Q4 Commentary (2008)
2008 Annual Commentary
Every year as we sit down to write our annual commentary we try to give much thought to both how we got here and, most importantly, designing a roadmap for the future. While it is now apparent to all that we are in the throes of the most challenging economic downturn since World War II, there is perhaps an even deeper issue that will affect how we emerge from the current recession.
In these pages over the last four years we have shared our premature anxiety over the foundation of the economic expansion. Our turn of the century expectation was for a more risk-averse U.S. consumer. Surely, the successive events of the “dot-com” bubble, recession, and the terrorist attacks of September 11, 2001 were significant financial events altering the behaviors of a consumer-driven economy. They were not.
Abetted by an administration and Federal Reserve seeing deflationary shadows and eager to avoid recession, the U.S. consumer and, indeed, all financial institutions and markets were allowed to feed at the trough of artificially and historically low interest rates for far too long. Into this mixture was added the financial alchemy of securitization encouraged and endorsed by those leaders and agencies charged with policing and regulating. The resultant housing bubble and concurrent extreme leverage employed by the Wall Street firms in packaging the asset-backed securities might have been damaging enough for the economy if it were only confined to our shores. Unfortunately, Wall Street and Main Street are also linked internationally. 2008 will go down in history as the year when global financial markets were shaken to their core and, perhaps, will mark the end of investment banking on Wall Street as we knew it.
As many have gone into great detail on the proximate cause and blame for the financial crisis in which we find ourselves, most of the focus has been confined to the above time frame. In setting a long term roadmap, however, one cannot ignore the secular forces that strongly impacted this period and the interpretation of how this might unfold.
This story really starts in 1982 as 78 million baby boomers between the ages of 18 and 36 were just starting out. This two decade period would witness a secular era of disinflation that would have a pronounced impact on the values of all financial assets. Concurrently, stocks, bonds and housing values soared. Tremendous technological and financial innovations along with major deregulation of the securities and banking industries ignited a secular credit expansion further fueling these gains.
As financial assets appreciated, the perceived need to save diminished. Between 1963 and 1984, the U.S. savings rate ranged narrowly between 8% -12% of disposable personal income. As assets appreciated and Household Net Worth grew, savings from income slowly declined until it turned negative in 2005. The U.S. consumer as a whole was literally spending more than he or she earned and Personal Consumption as a percentage of our GDP grew during this period from 63% to over 70%. However, not only was the U.S. consumer just saving less and spending more but he increased his debt as well. Between 1963 and 1984, debt-to-income ratios ranged tightly around 65%. Between 1984 and 2001 they increased to over 100% on the way to a peak of about 140% in 2007.
The life cycle changes of this generation and increasing leverage succeeded in muting historical business cycles extending expansions and shortening recessions as the boomers hit their peak spending years. The seeds for the current economic crisis were already sown. Asset appreciation would now be required to even maintain such pace of spending and the margin of error was becoming razor-thin. The bursting of the two bubbles of housing and credit was inevitable and may now set in motion a profound de-leveraging with long term implications.
Thus, we entered 2008 on borrowed time with the backdrop of a deepening housing depression, weakening labor markets, rising commodity costs and an emerging and still widening credit crisis. Expectations of a prolonged but shallow recession were dashed as both Wall Street top executives, the Federal Reserve and the Treasury underestimated both the magnitude of the crisis and the global interdependency. Reactive rather than proactive measures were employed. Indeed, the September bankruptcy of Lehman changed our views towards a much deeper downturn as panic hit the credit markets, fear of financial failures heightened and lending literally stopped. LIBOR (the rate at which banks lend to each other) spiked; the commercial paper market (the short-term funding lifeblood of corporate America) found no buyers; corporate and municipal bond yields rose to levels making financing prohibitive. The fear quickly hit the consumer.
As the assets that had long fueled consumer spending declined in values, the consumer had nowhere to turn. With housing values declining by 24% from their peak (Case-Shiller index) and bank lending drying up, Mortgage Equity Withdrawal (MEW) which had accounted for fully 8% of Disposable Personal Income and added as much as 3% to GDP, dried up and turned negative. Delinquencies and foreclosures would rise to as much as 10% of outstanding mortgages. Consumer spending which had a record 17 consecutive positive quarters hit the wall in September and has since turned negative. For much of the economic expansion many economists have dismissed the Cassandra warnings of those citing rising debt and declining personal savings. The view was that these calculations ignored the increase in the large assets of housing and investments and that people will spend based on growth in their net worth. Consumer Net Worth in 2008 is expected to show a decline of over 20% and as much as $13 trillion from the peak in 2007.
