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Continued
rally takes stocks into positive territory for 2009
The S&P 500
gained 5.6% in May and is now up 5.8% on the year. The most dramatic turnaround is in
financial service stocks, which fell 52% from the start of the year
through March 6th, but doubled in price through June 2nd and are
virtually unchanged on the year.
Returns range from up 70% at Goldman Sachs to down 47% at
Citibank. Materials stocks are top
performers this year with a gain of 24.0% as commodity prices rally. Oil prices have more than doubled from
late December 2008 to $68.55 barrel.
Copper is up 77%.
Technology stocks gained 23.6% YTD as growth expectations ratchet
higher.
We're particularly
impressed by the improvement in market technicals. In the 4th quarter of last year, the
NYSE VIX index (measure of market volatility index, often called the
"fear" index) peaked at 80 in November versus a 5 year average
of 20. Volatility remains elevated
at 29.4, but continues to decline.
Generally speaking VIX values greater than 30 imply that investors
are fearful, values of 20 or less imply that investors are
complacent. The daily
advance/decline line (number of stocks rising versus falling) is solidly
positive. Earlier this year, the
number of stocks making 52 week lows measured in the thousands. At present, only 17 companies out of
13,000 on the New York Stock Exchange and NASDAQ are in that category.
Through most of
the 4th quarter, stocks could be counted to sell off violently each day
in the last hour of trading as hedge funds and ETF holders flooded the
market with sell orders. That
selling has dissipated for several reasons. Last fall hedge funds massively
liquidated stocks to meet redemptions and reduce leverage. Over the winter, institutional
investors such as the endowments of Harvard, Yale and Stanford, which
have moved largely into "alternative investments" in recent
years including hedge funds, private equity, real estate and commodities,
discovered that those investments were illiquid when time came to pay
dormitory fuel bills and were forced to sell publically traded
stocks. Individual Americans largely
abandoned their stock investments in the first week of March. At that point, there was no one left to
sell. With stock valuations as the
lowest levels since 1982 and institutional investors rotating back into
traditional investments, stock prices have only gone up, rising now 11 of
the last 13 weeks in the steepest rally of the last 100 years. Now anyone attempting to short stocks
is generally losing at that game.
Stock market
strategists are generally dismissing the rally as a "bear
trap." However each lurch
higher puts more pressure on investors to get long. We wonder at what point does a buying
panic set in?
Banking
system continues to stabilize
Measures of stress
in the world's banking system continue to improve. Three month LIBOR eased to a record low
of 0.64% versus 2.8% last summer and 4.8% at the crisis' peak in October
2008. The spread of 3 Month LIBOR
over 3 month T-Bills eased to 0.56%, in line with the pre-crisis average
of 0.4%. The Federal Funds rate
remains effectively at zero, while ten year Treasury bond yields have
risen to 3.7% from a crisis low of 2.1%.
Banks can borrow at the Fed
Funds rate, immediately invest the proceeds at 3.7%
and capture a healthy profit.
Banks willing to lend to corporations can achieve an even higher
spread (10 year BBB corporate bond yields are around 8.7%.)
US banks generally
passed the low bar set by the "stress test," the results of
which were released May 8th. The
largest 19 banks in the US, which include JP Morgan, Goldman Sachs, Wells
Fargo and Morgan Stanley, needed to raise $75 billion in fresh equity and
promptly went to the capital markets for the cash. Bank of American had the largest raise
- nearly $34 billion - but achieved that goal by converting preferred
stock to equity and selling its stake in Bank of China. Among the largest 19 banks, only
Citigroup remains capital light.
Ten of the 19 banks are petitioning the Treasury to return the
TARP funds they received last fall (along with government oversight of,
among other things, executive comp.)
European banks completed their own stress test in late May. The results, which were not publically
disclosed, probably indicate that European banks are still substantially
undercapitalized.
Chrysler
and General Motors proceed with bankruptcy filings
US stock markets
trembled last November when General Motors first broached the idea that
the 101 year old company could enter bankruptcy. As General Motors succumbed on June
1st, US stocks hit the highest level of 2009. Chrysler previously filed for
bankruptcy on April 30th. Equity
investors in both companies are wiped out, while bond holders have taken
a severe cut in the value of their bonds, and creditors ranging from
advertising agencies to parts suppliers must also wonder when they'll get
paid. In principal, both car
companies are supposed to emerge from bankruptcy in the next 60 days - in
practice, even negotiated bankruptcies can take years to resolve -
consider the state of the US airline industry, which has operated
primarily in bankruptcy for over a decade.
Like airlines, car
companies have high fixed costs and suffer from industrial overcapacity
and highly variable revenues. When
times were good, the car companies could barely get by. As demand for cars slumped from 16
million/year in 2007 to the current annual demand of 9.5 million, not
even government cash could save GM.
What won't happen is the outright liquidation of the General
Motors or Chrysler, which would entail final closure of all car factories
and the jobs that go with those factories.
Consumer
and business confidence rise, though current conditions remain
recessionary
US unemployment
continues to rise, probably exceeding 9.0% with this Friday's
report. Despite rising
unemployment, US consumer confidence hit the highest level since last
September, though at 54.9 remains far below the level of 110 which
prevailed in 2006 before the housing market began to fail. Personal income is modestly higher
given a reduction in effective tax rates, though wages are falling. The savings rate, which was briefly
negative in 2005 as consumers borrowed against home equity and credit
lines, rose to 5.7%, the highest level since 1995. In the short term, consumer saving
hurts the recovery, but in the longer term makes for a stronger
economy.
The housing
market, which led the US economy into trouble, is showing faint signs of
stabilizing. Pending home sales
surged in the most recent report as mortgage rates remain favorable. Foreclosure sales as a percentage of
total sales declined slightly.
Prices are still falling at an 18% year over year rate; no real
recovery can take place until prices stop falling. Business confidence also rose to the highest
level since October 2008.
Businesses halted production and slashed inventory earlier this
winter, but are now increasing supply to meet demand. Semiconductor sales, for example,
gained 6.4% in April, a nice turnaround from December's 16.3% decline.
Strategy
The long term
returns in US stocks average 8%/year since 1900 and 10%/year since 1945
(stripping out the negative returns of the Great Depression.) Within that time frame, there have been
decades where stocks rose above or below the longer term rates. For example, in the decade ending
December 1999, stocks rose at an annual rate of 18.2%, giving a
cumulative return of 432% ($1 invested at the start of the 1990's was
worth $5.32 by the end.) In the
current decade, US stocks lost 3.1%/year for a cumulative loss of 26.0%
($1 invested January 2000 is currently worth $0.74.) Stocks lost a comparable 24.5% in the
decade ending September 1974, but gained 327% over the following ten
years. With the average baby
boomer woefully undersaved for retirement, with stock valuations still at
bargain basement levels and with institutional investors reallocating
assets back into liquid US capital markets, we believe stocks will do
much better over the next ten years than the last. We are fully invested at this time.
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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