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US stocks
set 11 year low, rally 17% in closing week of November
It was another
challenging month for stocks, with three month returns from August 31st
through November 20th the worst in 80 years. On November 20th, US stocks closed at a
level last seen in April 1997.
However, stocks rallied 17% over the next 5 days, still leaving
the S&P 500 down 7.2% on the month, down 22.8% on the quarter and
down 37.7% on year. Economic news
continues to be horrible, but stocks rallied simply because hedge funds
appear to have stopped selling.
The #1 question
our clients have asked over the last few weeks: "Can we sell all
stocks now, step back into the market when things calm down?" The problem with that strategy is that,
as volatile as the market has been to the downside in the last three
months, we've seen 4 occasions where stocks have gained 10% or more in
very short time frame. So rather
than protecting our clients against further losses, more likely we would
sell stocks low, only to buy back later at higher levels.
From a technical
point of view, the good news is that the Dow Industrials at 8000 and the
S&P 500 at 800 seem to be the hard floor of this particular bear
market. We've broken through those
levels a couple of times, but each time the market rallies back hard the
next day. As we have discussed in
other recent commentaries, stocks remain exceptionally undervalued even
if we discount next year's earnings expectations by a third.
Economic
conditions
Housing remains at
the root of all the current problems.
The rate of decline in home prices accelerated sharply in
September and will also probably show a sharp decline in October as funds
for mortgage lending dried up completely.
The rate of decline should slow when November's numbers are
reported (in February.) The
hardest hit areas include California, Nevada and Florida, with prices
down 36% from 2006 highs. Up to
half of all sales in those states are foreclosure sales, which may
overstate the total decline as foreclosure sales are generally at a
discount to local market conditions.
The latest
Treasury program, which addresses tight credit conditions by intervening
directly in the home mortgage, car loan and credit card markets, caused
mortgage rates to drop 0.75% in a day.
This program purchases newly originated loans directly from the
banks, which can make quick profits without worrying about getting stuck
with depreciating securities. This
is another step in the ongoing nationalization of the US financial
system, but necessary as the banks are unwilling or unable to do the job
themselves.
How to destroy investor confidence
If a hypothetical
Dr. Evil wanted to destroy the US economy and investors confidence in
stocks he would:
·
Underfund and understaff the regulatory agencies
·
Dismantle 60 years of market safeguards such as the uptick
rule, prohibition of naked shorting and separation of the functions of
commercial and investment banks (Glass-Steagall)
·
Load up bank balance sheets with illiquid securities whose
value balanced precariously on the assumption that housing prices (unlike
any other asset class) would never fall
·
Increase leverage ratios from 10 to 33 times among hedge
funds and investment banks
·
Promote borrowing over saving among average Americans
·
Hire thousands of MBA's, CFA's and PhD's, equipment them
with state of the art computers and trading programs, and enable them to
"bomb" the markets with millions of short sale transactions per
hour (short stock sales, ETF-exchange traded fund sales, put option and
credit default swaps purchases.)
Even as recently as August 31st it appeared to most
investment managers and to the Federal Reserve that the stock, housing
and credit markets were experiencing a modest correction. However,
the takeover of Fannie Mae and Freddie Mac in early September triggered
selling that completely overwhelmed market makers' ability to maintain
orderly markets. Selling accelerated in October and into November
as margin calls hit individuals and funds, and panicked investors rushed
to unload mutual funds and redeem hedge funds. If the selling is
truly finished, then we'd expect to see the stock market gain in December
(first time in 4 months) and in the first quarter of next year (first time
in 6 quarters.) The last time the stock market declined 5 quarters
in a row was during the 1969-70 bear market, and before that during the
1929-32 bear market.
The Obama
Administration
If Barack Obama
can apply the same discipline to government that he used to beat first
the Clinton political machine, then the Republican machine, he will do
very well. So far, we are
encouraged by the appointments he has made to his economic team and by his
willingness to get out in front of cameras and answer questions. We hope that the new administration has
the courage to establish minimum regulatory and maximum leverage
standards for all market participants.
