 22% compared to fair value based on projected interest rates and earnings growth.

Obviously there's no guarantee that stocks will rise the average first year gain of 34% that we have seen after other crises.  However, with interest rates very low and Fed policy accommodative, we're probably at the lows of economic growth for this cycle.  Even with all the bad news of the last 6 months, US GDP grew 0.6% in Q4 2007 and 0.6% in Q1 2008 (first estimate.)  The economy is projected to grow in the low 2% range for the second half of 2008. 

Strategy

Materials (up 2.7% YTD) and Energy (up 2.6%), which we are underweight, are the top performing sectors of the year.  We're overweight Financials (down 7.7% YTD), Healthcare (down 9.6%) and Technology (down 8.2%).  However, with the Fed easing apparently done, the dollar rallying, and energy and commodity prices falling, it seems that our strategy will be rewarded.  Materials and Energy stocks are now falling, while all other sectors are rising, lead by Financials (up 3.6% over the last week and up 10.4% on the quarter.)

We got confirmation from the Citigroup and Merrill Lynch April earnings reports that credit losses, while high, are diminishing.  Although US stocks have gained 10.9% since the March 10^th low, yet stocks are still generally at the lowest valuations levels since 1991.  We believe that plenty of upside remains over the next 12 quarters and are taking our clients 100% invested for the first time in a while.