Q4 Commentary (2009)
2009 Annual Commentary
Much as with New Year’s resolutions, we sit down to formulate our annual
commentary as if the turn of the calendar page represents a major economic and market
inflection point. It does not. Upon the conclusion of possibly the most challenging year of
our professional careers, headlines in the media are now filled with Outlook 2010. We
note with caution what appears to be a strong homogeneity in the positive market and
economic forecasts of major Wall Street strategists, analysts and economists (though
academic economists appear less sanguine). But what else might we expect following one
of the strongest market rebounds in history from the generational lows of March 2009?
Most of us are susceptible to anchoring our opinions to a few sets of data points, the most
favored of which only confirm our prior bias. We are further vulnerable to extrapolating
recent trends in an almost linear manner far into the future. Studies show the impacts of
initial and most recent experiences (Primacy effect and Recency effect) dominate our
cognitive biases. We view a much wider range of possible economic outcomes in 2010
and fear that government programs may be masking the underlying fundamental risks to
the economy.
For the full year, the S&P 500 and Dow Jones Industrial averages posted returns
in the top quartile of the last 80 years up 26.5% and 22.7% respectively (and up about
60% from the lows). International markets represented by the MSCI EAFE and MSCI
Emerging Markets indices posted even better returns up 32% and 79%. Even fixed
income assets classes such as the Barclay’s High Yield index (up over 50%) and the
Barclay’s Municipal Bond index (up 13%) rebounded tremendously. The tidal wave of
global stimulus and liquidity benefited virtually every asset class outside of U.S.
Treasuries with seemingly one common theme. The riskier the asset class the greater was
the return in 2009. The market appears to feel that as we leave the financial crisis further
behind in our rear view mirror, the economy will stabilize and prices will continue to rise.
Our shorter term crystal ball is not as clear. As we have done annually in these
pages, we try to focus on the more secular concerns and how they are evolving while
venturing out with trepidation into the cyclical projections for the economy and capital
markets. This recipe had focused over the prior few years on the growing risks of a
highly indebted consumer amidst an unsustainable credit and housing boom. A key
theme last year was the implications of a pronounced de-leveraging cycle and the likely
long term change in consumer behaviors. The distinctions between cyclical and secular
concerns are often blurred with the shorter term dominating the discussions. While the
unprecedented experiments of the Federal Reserve and Treasury may have succeeded in
placing a floor under our financial system and jump starting the capital markets, we may
wake up some time in 2010 to find that we have yet to fix the causes of the most recent
financial crisis. Indeed, we even have most of the same players making the key decisions.
What we do know is that the largest post World War II economic decline appears
to have abated in the second half of 2009. Early strength in economic barometers such as
the Institute of Supply Management (ISM) manufacturing numbers (up to 55.9 in
December, the strongest reading since 2006) and Leading Economic Indicators (which
has risen for 6 consecutive months) accurately foretold the improvement in Gross
Domestic Product. Third quarter GDP was revised down from an original estimate of
3.5% but still showed positive growth of 2.2%. What cannot be ignored, however, is the
part that stimulus programs such as Cash for Clunkers and the first-time homebuyer tax
credit contributed to this total. Indeed, vehicle sales subsequently plummeted sharply in
October and November as the auto program ended as did home sales before the tax credit
was extended. On Main Street, we have yet to feel the same recovery that most of Wall
Street has said is upon us. Much of the rebound occurs due to the statistical comparison
to the year ago seize up in economic activity in the last half of 2008. Residential
construction, business investment and inventories collectively subtracted over 8% from a
first quarter 2009 GDP of -6.4% (consumer spending did contribute 1.5% to GDP) as
corporate America seemingly shut down. Stabilization of these areas alone was enough to
move 3Q GDP into positive territory. Inventory restocking along with continued fiscal
stimulus should lead to 4Q GDP approaching 4% and further momentum into the early
part of 2010.
As the U.S. consumer retreated, 2009 may go down in the annals of recent history
as the first global recovery not led by the United States. While the more developed G7
nations struggled with our same debt and employment concerns, many developing
markets (should we still call them that?) aggressively employed excess reserves built up
in prior years to expand credit and build infrastructure. China represented the lone G20
country to actually show increased GDP growth from levels of 2008 despite a decrease in
exports of over 15% and now represents the 3rd largest world economy. Brazil, buoyed by
tax cuts, easing business and consumer credit and riding the wave of being named to host
the 2016 Olympics, moved up to the 8th biggest contributor to global GDP. Growth in
these regions remains strong enough that China recently raised bank reserve requirements
and Brazil imposed a 2% tax on foreign inflows as concerns of inflation prevail. As the
global economic influence of various developed nation’s wanes, these more dynamic
markets have and will continue to be relied upon for improving global growth.
Sovereign debt concerns may also play a huge role over the next few years as the
global de-leveraging continues. The default of Dubai and the debt-laden troubled
economies of Greece, Spain and Ireland are disconcerting signposts. Troubling debt
levels in the UK that exceed ours and worsening deflationary and demographic issues
facing Japan highlight the issues facing many developed countries. In the U.S. and other
developed nations, we may look to the inflation concerns of the emerging markets with
envy.