The Personal Savings rate has since risen to 2.8% and we estimate this will rise further to over 6%. While we view this quite positively as savings and investment is the cornerstone of a strong economy, we also realize the journey has major negative implications for spending and shorter-term economic growth. We look for the reparation of consumer balance sheets and a return to frugality to be an overarching, generational theme. This will not be a short term cure but rather a secular change in behavior as asset-based spending changes to income-based spending, a novel concept.
This holiday season appears to have been the worst in 40 years for retailers. According to the International Council of Shopping Centers, we can expect over 73,000 retail outlets to close in the first half of 2009 on pace to match the 148,000 that closed in 2008. Since 2001, real incomes in the U.S have stagnated while total retail square footage has increased in the mid-single digits. This has occurred in an era where one can buy virtually anything without leaving one’s home. We can expect a protracted period of retail downsizing. This is another growing concern as 10% of our work force is employed in retail and major investments in commercial retail space reside on bank balance sheets.
Our anticipation of unemployment rising to 6.5% was woefully optimistic and did not account for the corporate layoffs and financial industry depression that would mark the start of the 4th quarter. Though we enter 2008 with New Jobless Claims (a coincident indicator) appearing to stabilize, other data contradict this. Indeed, Non-Farm Payrolls (NFP) reported a loss of 2.6MM jobs in 2008 with fully 1.9MM occurring in the last 4 months. Revisions will surely take this even higher. Additionally, the broader measures of unemployment such as the U-6 of Marginally Attached Workers (those not looking but who want a job and/or working part-time but desire full-time work) have risen to 13.5% of the work force from 8.7% at the end of 2007. While a recent NABE (National Association for Business Economics) survey forecast an unemployment rate of 7.4% at the end of 2009, we fear the rate will approach 9% at its peak.
Housing is still showing few signs of stabilizing as existing home inventory has doubled to 4.2MM for sale over the last three years representing an 11.2 months supply. Some hope resides in the efforts by the Treasury to target mortgages which are finally making progress. Mortgage rates have declined to about 5% on conventional, fixed-rates which combined with the above declines in home values have moved the Affordability Index towards record highs. This stabilization is a requisite for an economic rebound.
As the Consumer Price Index rose steadily to almost 6% over the summer with Oil passing $145/bbl and food prices soaring, our view was that inflation would be a passing concern. Recessions and major de-levering are by definition deflationary and we noted our expectation that overall CPI would drop to 1% over the year. As the global velocity of money plummeted (as lending and spending slowed), these readings receded much quicker than we expected. This placed the Federal Reserve and Treasury in a fight to reflate the economy quickly before insidious deflation set in. A student of the Great Depression, Ben Bernanke was fearful of such a repeat or Japanese style economy settling in.
One of the critical debates currently centers on the short and longer term issues of deflation and inflation. Many have postulated that the incredible stimulus packages already put into place and the dramatic increase in the money supply (M2 up at an annualized rate of 20% over the last 3 months) may result in inflation similar to the 1970’s. We do not see that as likely. Asset collapses are generally deep and protracted events. Here we had both housing and credit in two huge bubbles. Roughly $6 trillion of credit debt has been saddled on the consumer also facing the prospect of $13 trillion of lost net worth. Adding in fractured securitization, restricted lending, eroding consumer credit quality, labor force slack and excess global capacity and we do not see the prospect of inflation in 2009. As our secular view remains a more conservative consumer, we view a decline in velocity over time to be the most likely outcome mitigating the impact of M2 growth. We will continue to monitor this issue closely, however, as it has profound impacts on financial asset valuations.
While the National Bureau of Economic Research (NBER) recently confirmed our long held view that our economy entered recession in December of 2007, many economists continued to focus on positive GDP numbers into September as proof that we would experience a “soft landing”. Where we disagreed was in the contributions of the calculation and the impact of a slowing U.S. consumer on the global economy. As the U.S. slowed in late 2007 and the first half of 2008, more than 100% of the total GDP calculation was attributable to increased exports via a weaker dollar and still and expected strong developing markets. While decoupling is on the global horizon, it is not in this decade. During crises, globalization tends to increase correlations for both markets and economies and this period held true. Expectations of NABE are for the 4Q GDP to come in at -2.5% and the 1Q of 2009 to approximate -1.1% before stabilizing and turning up in the second half of 2009. We are less sanguine and would not be surprised for 4Q GDP to approach a decline of 6% with the 1Q 2009 only modestly better at -4%. Additionally, we are less comfortable in projecting even a positive 4Q 2009 until we see more stabilization in housing and employment.
