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World
stocks set October low, rally in closing week
As bad as
September was for stocks, October was worse. US investors sold a record
$56.0 billion in stock mutual funds in September and set a new record for
sales of $70.7 billion in October.
Liquidations among hedge funds across all asset classes totaled $600
billion by one estimate for the last two months. Facing that kind of selling pressure,
buyers disappeared. Through
October 24th, virtually every asset class including US stocks,
international stocks, preferred stocks, corporate bonds, muni bonds, asset
backed securities of any kind experienced panic liquidation.
Had the month
closed October 24th, US stocks would have delivered the worst monthly
return ever - worse than during October 1929 stock market crash, the
outbreak of World War II, Pearl Harbor attack, Cuban Missile Crisis,
assassination of Kennedy, 1987 Stock Market Crash, 9/11 attacks or any
other historic event in the last 100 years. Even with the rally of the last week,
which lifted the S&P 500 11% on the week, US stocks are down 37% from
last October's high, international markets down 43%. The decline represents a loss of
trillions of dollars in investor wealth and will deliver the US and most
of the world's economies into recession for the next 2-3 quarters. Of the 13 bear markets in US stocks
over the last 100 years, the 46% decline through October 27th represents
the 5 largest. Stocks declined 49%
from March 2000 through October 2002.
The role of
hedge funds in the melt down
In principle,
hedge funds are supposed to deliver positive returns in all market
conditions. In practice, many of
the funds should be labeled "aggressively leveraged one-way bet
funds." Supposedly
sophisticated investors allocate their capital to hedge funds in hopes of
receiving outsized returns net of the funds' high fees and expenses. In return, investors are limited in
withdrawing their funds to a few times, or perhaps even once per
year. We've mentioned in previous
market letters how hedge funds meeting margin calls have been dumping
securities at fire-sale prices all year long. This selling reached a crescendo when
hedge fund investors delivered record notices of redemption on September
30th, forcing massive fund liquidations over the next several weeks. Even now, every afternoon when the
market looks set to close up a couple of hundred Dow points, we see a
massive wave of S&P 500 futures selling in the last 15 minutes of
trading as the hedge funds try to raise additional cash.
About a quarter to
a third of all hedge funds will be out of business by year's end. Those that remain will be sharply
constrained by their investors and prime brokers on how much leverage
they can exercise. We hope, also,
that the next administration will prepare legislation to require
government regulation of hedge funds to standards at the very minimum
required of investment advisors such as our firm.
Stock and
Stock Market Valuations
Whether the stock
market is currently fairly valued, over or under valued right now depends
on overall stock prices, whether current earnings forecasts are credible
and levels of interest rates. The
Fed just dropped overnight rates to 1%, matching the previous record
low. 10 year Treasury yields are
at 3.9%, near the lowest levels of the last 60 years. Earnings for the S&P 500 are expected
to shrink 7.7% for 2008 and grow 13.4% in 2009. Excluding financials, S&P 500
earnings are expected to grow 5.7% in 2008 but only 2.9% in 2009,
primarily due to the impact of sharply lower energy and commodity prices
on companies in those sectors, but also continued weakness in consumer
discretionary and industrial companies.
If the projected earnings are correct, then the S&P 500 has a
P/E of 11.8 for 2008 and 9.9 for 2009.
If we take a worst case
scenario that earnings estimates for 2009 must be reduced by a
third, we still have a 2009 P/E of 14.9.
In the context of current low interest rates, the stock market is
undervalued by 15%. If earnings
are even flat over the next year, the stock market is undervalued by 80%
- the steepest discount ever. Also,
if we look at individual stocks, we see many trading at the lowest
valuations in decades. Microsoft,
for example, reached a P/E below 10 recently, which is the lowest in the
history of the stocks. Pfizer can
be bought with a record low P/E of 7.5 AND a record high yield of 7.2%.
What next?
As recently as the
end of August, we thought that the US economy would grow at reduced
levels, but not actually experience a recession, commonly defined as two
consecutive quarters of negative GDP growth. The US can no longer avoid that
recession. Jobs losses have
occurred every month since January, and now total over 1 million
YTD. If anything, the rate of job
losses will accelerate over the next three months as layoffs are now
hitting mainstream companies like American Express. Consumer confidence figures are near
record lows for the history of the series, even worse than after the 9/11
attacks. Good news on gas prices
does not make up for a huge surge in worry about unemployment, further
declines in housing prices, and whether the year's decline in stocks put
college plans or retirement out of reach.
If we take a look
at US stock prices over the last 11 years, we see the index just above
the level of stocks at the end of  the last bear market in October 2002, and
also at the same level of stocks in August 1997. Even though US GDP is 37% larger than
in October 2002, and 72% larger than in August 1997, US stocks have
essentially generated a net return of 0% for the past 11 years (including
dividends, the total return is 2.3%/year.) Since 1945, the S&P 500 delivered
average annual returns of 11.3% and delivered returns of 18.0% in the
decade of the 1990's. This suggests that after a decade of
underperformance in US stocks, we're due for a decade of average or even
better than average returns. Of
the 10 post 1945 bear markets, stocks rallied an average of 36% over the
next year, including 34% in the year following October 2002. We have to go back to the crash of
October 1987 to see a decline as steep as the past two
months;
prices gained 23% following December lows of that year. So much of what has happened over the
last year is "unprecedented," that we can't make any precise
estimates of where stocks will be a year from now. We do know that stocks are
"cheap," and we do know that after every bear market comes
another bull rally.
Strategy
We were net buyers
of stocks over the past few weeks.
We sold a couple of companies that are very dependent on wholesale
borrowing and which we don't think can survive the current freeze in
lending. 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.
As always, please
don't hesitate to call with questions and concerns.
Yours sincerely,
David Edwards
President
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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