As the administration has stepped in to cushion the economy’s impact from what
some refer to as the Great Recession, we have witnessed the simultaneous expansion of
the monetary base of the Federal Reserve from $800 Billion to $2.2 Trillion and the fiscal
deficit increase to over 10% of GDP. This spectacular government intervention requires
outside capital and relies on the ability of the U.S. government to raise dollars in the debt
market. The associated decline in the U.S. dollar and recent rise in interest rates has
flamed fears of imminent inflation. This concern has been further accentuated as recent
CPI data has shown an increase to a 3.2% annualized rate over the last 3-month period
from levels of outright price declines earlier in the year. We continue to stress that these
are not our concerns as we see the next few periods unfolding. This recent price increase
is almost exclusively due to the anniversary of the collapse in oil prices from over
$145/bbl to below $34/bbl and now back up towards $80/bbl. We take the view that the
tremendous demand for gold (up over 24% in 2009 to $1100/oz.) is a stronger vote
against fiat currency than a harbinger of inflation. We see the continued unwinding of a
credit bubble to be deflationary and the associated excess capacity evidenced in the near
historic low capacity utilization numbers and horrid employment figures to underscore
that view.
These fiscal and monetary efforts appear to have successfully stabilized housing,
aided consumer spending and increased exports (mostly due to the debasing of the
currency). The bullish case is that the recovery will be the mirror image of the recession.
The assumption is that the deeper the economic decline the greater will be the rebound.
However, this is not the typical boom-bust, inventory adjustment recession to which we
have become accustomed. This is a broken asset and credit bubble accompanied by a
credit contraction of epic proportions. Post-recession expansions have typically been
driven by pent-up consumer demand and increasing credit and leverage focused on
durables such as housing and autos. We do not see that happening this time as consumer
balance sheets remain constrained and access to available credit tight. A prolonged
economic rebound will require a successful handoff from government stimulus to
sustainable consumer demand. On this point, data is less positive and we are less
optimistic.
Even though the Christmas shopping season may have been better than feared,
total retail sales reported for 2009 still declined 6.2%. That may still understate the actual
decline as state and local sales tax receipts (difficult to fudge those numbers) actually
show a greater decline of 9% through the end of the 3rd quarter. Real disposable personal
income did manage to rise 1.5% in 2009 as almost 20% is now comprised of government
transfer payments. A more accurate barometer might be wages & salaries which declined
2.9% (though shockingly government wages & salaries rose 2.9% as private sector wages
declined 4.1%). Recessions always exhibit declining incomes followed by moderating
personal consumption expenditures but the influence of expanding credit has served to
moderate these declines. Not this time. We feel we are in the early stages of a secular
change in consumer attitudes towards spending and credit in a new era of frugality.
Consumer debt is shrinking for the first time in over 60 years. Outstanding
consumer credit declined $17.5 billion in November (a record) and has now contracted by
$117 billion from the peak in 2007. This has occurred despite the massive auto and
housing incentives. Credit card companies have reduced available credit by over $1.6
trillion with delinquencies at all-time highs and charge-offs greater than 10% of
outstanding balances. This drawdown of debt may be a huge longer term positive. We
have already seen the ratio of household debt to disposable personal income decline from
the peak of 139% in 2007 to a recent figure of 125%. To place this in perspective,
however, one must also note that this ratio was 100% in 2000 and consistently in the 30%
range in the 1950’s. We still have a long period of further debt contraction in front of us.
Underlying all of these concerns is the employment picture and herein lays the
greatest challenge to economic recovery and one of the most difficult to understand from
the data. The most coincident of indicators, initial jobless claims, have moderated and are
pointing towards positive job growth in early 2010. Additional positive signs may be
found in an increase in the average workweek from 33.0 to 33.2 hours and the 5
consecutive month increase in temporary hiring which usually precedes full-time job
growth. If corporate America’s job cuts were truly an overreaction to the downturn,
surely the rebound in hiring will be strong.
However this data gleaned from the establishment survey (or payrolls survey) of
businesses is in increasing contrast to the household survey (of individuals) which is still
weakening. Though the larger establishment survey is generally more reliable, the
household survey (as it picks up self-employed and small businesses) tends to be more
accurate at economic turns. As small business accounts for 50% of jobs and 35% of GDP,
the current dichotomy is alarming and yet consistent with other data. The National
Federation of Independent Businesses (NFIB) indicates small business confidence, hiring
and pricing power to be weakening at a point in a recovery where this should not be so.
Minimum wage increases, health care costs, higher taxes, and less access to credit than
their larger competitors (who have access to public markets and international growth)
have created tremendous strain on this critical segment. Mid to large corporations are
seeing productivity levels surge and profitability returning. Smaller firms remain capital
constrained and are losing market share. If consumer demand remains tepid, hiring will
be much slower than hoped.