In a global downturn, it is paramount to get the direction of global economies correct in order to project U.S. corporate earnings. While very conservative versus consensus, we were evidently quite optimistic in projecting S&P 500 profits entering this past year. As the consensus held the view of earnings rising about 10% to $95, we anticipated a number below $80. In our last letter we lowered that projection to $75 with an additional decline in 2009 to $65. We now maintain that same direction and rate of decline but subtract an additional $10 from each estimate looking for 2009 to approach $55. This level would represent a 40% earnings haircut from the cycle peak of $92.
Bear Market declines occurred in virtually every asset class in 2008 with only U.S Treasuries and Gold showing positive returns. The magnitude of the correlated losses was striking. The S&P 500 (-37%) and Dow Jones Industrial Average (-33.8%) experienced the worst losses since 1937 and 1931 respectively yet outperformed other major indices. The EAFE developed markets index declined over 43% and the Emerging Markets index was down over 53.3%. The uniformity of global market equity returns was so strong that Japan was the top performing developed market with a decline of over 34%.
As the global economies and markets enter 2009 and we attempt to forecast, we are struck by the strong likelihood that we may be experiencing one of those generational inflection points. Our thesis remains that the current economic crisis was more than two decades in the making. Therefore, we would be foolish to believe it to be unwound quickly or without longer term structural changes. We believe most of those changes domestically will center on consumer behaviors and dictated by evolving baby boomer demographics. But that is quite parochial. The longer term impact may be to find the U.S consumer to no longer be the sole engine for global growth. These thoughts may both frighten and excite long term global investors.
Another topical and related subject to consider is the popular demise of the “buy-and-hold” investor. One cannot pick up a magazine or turn on a market news channel without being scolded by those entertainers propagating the need to trade. The alleged proof of the idiocy in the Buffet-like strategy is found simply in the returns of such a philosophy over the last 10 years. It is true that an investor holding a basket of S&P 500 stocks over the prior 10 years lost money (this is the third such occurrence in history). The fallacy of both this argument and those that make it is the ignorance of valuations. The price one pays for an asset determines the long term returns. Those making such “buy-and-hold” decisions with the S&P 500 in 1999 were indeed buying assets priced to lose money at 35 times current earnings. Some fundamental analysts attempt to normalize earnings in a variety of ways to minimize the impacts of peak and trough earnings that distort valuation analysis. One such way is to value an index based on trailing 10-year earnings. Using such a method in 1999 would have shown the index to be priced at 45 times average earnings. That was the time to trade (or just not buy).
Annual forecasts are fraught with risks given the finite period viewed but especially this year. There appears to be a growing consensus that the economy will rebound in the second half of the year and that a 10%-15% return expectation is realistic (there goes that 10% staircase pattern again). We believe that an economic recovery may be a 2010 event. In commenting on the stock market, we rather feel much more comfortable with the following. U.S. equities are now more reasonably valued than they have been since the early 1980’s. The same 10-year earnings analysis used above places the S&P 500 index at about 14 times earnings. This is attractive by 50-year averages and the lowest in 23 years. Excluding the high inflation period from 1974-1985, it is the lowest ever over that time frame. High Grade Corporate and Municipal bond credit spreads are also at record levels pricing in a horrific economic environment going forward. Lower-rated or High Yield corporate bonds are pricing in default rates of 25%......annually! Cash is paying less than 1%. As long term returns are stamped at the time of purchase, bear markets often offer very strong long term value and the ability to pick up high quality companies at attractive values. We feel this is such a time.
At Coho our focus on such demand-defensive companies with low debt, strong cash flow, and shareholder-focused management allowed us to avoid fully half of the market downturn in 2008. Dividends for the S&P 500 actually declined by 3% but our portfolio generated an increase in actual dividends paid of over 11%. While we remain vigilante in analyzing the macro-economic impacts to our companies and alert to the various downside possibilities, we are finding more attractive companies currently than at any prior time in our history.