At present, hedge
funds are pretty much unregulated.
As we have seen, these funds can do enormous damage to individual
companies and to the stock market in general. Certain of those funds have made
hundreds of millions of dollars by attacking, for example, Bear Stearns,
Lehman Brothers and Citigroup, which were worth hundreds of billions of
dollars. We would be the first to
agree that managers were not doing their jobs at those banks. However, allowing speculators to
destroy these banks is like smashing stain glass windows to salvage the
lead.
Can the US
economy, and by extension, the world's economy, be saved?
We have often
described the US economy as an aircraft carrier, slow to turn and with
enormous momentum. However, as we
have seen over the last three months, even an aircraft carrier can stop
on a dime if it hits a big enough reef.
US consumers, who account for 70% of economic activity, are scared
to death for their jobs, by their high levels of debt, and by the
negative wealth effect of sharp declines in housing and stock prices.
Third quarter GDP
was revised from down 0.3% to down 0.5%, which is not bad compared to
expectations of down 1.0%.
Economists are racing each other to paint the worst possible
picture for fourth quarter GDP, with estimates ranging from an average of
down 2.7% to a worst estimate of down 5.6%. Unemployment, currently at 6.5%, is
expected to rise to levels of 7-7.7%, with one economist calling for
10.0% unemployment by the end of the 2009. If so, unemployment would exceed levels
seen during the 1981-2 recession, which was far worse than current
conditions. Car sales, which have
a big impact on the economy and on employment, are running 35% below year
ago levels as tight credit and consumer fear keep buyers out of the
showrooms. Discretionary spending,
for example on clothing or electronics, slammed to a halt, hurting
retailers badly. Prior to
September, it seemed that US would experience a couple of quarters of
slow or flat growth, and then resume growth in the 2% range. Now it seems that we'll experience
negative growth through the first half of 2009, and then slow growth in
the 1-1.5% range through year end.
The one piece of
exceptionally good news is that inflation is simply not an issue, either
in the US or in most economies, with energy down 63%, commodities down
45-57%, wage pressure negligible and prices for housing, cars, and most
goods under incredible pressure.
The bigger fear is deflation, which clobbered the Japanese economy
in the decade of the 1990's. Thus,
the Federal Reserve and European central banks have no need to raise
rates or reduce monetary expansion until late 2009-early 2010.
The biggest
hindrance to recovery is the world banking system. As we see in sharply reduced LIBOR
rates, banks are willing to lend to each other. However, banks aren't willing to extend
credit to businesses or individuals as we see in exceptionally high rates
in corporate and personal lending.
Eventually, banks won't be able to resist the profits that can be
obtained by borrowing from the central banks at rates as low as 1.0% (in
the US) and lending to corporations at rates of 8% or higher, or to
individuals at mortgage rates of 5.25%, car loan rates of 8% or more and
credit card rates of 15% or more.
Strategy
The #2 question of
clients over the last month: "How can stocks rise while the economy
is contracting?" Generally
speaking, the stock market anticipates the economy by 6-9 months -
peaking before the economy peaks, rallying before the economy rallies. Stocks were down 10.7% YTD on August
31st, which seemed consistent with a mild slowdown. The absolute collapse of stocks over
the next three months would normally imply a substantial recession, which
it looks like we're going to experience.
However, the Treasury and Federal Reserve are going all out to
mitigate the impact of the recession.
If we make the assumption that GDP starts to expand in the second
half of 2009, then stocks should start moving higher through the first
half of 2009, perhaps as early as December. Of course, nothing this year has played
out as expected, so we can't take that expansion for granted. On the other hand, the majority of
economic indicators we follow are showing "unprecedented"
negative readings, which tells us that the risk of further downward
movement in stocks, while possible, is limited.
We remain net
buyers of stocks over the past few weeks.
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 lasts longer than our current forecast of three quarters. The riskiest sector remains financial
services, which lead the stock market into the current decline and even
now remains down 55% on the year.
A rally in that sector would give us a lot more confidence about
the rest of the 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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