Even in a more traditional environment for smaller businesses it is difficult to
ignore how daunting the challenge of job growth strong enough to sustain economic
growth. An unemployment rate of 10% and the U-6 rate (the most inclusive definition of
unemployment that also includes discouraged workers who have given up looking for
work, marginally attached workers and those working part-time for economic reasons)
over 17.4% will converge as the job picture improves. As the job market improves many
that had given up looking for work re-enter the work force and increase the denominator
of the calculations. Thus, we now fear the unemployment rate may approach 11% (our
much weaker than consensus estimate of 9% in last year’s commentary still proved to be
very optimistic) even as the economy improves. As mentioned in our 3Q commentary,
we will need far greater levels of job growth than seen in the last 2 decades just to move
the unemployment rate towards 7%........by 2015!
The continued weakness in jobs will in turn create further pressure on housing as
mortgage delinquencies and foreclosures may be set for another stress test. We have just
passed a period of a moratorium on foreclosures and are now entering a second wave of
mortgage resets from the peak periods of the real estate market in 2006. Properties
foreclosed upon approached 3 million in 2009 up over 21% from 2008 and almost 4
times the level of 2006. Currently over 14% of all mortgage loans are in some state of
delinquency or foreclosure. It is additionally estimated that over 25% of homes with a
mortgage currently owe more on their home than it is worth. The combination of high
unemployment, increases in mortgage resets and high loan-to-value ratios along with
high shadow inventories of homes is a combustible mix that threatens another leg down
in home prices. While the government via the FHA has stepped in to subsidize home
purchases, these efforts may actually be hampering a full recovery. By creating artificial
demand we are delaying the market clearing process of consumers giving up on
unaffordable loans and banks recognizing these loan losses. In so doing, we are actually
artificially maintaining prices higher than they would otherwise be and transferring home
ownership between still weak hands. As the homeowner tax credit expires and the Fed
ceases purchases of mortgages (thus increasing rates), greater pressure on this market will
ensue.
Forecasting 2010 is highly predicated upon the actions of the administration and
the Federal Reserve. As it currently stands, the Fed will complete the balance of the
purchases of mortgage-backed securities in March and the homebuyer tax credits will
expire at the end of April. Municipal budget shortfalls are estimated to exceed $260
billion amid a 12.5% revenue decline. This is placing further pressure on reduced
services and the prospect of increased taxes. As we factor in the expiration of the Bush
tax cuts in 2011 and the possibility of higher interest rates, the risk of another economic
leg down in the second half of the year into 2011 increases. Certain political risks must
also be considered. What will be the administration’s response if unemployment rises (at
least statistically) as we expect? Will continued waves of populism lead to stricter capital
requirements which further curtail consumer lending? While much of the current focus is
on Fed exit strategies to withdraw prior economic stimulus and fend off inflation, the
opposite may occur. We project it to be unlikely that the Fed will give more than lip
service to exit strategies and that interest rates and inflation will not be a concern. Given
mid-term elections on the horizon, we would not be surprised to see more stimulus
programs discussed. Presently, consensus growth estimates have GDP increasing 3% in
2010 with most of these forecasts on the rise. We feel that the peak growth rate may
actually be in the 4th quarter of 2009 with sequential moderation into the second half of
the year. Without further stimulus, we see the risk of a second half downturn becoming
more likely and project full year GDP to come in somewhat below expectations at 2%.
The capital markets offer different sets of concerns and opportunities. At this time
last year we forecast S&P 500 earnings of approximately $55 in the face of our estimate
of 4Q 2008 GDP and 1Q 2009 GDP declines of 6% and 4% respectively. Alongside those
forecasts (which were surprisingly accurate as the blind squirrel found an acorn) we
chickened out on projecting the short term returns of the stock market. We chose instead
to point out in both the annual and 1Q commentary that equity valuations on the S&P 500
based on normalized earnings were the most attractive that they had been since the
1980’s. We additionally stressed that fixed income credit spreads offered generational
opportunities at lower risk. That is no longer the case. While not overly expensive,
normalized earnings on the major indices do indicate a moderate overvaluation.
Additional possible headwinds of rising inflation (not our base case), interest rates, taxes
and increasing regulation could serve to further compress price/earnings multiples. Fixed
income credit spreads still offer some modest value but are now more aligned with
historical norms and subject more to interest rate risk.
As 2009 may be categorized as a return to the risk trade, we feel 2010 may be the
opposite. High quality, multinational U.S. companies are very attractively valued on both
an absolute and relative basis. A focus on consistent and secure dividends should also
return. At Coho we focus on such companies. While the stocks that comprise the S&P
500 witnessed consecutive years of dividend cuts of 3% and over 21% respectively, our
companies did not. In fact 2008 dividends increased in excess of 11% and 2009
witnessed an increase of just over 6%. In neither year did we experience a dividend
reduction much less elimination. Though not as much as this time last year, we continue
to find many very attractive companies that continue to meet our stringent criteria.
