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US Stocks
set to slide at the open to fresh 2008 lows
Though May 19th, US stocks rallied from the March 10th
low, gaining 12.1% and taking the S&P 500 to within 2.8% of breakeven
on the year. Since mid-May, an acceleration of fears about the
credit crisis has dropped the S&P 13.9% in 8 weeks, and to a decline
of 21.5% from the October 9th, 2007 record high.
S&P 500 - 2008 YTD
At current levels, US stocks are at the lowest levels
since July 2006, and before that December 1998.
S&P 500 - 10 years through July 2008
So even though US GDP has grown 30.1% over that time frame
to the current record of $11.7 trillion, stocks haven't
budged at all and currently remain 25-35% below fair value.
US GDP - 10 years through March 2008
Housing & Credit Worries
Fannie Mae and Freddie are "Government Sponsored
Entities" which are chartered to extend credit to
US homeowners and currently hold or guarantee $5 trillion.
Earlier this year, regulators moved to expand the GSE's
lending abilities to backstop private lenders that were
faltering. The fear now is that Fannie Mae and Freddie
Mac are now facing the same sharp increase in defaults
that have already taken out IndyMac, a bank, and brought
the mortgage insurance companies such as AMBAC to the
brink of insolvency. Stock prices in both companies
have fallen about 85% so far this year, with the chart
looking spookily like the chart of Bear Stearns right
before that firm was forced out of business.
Case-Shiller home price index 15 years through 2008
House prices are now 16.2% off the June 2006 high and could fall another
10% before flattening out in 2009. Prices in certain markets are
already off 25-30%. Price data is not as readily available for
previous time frames, but prices fell peak to trough about 12% from
1989-1997, and about 12% in 1980-1985. The current slide already
exceeds the experience of any homeowner alive today (comparable price slides
were last seen during the Great Depresssion.)
The real estate woes of the 1980's and early 1990's led to the insolvency
of nearly 800 Savings and Loans. These banks primarily funded
mortgages (long dated, fixed rate loans) with short term funds, primarily
demand deposits. As short term rates soared through the 1980's, the
banks found that the cost of funding mortgages was higher than the
revenue stream derived from those mortgages. In 1989, the
Resolution Trust Company was created to roll up the impaired assets of
the S&L's, and the assets were disposed of in an orderly fashion over
the next 6 years. The way things are going, it's not out of the
question that we'll need another RTC.
Fear Factor
Action at the Treasury and Federal Reserve over the weekend failed to
reassure investors. A rally Monday morning lasted less than an hour
before stocks slid again. The US dollar, which had stabilized in
recent weeks, abruptly fell to a new all-time low against the Euro and a
generational low against a basket of currencies represented by the dollar
index. A lower dollar pushed the price of a barrel of oil higher,
back near record highs at $146.54.
Ignored in all the mayhem is actual earnings reports. Energy
earnings are expected to grow 30% as the price of oil double since since
last year. Technology earnings are expected to grow 20.8%,
industrials 18.0%, telecom 13.9% as the cheap dollar drives an export
surge. Healthcare earnings are expected to grow 15.2% and consumer
staples 10.9%. The areas of greatest weakness are financials, down
7.3% and consumer discretionary, down 0.7%. Overall, Earnings
growth for Q2 2008 could grow 10.0% - pretty good! (Estimates from
Zacks.)
The critical earnings reports we want to see are Merrill Lynch on 7/17,
Citigroup on 7/18 and Bank of America on 7/21. These three
companies were the first to report major problems last November and were
deepest into the poor quality mortgage assets. While we expect
further write-downs, we also expect the size of the write-downs to decrease
relative to the last two quarters. That would be confirmation of
our opinion that we are over half way through this crisis.
Strategy
The fantasy is that stock investors are careful, calculating economists,
rationally evaluating trends and forecasts and deploying their capital in
a rational fashion. The reality is that most investors swing wildly
from euphoria to fear, time and time again buying high and selling low
(Internet stocks in the late 1990's, Florida condos in 2005, China and
India markets in December 2007, down 46.8% and 44.9% since last year's
highs.)
We're not selling ANY stocks right now. We have Fannie Mae and
Freddie Mac in nearly every clients' portfolios, but no more than 0.5% of
assets, so little downside risk, much upside potential. We
considered adding to those stocks last Friday, but held off waiting for
the weekend's news. We have plenty of cash we'd like to invest, but
we need to others buyers willing to step in as well. Our clients
that are drawing on cash now are drawing those funds from money market
and bond funds and we'll reload those funds as stock prices rise.
Clients that do not expect to draw on their accounts for at least 5 years
are invested only in stocks as the current bear market will be in the
rear view mirror soon enough.
We have had many conversations with our clients over the last 6 weeks
about the state of the markets and we remind our clients that they should
never hesitate to call with questions. The key point we have made
to our clients is, "Remember how terrible you felt September 12th,
2001? As a nation, we had just experienced a previously
unimaginable tragedy and it was hard to believe that we could ever be
optimistic again. Not even 7 years later, hardly anyone remembers
those days." The current crisis, by comparison, is a
mild. Yes, some people will lose their homes, some people will lose
their jobs, some banks will close, but as the chart of US GDP shows
above, the enormous aircraft carrier that is the US economy will sail on.
Yours sincerely,
The Heron Capital Management client letter is published
immediately following month end and when market conditions require
comment. The views expressed in this letter represent HCMI opinion and
strategy as of the date published and can change at any time upon receipt
of new information. Data quoted in this letter are from sources deemed
reliable, but no guarantee of such data is implied.
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