Continuing
stock rally lifts S&P 500 29.7% from March 9th low
In the first week
of March of this year, millions of Americans opened their February
statements, saw that their accounts were down another 20% on the year
after falling 38% in 2008, and sold out their stocks for good. Through March 9th, the S&P 500 fell
another 8%, leaving the S&P 500 down a sickening 57% from the October
2007 high - the steepest decline in stock prices since 1929-32. Unfortunately for those Americans who
sold, March 9th marked not only the low for the current bear market, but
the lowest price for stocks in 13 years.
Through May 1st, stocks rallied 30% in one of the steepest rallies
ever for US stocks.
The S&P 500
still remains down 2.8% for the year and down 43.9% from the high. However, the NASDAQ is up 15.5% YTD as
technology stocks soar 17.6%.
Materials stocks are up 13.2%, and consumer discretionary stocks
are up 8.3%. These sectors
typically rally ahead of economic growth, which means that more and more
investors are anticipating the end of the recession. We note that emerging stocks markets
are particularly bullish - China up 50.0% YTD, India up 15.3% and Brazil
up 25.9%. Those economies were not
particularly damaged by the financial meltdown that swamped the US and
Europe. Hundreds of millions of
consumers in those countries moved into the middle class earlier this
decade, driving current economic growth for those countries and
ultimately for the world.
Sustainable
rise or bear market "trap?"
The S&P 500
rallied 7 of the last 8 weeks, and the NASDAQ gained in 8 out of 8 weeks,
the best "streak" this century.
The one month gain of 9.4% and two month gain of 18.7% are
consistent with rallies we've seen at the end of previous bear
markets. However, the current
rally is almost universally derided as a bear market "trap,"
which entices investors to invest in stocks, only to dash their hopes
weeks later.
We have a bit more
confidence in the current rally than most of our peers. As we have remarked in recent letters,
valuations as seen in P/E ratios, Price/Book ratios and dividend yields
are the best since the early 1980's.
With one third of S&P 500 companies reporting, earnings are
down 9.4% from a year ago.
Excluding financials, which have rebounded significantly from last
year's catastrophic results, earnings fell an average of 22.4% from a
year ago. Stocks, however, have
rallied on earnings reports because most companies have beaten the worst
case expectations of analysts. The
overall psychology of the market seems to have turned. In December, discussion of the
bankruptcy of General Motors or Chrysler drove stocks sharply lower. Last Thursday, Chrysler declared
bankruptcy, yet stock prices barely moved.
In recent years,
institutional investors placed substantial percentages of their
portfolios in real estate, hedge funds and private equity deals. Turned out, those investments were
illiquid during the financial crisis, so institutions were forced to
raise funds over the winter from the liquid parts of their portfolios,
mostly by selling US stocks and investment grade bonds. Now institutional funds are flowing
back to those sectors to restore asset allocations. Individual investors were heavy sellers
of stocks in February and March (-$29.5 billion,) and barely bought
stocks in April (+$1.6 billion.)
Eventually, individuals will play catch-up. Hedge fund trading, particularly
short-selling, which totally dominated markets from September through
January, is diminished. We suspect
that quite a few have closed doors for good, and those that remain are
sharply constrained in taking on leverage and risk. The volatility indices on the NYSE and
NASDAQ, while double the levels that prevailed from 2002 through 2007,
are half the peak levels achieved in Q4 2008. Other technical indicators such as the
solidly positive Advance/Decline line and the few stocks making new lows
(16 on May 1st versus 1,220 on March 9th and 3,377 on October 10th) show
net buying.
We see continued
strength in all commodities with the exception of gold. Prices rise for copper, oil and farm
products because demand is increasing, which speaks to a rebound in
worldwide economic activity. Gold
prices reflect industrial demand for jewelry and electronics, but are
also affected heavily by "flight to safety" purchases. Gold prices peaked February 20th at $993/oz.
but subsequently sold off 10%. The
prices of US Treasury Bonds, another "flight to safety"
investment class, are also lower over the last two months by about
5%. One of the most sensitive
economic indicators, the Baltic Dry Index, which tracks the worldwide
average cost of shipping, tripled from its December low after falling 94%
from the May 2008 peak.
Bottom line:
staying out of US stocks is becoming increasingly uncomfortable for many
strategists. When that sentiment
turns, will a "buying panic" ensue?
Recession
continues in the US
1st quarter US GDP
declined at 6.1%, hardly a cause for celebration after the decline of
6.3% in Q4 2008. Shrinkage of
inventories reduced GDP by 2.8%, while a 38% decline in capital
expenditures (construction, heavy machinery, computer hardware and
software) subtracted 6.0% from GDP.
However, increased consumer spending added 2.2%, and exports added
another 2.0% to GDP. Last month we
opined that "doom fatigue" had set in among consumers; rising
consumer spending is mirrored by rising consumer confidence. The numbers are still way down compared
to as recently as 2007, but trends are turning in the right direction. The charts below represent three of
dozens of economic indicators that are higher including Consumer
Confidence, the Institute of Supply Management-Manufacturing Index, and
the Economic Cycle Research Weekly Leading Indicators.
At the same time,
current conditions remain grim, with housing prices still falling at an
18% annualized rate, jobless claims still rising at historic rates, and
personal income flat to negative.
