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US stocks
retest lows for 2008 but close sharply higher
US stocks made a 1
month high on November 4th as the 2 ½ year long US
presidential election finally came to a close with the widely anticipated
election of Barack Obama. Stocks
subsequently slid 15.3% over the next 5 trading days, ending near the
lows for year set on October 27th, tracing out a 15-20%
trading range in the S&P 500 with 1005 at the top, 850 at the
bottom. Either the October 27th
low of 848.92 holds, or it doesn't.
If not, then market technicians look at 776 in the S&P 500 as
the next floor - that was the low set during the last bear market which
ended in October 2002. At the
worst point today, US stocks were down 2.8% on the day, 14.3% on the
month, 28.7% on the quarter, 42.6% on the year, and down 47.2% from the
October 2007 high. However, at the
close, the S&P 500 was up 6.9%, an intra-day swing of 11.3%.
Fundamentals
haven't remotely changed in the last two weeks to justify these
swings. We've discussed stock
valuation at length in recent commentaries, but favorable valuations do
not seem to drive investor decisions right now. So instead, let's detail what investors
are focused on:
Fear
Factors
· The Credit Crisis
· Housing prices continues to fall
· Unemployment continues to rise
· Probable bankruptcy of General Motors, Ford and Chrysler
· Recession in the United States
· Media saturation of bad news
· Continued liquidation of hedge funds
· Can
"Baby Boomers" retire?
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Is there any good news at all?
The Credit
Crisis
All of our current
woes tie back to the period of 2003-2006 when low prevailing interest
rates caused investors to seek out high yielding, but "safe,"
fixed income securities. Wall
Street responded by underwriting vast supplies of mortgage and debt based
securities, which, when push came to shove in 2007 and 2008, were worth
far less than stated value. US
banks, and later European banks, were forced to write down the value of
these securities, by $900 billion to date. Bear Stearns, Fannie Mae, Freddie Mac
and ultimately Lehman Brothers all broke under the strain. The failure of Lehman impacted the
commercial paper market and credit default swaps markets, causing banks
worldwide to run away from lending to each other, let alone actual
customers. Peak fears were seen in
soaring LIBOR rates on October 10th; the normal spread of
0.75% between 3 month LIBOR and 3 month T-bills jumped to 4.8%. That spread is way down now at 1.9%, so
still about 1.1% higher than normal.
Overnight LIBOR is back to normal, about par with Fed Funds.
Spreads widened
dramatically in other securities.
For example, yields on investment grade corporates jumped from 6%
to 9%, high yield bonds from 11% to 19%, municipal bonds from 4% to 5.5%,
and preferred stock yields from 5% to 9%.
Since the October peak, yields have fallen by a percent or so and
thus remain well elevated compared to August. So even though the Federal Reserve Bank
has dropped the Fed Funds rate from 5.25% as of September 2007 to in 1%
as of October 2008, investors are only just starting to take advantage,
preferring "safe" Treasury bills at 0.3% or Treasury bonds at
3.7%.
Meanwhile, it
seems like the risk of additional large banks failing has
dissipated. US and International
central banks have placed trillions of dollars into the banking systems
to replace capital destroyed by the credit crisis and forced weaker firms
to merge with stronger. The
capital injected into the banks, however, is only grudgingly making its
way to corporate and individual borrowers, and borrowing rates remain
high. As a result, bank profits
are widely expected to surge in 2009; write downs on securities holdings
will diminish, while profits on conventional lending will soar.
The $700 billion
TARP program passed by the US Congress in October continues to
evolve. The original plan was to
use the funds to buy up illiquid mortgage backed securities and get them
off bank balance sheets. As we
expected, implementing such a program was far too cumbersome if the goal
was to get cash into banks quickly.
The straightforward purchase of preferred stock in the banks is
faster, cleaner, and offers a clear path to the Treasury recouping its
investment within 5 years. There
is also discussion of whether to extend TARP funds to non-banks such as
credit card and car loan companies.
Housing
prices continues to fall
Housing statistics
continue to look grim, with prices likely to level off only in mid to
late 2009. Foreclosures are up,
mortgage money is hard to obtain, many homeowners find that their
mortgage is higher than the current value of their house. However, supply is starting to shrink
relative to demand as new housing construction is at the lowest level in
decades. JP Morgan, Citigroup,
Bank of America, Fannie Mae and Freddie Mac have all announced programs
to modify existing mortgages, either by reducing principal, reducing
rates, or extending terms. The
programs will reduce the foreclosure rate, which will put a floor under
the entire market.
Unemployment
continues to rise
US unemployment at
6.5% in October exceeded the peak of 6.3% set at the tail end of the
2000-2002 recession. Forecasts for
2009 range up to 8.7% (average forecast is 7.3%), which would exceed the
7.8% level set during the 1991-2 recession, and would close on the peak
level of 10.8% set during the 1982-84 recession. Biggest contributing factor to the rise
in unemployment is the decline in construction jobs, but now we're seeing
spillover into automobile and retail jobs as consumer spending has
slammed to a halt. The US economy
has lost jobs in every month this year, for a net loss of over 1.2
million jobs. Unemployment usually
trails the economy, so unfortunately we expect job losses to increase
into 2009.
Probable
bankruptcy of General Motors, Ford and Chrysler
US car sales
plunged nearly 40% in October relative to the year ago period. US automakers were not in robust health
even when car sales were strong.
