Q1 Commentary (2009)
“We’re in a government-dependent financial system; I never thought I’d see the day.” Paul Volcker
The post-election excitement and optimism that may have helped fuel a 24% rally in stocks from the depths of the November lows quickly dissipated during the opening quarter of 2009. The historic inauguration of Barack Obama was expeditiously greeted with the stark realities of an economy deteriorating more quickly than at any time since the 1930’s. Expectations of an immediate and focused policy response to the financial crisis were dashed as the equity markets declined a further 27% into early March, a full 57% lower than the peak of October 2007.
Our 2009 Annual Commentary focused on secular changes facing consumers and our economy after a generation of growth exaggerated by increasing degrees of leverage. For several years we have witnessed credit expanding faster than our gross domestic product. As the supply of credit vaporized, governmental intervention has focused on stabilizing otherwise potentially insolvent institutions to resuscitate the blood flow to the lending extremities. While not as politically expedient as interceding on behalf of the consumer via stimulus to spending, many have viewed this as necessary to reignite our economy.
The larger more long term adjustments are important to focus upon. While PPIP (Public Partnership Investment Program) joins TARP and TALF in our alphabet soup of policy responses, none addresses the demand side of the equation as the desire and ability to take on additional credit is contracting for the first time in our history. Increased availability and improved pricing of credit may help the new and healthy buyer but does little to directly stem the tide of foreclosures and levels of debt that will continue to constrain our economy. Without restructuring the mortgage obligations of homeowners and debt obligations of distressed financial institutions, we may continue to hold public funds hostage. The result might be a contracting liquidity environment that would not be friendly to future asset valuations.
Indeed, we are also experiencing other secular changes which may raise the risk premiums on various asset classes and impact future expected returns. The most pronounced is a seeming repudiation of the free markets theory with our government taking and employing a much larger role in our economy. In an environment of widening income disparity amidst the worst economy in decades, we may expect a long-term move away from self-regulation. After years of outright failure in the role of referee, the government is now a participant. While the result may be a less volatile economy, the efficiencies borne of capitalism will not likely be improved upon.
Additionally, benefits of globalization may be slowing or even reversing. As the recession spread around the world, governments retreated to the populist cries and looked inward for growth. Pressure to “buy American” are not just local phenomena, as witnessed by China’s rejection of Coca-Cola’s bid to purchase a Chinese fruit juice maker, and do not augur well for future growth. Also at the recent meeting of the G-20, the World Bank noted 17 of 20 nations with recent protectionist actions.
While many have postulated that the green shoots of Spring have been recently spotted in recent economic data, we remain agnostic. It is true that one may find positives in higher refinancing activity and lower mortgage rates, tax refunds, tax cuts, lower gas prices and improving access to credit. However, the economic releases indicating an unexpected increase in sales of new and existing homes along with noted upticks in manufacturing (as noted by Institute of Supply Management releases), retail sales and consumer confidence may be misleading. Indeed, like sunshine on a mid-January day, it may only look good in comparison to prior data which could be categorized as catastrophic. In the three month period of December 2008 to February 2009 home sales were declining at a 60% annual rate while manufacturing and retail sales declined at 70% and 30% respectively.
Our worse-than-consensus estimate of 4Q GDP of -6% proved fairly accurate. Revised numbers came in at a contraction of 6.3%. The National Association of Business Economists (NABE) consensus is looking for continued declines for the first and second quarters of the year of -5.0% and -1.7% respectively followed by an increase of 1.6% in the second half of the year and above-trend growth in 2010. We are less sanguine as we are currently in the throes of the first global GDP decline in 60 years. Japan is expected to show a 6.6% contraction in growth in 2009 and the Eurozone only slightly better at -4.1% according to the IMF. Even China has endured a nearly flat quarterly growth rate in the last quarter of 2008 and the first quarter of 2009 though a return to 6% growth later this year is viewed as likely.
As the new paradigms noted above will take years to unfold, the current cyclical concerns of the economy will primarily focus on housing and employment. Falling housing prices and defaulting mortgages started the downward spiral in the global economies and stabilization in these areas is a requisite to recovery. While we may have seen a deceleration in the rate of decline, we are nonetheless still declining. Though sales have ticked up and inventories are now down to 9 months supply for 3 consecutive data points, prices and foreclosures are not abating. The Case-Shiller index of home prices through January is now down 19% y/y and dropped over the prior quarter at an annualized rate of 26% y/y. National home prices are now back to levels last seen in 2003. Foreclosures are up over 30% y/y and 11% of all mortgages are in some form of default. 33% of all homes with an existing mortgage now owe more than the value of the home and with expected further price declines of 10% this figure will rise to 50%. Further concerns regarding the amount of option ARMs and ALT-A loans that reset in 2010 and 2011 place even greater urgency on some form of foreclosure abatement.
Unemployment has quickly jumped to 8.5% from 5% as recently as one year ago and appears poised to break 10%. The U-6 figure of marginally attached workers (unemployed and underemployed) is up to a shocking 15%. Since the start of the recession the Non-farm payrolls have shown a collective loss of over 5MM jobs. While these are usually lagging indictors to economic recovery, the more coincident claims figures are still getting worse. Employment worries have caused concerned Americans to pull in the reins on spending and pay down personal debt. The savings rate has now jumped to over 5% of disposable personal income from levels that were actually negative as recently as late 2007. It is essential for the longer term growth of an economy to have savings and investment. It is the process of getting there that is painful. With the savings rate poised to increase to over 8% by summer, it is challenging for us to envision more than a tepid rebound.
The focus on the supply and pricing of credit has succeeded in lowering mortgage rates on conventional 30-year fixed to the lowest on record 4.85%. The Affordability Index of home buyers measuring median incomes with median housing costs is also the highest on record. While all of this is good news and helps at the margin, it is difficult to imagine much of a rebound in home prices while employment is still worsening and incomes stagnating. These employment dynamics also mitigate concerns of inflation for the foreseeable future and focus on deflationary concerns as the CPI will show negative year over year prints. Efforts of the Federal Reserve to reflate the economy by printing money give us great concern over subsequent inflation. However with little current velocity, deflation is the current concern and we cannot see that far into the future.
All of this Spring cheer was not lost on the equity markets in the quarter just ended as the S&P 500, MSCI EAFE (International index) and Russell 2000 (U.S. Small Cap stocks) declined 11%, 15% and 13.8% respectively. Earnings for the companies that comprise the S&P 500 were negative for the first time in history and reported earnings are now down 82% from the peak. Our prior estimate for 2009 operating earnings on the S&P index was $55. We are now looking closer to $40 with a rebound into the mid-50 area for 2010.
With fear and pessimism as strong as we have ever witnessed, the S&P 500 was seemingly repelled at the 666 level and mounted a strong 25% rally into the 2nd quarter. Is this a bear market rally? Or is this the start of a sustained move upwards in stock prices? One useful gauge is the bond market. The fixed income market is often viewed as the PhD of the capital markets and correctly foretold of systemic problems long before the stock market heeded the call. While segments of the bond market such as commercial paper have normalized, credit spreads on corporate bonds are extremely wide and pricing in default rates that are multiples of all-time highs. The same factors that would give us greater confidence in the stability of the equity markets should manifest themselves first in the debt of these companies that is higher in the capital structure. As of yet, they have not and we view fixed income as very attractive at current levels. However, all of the focus on whether or not we have experienced a bottom at that cryptic level and the rush for such predictions continue to add unnecessary noise to the long term equity investor and the primary focus on value. We focus back to exactly what we mentioned in our annual review as this has not changed at all.
“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.”