Personal income
bumped up in May 2008 as tax rebates checks spread through the economy,
and will bump up again this May for the same reason. Government stimulus spending in general
will boost economic growth through year end. Meanwhile consumers and businesses
alike have a certain amount of capital spending that can't be deferred
indefinitely. Lastly, with
inventories at the leanest possible levels, businesses have limited scope
to further reduce production. Net,
US unemployment should peak within the next 3-6 months, start falling
slowly into 2010.
The vicious cycle
of reduced spending leading to increased unemployment leading to reduced
spending is nearly broken. The US
economy will shrink one, perhaps two more quarters, but will turn higher
by year end. Many commentators
feel that current recession is the worst since the Great Depression.
We believe that
recessions in 1958-59 and 1979-82 were worse. The recession that ended in 1983 was
particularly brutal, with unemployment peaking at 10.8% versus the
current 8.5%, Fed Funds peaking at 15.0% versus the current 0.25%, and
mortgage rates peaking over 18% versus the current 4.7%. Note how the quarter to quarter
volatility of economic growth moderated after the US shifted to a
primarily service driven economy in the early 1980's. Compared to the relatively stable US
economy of the last 30 years, the current economic situation feels like
the worst conditions since the 1930's
World's
financial system continues to stabilize
US banks including
JP Morgan, Goldman Sachs and Wells Fargo handily beat earnings estimates,
while even Citigroup and Bank of America turned in better than expected
results. Although it can be argued
that the entire US banking system is currently insolvent, the rate at
which banks must write down assets values is sharply reduced while
spreads on conventional lending are at the highest level in a decade, so
banks are currently cash flow positive.
The Federal Reserve will release details of the banking system
"stress tests" next week.
We expect some banks to fail, but most to get by with a grade of
"good enough." Banks are
far less eager to finance hedge fund trading or private equity projects
and will cut back heavily on risky derivatives trading such as credit
default swaps. We regard this
hesitation as good news - less leverage means more stability means more
confidence, which ultimately feeds back to economic growth.
Much whining among
financial professionals about how the US government is setting bank
policies including capping pay and selecting executives. These professionals have yet to grasp
the fact that if you kill the Golden Goose, you don't get any more Golden
Eggs. Bank managers are concerned
that their "All-Stars" will jump to hedge funds or boutique
firms. Indeed, a few will make
that transition, but bankers are more replaceable than they think they
are. With 200,000 unemployed
financial professionals in the US alone, filling the ranks should not be
a problem.
Swine Flu
The current excitement
over Swine flu reminds us that the television news programs are becoming
ever more desperate to attract viewers, but also becoming ever less
useful as a source of information.
The dramatic graphics and breathless reporting implies that
Bubonic Plague is on the march.
Actual numbers tell a different story. Perhaps 150 people have died of Swine
flu in Mexico City in the past month (we say perhaps, because the deaths
occurred primarily in the slum part of Mexico City, where good healthcare
and good health records are hard to come by.) By comparison, over the past year
nearly 6,000 Mexicans have been killed in narcotics trade murders
("Bullet flu!") There's
one confirmed death by swine flu in the US so far. In the last 9 months, 30,000 Americans
have died from other strains of flu.
Worldwide, 250-500 thousand people die of flu related symptoms
annually, compared to about 3.9 million who die of pneumonia, 2.7 million
who die of AIDS and 1.2 million who are killed in car accidents.
Net, the average
person's chance of dying of Swine flu is slightly higher than being hit
by lighting or killed by a shark.
There's always a risk that Swine flu could evolve into a pandemic
such as the Hong Kong flu of 19868-9, which killed 700,000-1 million
people, or the Spanish flu of 1918, which killed between 20-100 million
people out of a worldwide population of 2 billion. Disease control specialists should be
concerned, but average people should be far more worried about smoking,
obesity or careless driving.
Obama: the
first 100 days
We find that the
media's coverage of the first 100 days of the Obama presidency to be
about as useful as their coverage of the Swine flu outbreak. Our primary observation is that the new
administration is trying to make the best of a pretty poor set of
circumstances. Hundreds of high
level positions are still unfilled in the administration as nominees
struggle to get through the confirmation process. Those that have been appointed hardly
have had time to find their offices, get their phones connected and
business cards printed up, let alone design and execute strategy. We know that the SEC, FDIC and Treasury
are trying to hire hundreds of new forensic accountants, risk and
compliance managers to supervise the vast array of programs implemented
in the last 9 months. Our society
has become accustomed to instant gratification, but we think that perhaps
by the 1000th day of the Obama presidency, it will be possible to make a
useful evaluation of the quality of this administration.
Strategy
We began investing
our cash balances in mid-March, starting with the clients who had the
highest cash percentages, and so far have been rewarded. We continue the process of rebalancing
all our portfolios, with about half done so far. We've pared back healthcare positions
primarily, while adding to financials.
We've also taken advantage of cyclical highs of dividend yields in
energy, materials, utilities and telecomm stocks, and also added to
preferred stock positions. After a
6 month period (September 15th-March 15th) where "normal"
investing didn't work, the rules and strategies that have worked for
generations once again apply.
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.