In the current environment, General Motors burns through between
$5-7 billion a month. With a cash
cushion of just $16 billion the firm might be bankrupt as early as Q1
2009. We have long avoided this
sector, even the relatively healthy Toyota, but should the US automakers
go into bankruptcy, hundreds of thousands of workers will be idled,
delivering another major blow to consumer confidence. There's some discussion that US
automakers will get cash infusions from the TARP, but we think the
probability of that is low. More
likely, the automakers will experience what US steel makers experienced
in the 1980's: bankruptcy, restructuring and emergence as much smaller
but more profitable companies
Recession
in the United States
Through August
2008, it looked like the US would skirt by recession. The credit crisis slammed economic
activity to a halt. This chart from
Economy.com shows how economic
forecasts evolved
over the last three months.
Previously, economic growth looked slow but positive in the 1%
range from the end of 2008 and into 2009, rising back towards average by
year-end 2009. Now we see Q4
growth declining sharply at a 2.8% rate in Q4 2008, working back to
positive territory only late in 2009.
Media
saturation of bad news
There was a time
as recently as the 1990's when average investors checked their statements
once a month, or possibly looked up stock quotes in their daily
newspaper. Now, every health club,
bar and shoe shine place in the country is tuned continuously to the
business channels, with a camera focused on the value of the Dow Jones
Industrials at all time. Americans
see that Dow bug wherever they go and feel compelled to do something
about it!
We've tried to
educate our clients to expect 8-10% annual gains in the stock
market. Meanwhile the markets are
swinging up or down 15%/week, which doesn't instill confidence. On top of that, we have market gurus
like Jim Cramer trying to educate the US public to become day-traders
because "buy and hold is dead!"
Jim Cramer is a very smart guy and a very successful
investor. But the idea that
millions of Americans can do their jobs, take care of their families AND
day trade stocks is ridiculous.
Over the last 10 years, the cost of trading has plummeted, the
amount of information available to the average investor has surged, and
all kinds of trading vehicles such as ETF's have been introduced to make
investing as easy as a click of a mouse.
Unfortunately, the results have been terrible - US investors
bought high/sold low in technology stocks, bought high/sold low in
housing, bought high/sold low in international funds and right now are
liquidating their mutual funds at record rates for fire sale prices.
Continued
liquidation of hedge funds
A minority of
hedge funds have made phenomenal returns over the last two years. A third to a half of all hedge funds,
however, delivered horrible returns, in some cases losses of 100%. We see daily announcements 2-4 funds
going out of business, either from investment losses or investor
redemptions. As each fund closes,
it's forced to sell its investments at whatever the market will
bear. We also see huge daily
swings in, for example, the S&P 500 futures contracts, as funds
desperately try to generate marginal returns to keep in business. Typically, we'll see the markets up
reasonable levels at 3PM, or even 3:45PM, only to see massive shorting of
the futures, which turns into stock declines, by the close (the hedge
fund profits by shorting the future, which triggers sales by other
investors, and then buying back the contract at the close for a profit.)
Today, however, massive hedge fund buying in the last hour
lifted stocks dramatically. Nice, but what we'd really like to see
is the market go up for more than 2 days in a row (once in the last
two months,) or more than one week in a row (not since early
September.)
As the hedge
fund sector shrinks into 2009, hedge fund volatility will be
reduced. Also, the surviving
funds, which are mostly in cash right now, will eventually invest in
stocks and other assets and that will help boost prices. We hope that the new administration
moves aggressively to regulate these funds going forward.
Can
"Baby Boomers" retire?
The leading edge
of baby boomers born in 1945 is now 63.
There can hardly be anything more demoralizing than being a year
or two away from retirement only to see one's stock investments down 40%
and house down 20%. Boomers will
have to adjust to lower spending levels in retirement, or will end up
working a few years longer. It may
take 3-5 years, but stocks eventually will make new highs. Our retirement age clients are
generally 30-40% in fixed income, from which we make monthly
distributions. As stocks recover
going forward, we will reload the fixed income allocation from stock
sales.
Is there
any good news at all?
The price of oil
is down 62% since July; $4 gasoline is headed to $2. That decline alone is worth about $230
billion to American consumers. The
decline in energy, commodities and food prices, ranging from 40-60%,
along with falling housing prices and flat to lower wages, means that
inflation is not an issue for several years. This will allow the Fed to keep
interest rates low. Eventually the
shock of this year's events will wear off, and businesses and consumers
will start making up for deferred purchases. There may be some psychological benefit
from having a new administration Washington. If Obama can bring the
discipline of his campaign, beating both the Clinton machine and the Republican
machine despite major initial disadvantages, to how he conducts
government, he will be very capable in addressing the ills of the nation.
Judging by other
bear markets which seem similar to this one, notably 1987 and 2000-2002,
our best guess is that stocks will trade sideways over the next 3,
possibly 6 months, held down by investor fear, but supported by company
valuations, and then start rising again.
The one year return in the S&O 500 after the final low in
December 1987 was 23% and a new high achieved within two years. After the October 2002 low, stocks
gained 34% over the next year, making a new high after five
years. Market historians are well
aware that maximum gains occur just as a bear market ends. So which will dominate investor
decisions over the next three months - fear of all the factors above, or
fear of missing the rally? If the
latter, then perhaps, just perhaps, we've seen the final low for this
bear market.
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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