New Year's
rally fizzles on economic woes
US stocks rallied
24% between the low set November 20th and January 6th. However, the release of universally
dismal economic reports in the United States dropped stocks over 11%,
leaving the S&P 500 down 7.4% on the year, and down 47.0% from the
record high set in October 2007.
This chart of the S&P 500 since 1928 shows the violence of the
current  bear market.
At the far left, we see the 80% declines of the Great
Depression. At the far right, we
see two major sell-offs - the first in 2000-2002 with the bursting of the
tech bubble, and the second from 2007-present with the bursting of the
credit bubble. The 1987 stock
market crash is minor by comparison.
We see that US stocks are net unchanged from 2003 and before that
from 1997. Between 1965 and 1978,
US stocks were also stuck in a range.
Following the conclusion of the 1982 recession, stocks rallied for
the next two decades.
The first estimate
of 4th quarter US GDP showed a decline of 3.8% versus expectations of a
decline of 5.5%. These growth
figures are the worst since a decline of 6.4% in 1982. The first estimate includes minimal
data from December, however, so we would expect lower revisions in the
February and March estimates.
Soaring layoffs and jobless claims, and a rising unemployment rate
bode ill for subsequent quarters, with GDP growth estimate at -3.0% for
Q1, -0.8% for Q2, 1.1% for Q3 and 2.0% for Q4. Unemployment, which usually trails
economic growth, is expected to peak between 8-9% towards the end of
2009. Considering that the US
economy appeared to be on the mend as recently as August 2008, we're
shocked at how dramatically the US and world economies have slowed. In particular, we're astonished that
the major interventions by the US Federal Reserve and Treasury, and by central
banks worldwide, have had little or no effect on the continuing collapse
of the world's banking systems.
Can the
banks be saved?
The 75% slide in
the financials index since June 2007, including a decline of 24% since
the start of 2009, is unprecedented.
This decline
reflects a
write-down of $1 trillion in assets among banks world-wide AND the fear
that another $1-2 trillion will be written down before the crisis is over
(US banking assets currently total about $14 trillion.) The "toxic" assets are tied
primarily to US residential mortgages.
Housing prices, according to the Case-Shiller indexes, are down
25.2% across the US since July 2006, with the rate of decline
accelerating in the two most recent reports at about an 18% year over
year rate. Prices are expected to
level off by mid-2009 at the earliest, or could continue falling through
year end. So the value of mortgage
backed securities must also continue to fall. The ability of banks to lend is tied to
the value of their assets which could range from simple cash deposits, to
preferred stock issued to the TARP program, to various types of
securities. The $350 billion in
TARP fund distributed so far has offset a third or less of the capital
lost to write-downs, hence the net contraction in lending.
Although the
situation is grim, there are some indicators that the credit squeeze is
easing. This chart shows the
spread between the
three month
treasury and 3 month LIBOR - the rate that banks lend to each other. After spiking to record levels in
October 2008, the spread is near normal levels.
Spreads between US
treasury bonds and BBB corporate bonds, which also spiked to record
levels last fall, have also eased, but have a ways to go to get to
"normal."
Rates for
conventional mortgages (30 year fixed rate) are higher than the January
9th low of 4.2%, but, at 4.7%, are near the lowest levels in the last 40
years.
The US Treasury
and Federal Reserve have struggled since March 2008 to contain the credit
crisis. Fannie Mae, Freddie Mac
and AIG were effectively "nationalized" last fall. Among the five largest banks, Citibank
and Bank of America are on life support, and JP Morgan, Wells Fargo and
US Bancorp are damaged but seemingly able to survive with TARP
support. Should Citibank or Bank
of America fail, their depositors will be protected and there are plenty
of healthier banks that can take over their operations. The big question in Washington right
now is whether a strategy can be implemented to segregate "bad"
assets in a government sponsored entity (the "bad bank") so
that declining asset prices will not further depress lending. The problem is how to price the assets
to be transferred - too low and bank lending is impaired anyway; too high
and tax payers foot the bill for the difference.
Can the US
economy be saved?
We receive several
hundred economic reports each month, and most show the worst news since
the 1982 recession, many the worst news in their entire history. The statistic which captures the
current angst most succinctly is the US
Non-Farm Payrolls
report. Not only have a net 2.6
million jobs disappeared in the last 13 months, but job growth from the
end of the previous recession in 2003 was low compared to the end of previous
recessions.
The US
unemployment rate is now higher than at the end of the 2003 recession and
is approaching the peak of the 1992 recession. Measures of US consumer confidence are
at or near all time lows over job insecurity and wealth destruction in
both housing prices and investment portfolios.
Consumer income is
falling, but consumer spending is falling at a faster rate, reversing a
slide in the US savings rate which dates to early 1980's. The increase in the savings rate, while
a long term good, is a short term disaster.
Net, the recession
in the US, which appeared to be short and mild a few months ago, will now
be longer, deeper and more painful than many economists had
forecast. A return to the Great
Depression, with 25% unemployment rates and a 30% decline in GDP, seems
unlikely. US recessions in the
post 1945 period generally reflected increased interest rates and
restrictive monetary policy in response to inflationary pressures, in
particular the "oil shock" recessions of the 1973-5 and
1980-82. However, US CPI is
currently mild at 1.8%, excluding food and energy, or 0.1% including food
and energy (reflecting the 72% decline in oil), and US monetary policy is
exceptionally expansive so those examples don't apply.
From 1986-1990,
Japan experienced a parabolic rise in both stock market and real estate
prices, which peaked at valuations roughly 2.5 times higher than the US
saw in the stock market bubble of 2000 or the real estate bubble of
2006. By 2004, Japanese real
estate prices had fallen about 90%, and the stock market (Nikkei,) which
peaked in 1989, fell 80% from December 1989 through April 2003, increased
by 137% through July 2007, but gave back all those gains through October
2008.
We think that the
Japan experience applies best to the US in the current situation -
extremely low interest rates in the 0-0.25% range and expansive monetary
policy totally unable to offset a collapse of consumer and business
confidence. The Japanese economy
pretty grew at an average of 1%/year over the next 18 years, with four
recessions along the way.
The obvious
question - is slow or no growth all that the US can expect over the next
two decades? Several important
differences: First, the size of
the Japanese bubbles in real estate and its stock market dwarf the
equivalent bubbles in the US.
Second, in Japan, the bubbles burst simultaneously, whereas in the
US, the stock market bubble burst in 2000, and the real estate bubble in
2006. Yes, stocks peaked in
October 2007, but stock valuations were reasonable given earnings and
prevailing interest rates. Third,
Bank of Japan resisted forcing banks to recognize loans as
non-performing, which delayed taking necessary actions. US banks have gone to the opposite
extreme in marking down the values of loans and securities. Fourth, the US is much less patient
with the status-quo, moving aggressively months into the crisis to offer
stimulus plans, while the Japanese government waited years. Still, Japan's experience of the last
18 years suggests that the US will experience sub-par growth for at least
several years.
Does
investing in stocks make any sense at all?
From 12/31/97
through the present, including dividends, the net return in the S&P
500 was 0.2%/year. From the end of
the last bear market in October 2002 through the present, the net return
of the S&P 500 with dividends was 0.8%. However, the net return in stocks from
1945 through the present including dividends is 10.5%/year. That 10.5% return includes not only the
negative effects of current crisis
but also the 9/11 attacks, bursting of the tech bubble in 2000, 1987
stock market crash, assassinations of John Kennedy, Robert Kennedy and
Martin Luther King, and the outbreaks of the Korean War, Vietnam War,
Gulf Wars I and II, and the Cold War.
So we continue to believe in investing in US stocks.
January, with a
decline of 8.3% for the S&P 500, hardly bodes well for stock market
returns in 2009. The decline is
attributable to continued bad news out of the banks, which fell 26.3% in
January and continued uncertainty about various bank bailout programs and
stimulus packages. Hedge fund
selling not only of stocks, but also preferred stocks, bonds, securitized
loans diminished sharply after the "Great Margin Call" of
October and November. Stock market
volatility (the amplitude of daily swings in prices) has diminished as
well. This chart of the Volatility
Index
shows a surge of
volatility last October-November to levels not even seen during the 1987
Stock Market Crash. Although the
VIX has fallen by half, it remains at twice the levels seen during the
2002-2002 recession, when stock prices fell by an equal amount. Investors remain extremely skittish
about stocks, with mutual funds seeing net investments of $9 billion in
January, versus net withdrawals of $221.4 billion in 2008 ($72.3 billion
in October alone.)
Strategy
A meaningful
upturn in the US economy doesn't seem likely before the end of 2009 or
the beginning of 2010. The US
stock market generally leads the economy by 6-9 months, so by the second
half of 2009, stocks should be higher.
We've had several false rallies in the last 4 months of up to
25%. Each time, the stock market
falls back to around 8000 on the Dow Industrials and 800 on the S&P
500, which is about where stocks closed at the end of January. We're going to sit tight with the
companies we have, and continue to look for opportunities to get more
fully invested.
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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