First Quarter 2009
ByQuarterly Review & Outlook
The sun began to come out in March after a dreadful January – February period. As you are probably well aware, by early March the S&P 500 had slid another 25% on top of last year’s decline of 37%. The markets began to recover during the balance of March and ended the quarter down “just” 11%. The sun continued to shine in April as the S&P 500 rose another 9.7% bringing the index to just 2% below where it began this year.
We hope you are pleased that we were able to avoid most of the carnage this year and that we are up slightly through April. This naturally leads to the question: where do we go from here? Many market strategists are opining that the March lows were the lows for the market and that we are now in a new bull market. While a number of technical indicators tend to support that position, we continue to be skeptical. It is quite common to have rallies exceeding 20% within a bear market. In the present case, the market has rallied about 30% off its March lows.
The economy is continuing to decline although the rate of decline is slowing down – a good sign for an eventual recovery. The economic news is viewed as getting better because it is not getting worse, continuing to decline but at a slower rate. The reality is that no one can predict the future and our crystal ball is no clearer than any others. However, there are some macro-economic principles that we can use to help frame probable outcomes for the next 18 – 24 months.
“The future ain’t what it used to be.” – Yogi Berra
As we mentioned in our last letter, the world has radically changed over the past year. We are witnessing a massive de-leveraging of the worldwide economy that is, at best, only halfway through the process. Twenty five years ago, a 1% increase in debt would produce almost a 1% increase in GDP. By 2007, it took more than a 4% increase in debt to raise the GDP by 1%. The de-leveraging of corporations and consumers is likely to be a drag on the economy for years to come and, we believe, will limit economic growth to sub-optimal levels. The consumer accounts for 70% of GDP and have, counter to the trend of the past 20 years, begun to save money. In short order, the personal savings rate has gone from a minus number to a positive 4%. Long term, this is good news but in the short run, it is a negative as consumers that save don’t spend.
In the short run, the massive government “stimulus” is bound to have an impact on the economy. Markets usually respond well to government spending (as they have done recently) as it is perceived that they are getting something for nothing. Eventually, there is a price to pay. The deficits going forward defy imagination! The sheer magnitude of the Federal deficits plow new ground and we don’t know what the unintended consequences will be. But we do know that there will be consequences, perhaps inflation? Rising interest rates? A declining dollar? Something totally unanticipated? We believe that the recent government “stimulus” actions will lessen the steepness of the economic decline (were there no stimulus). However, injecting massive amounts of money into the economy (money we must borrow from others) is not a long term positive and is likely to extend the duration of the decline and lessen the rate of recovery.
The basic problem is that there is too much debt on the part of corporations and consumers. The debt ratio will come down by some combination of repudiation (bankruptcy) or repayment. This is a natural part of the capitalist system. Historically, recessions have served to reduce speculation, clean up balance sheets (reduce debt) and scare the heck out of people so they become more prudent (for a while). Recessions “clear the deck” and set the stage for renewed economic growth. Since the1990’s, politicians have realized that recessions are injurious to their health should they occur during their re-election cycle and they will do everything within their considerable power to diminish or forestall a recession. This worked during the 1990 and 2001 recessions (which barely counted as recessions). By 2007, the excesses had grown so large and the tools available to the government so limited, that it was only a matter of time before a catalyst (Sub-Prime crises) would tip us over into a recession. The massive amount of “toxic” assets held by banks (estimated at more than $4 Trillion) will eventually have to be dealt with. The resolution of this debt problem will not happen quickly.
We’ve seen the de-facto nationalization of most major banks. It’s possible that the banking system will muddle through but one thing is clear: the government is in the banking business as well as the car business and insurance business. Like it or not, we have entered into a new environment where business has a new partner – an activist government. Increased regulation will mean additional costs, less flexibility and a drag on corporate profitability. Coupled with the ongoing de-leveraging, it’s hard for us to envision that corporate earnings and P/E multiples will return to their 2007 levels anytime soon.
We have only slightly modified our economic scenarios that we think will be the three most likely outcomes for 2009. (The old estimates are in parenthesis.)
1) The economy bottoms in the 3rd to 1st quarter (2nd to 3rd) quarter 2009. Credit markets stabilize over the next 6 months and the equity lows of November 2008 are (tested but not) violated. Equity markets move higher by year end and GDP begins to grow in late 2009 at a below optimal rate. Life begins to return to normal. This scenario would be very positive for the debt markets as risk premiums move substantially lower and also positive for equities as confidence in the corporate profit outlook for 2010 improves.
Assigned probability = 20% (25%)
2) The economy bottoms in late ’09 early ’10 and the economy grows at an exceedingly slow rate for the following 1-3 years. Credit markets stabilize over the balance of 2009 with a higher than normal level of volatility in both the equity and debt markets. The equity markets establish a new low with the S&P falling to near the 700 level but recovering somewhat by the end of the year. The S&P finishes 2009 with a loss in the 10% to 15% range. We think this scenario is the most likely as we believe that we are entering into an environment that will be different than that of the past 35 years. Consumers will be spending less and saving more for years to come. Long term, this bodes well for the U.S. economy but will be a drag on economic growth as this process takes place.
Assigned probability = 60%
3) The economy continues to deteriorate well into 2010 and does not recover until late ’10 to early ’11. Credit markets do not improve and remain in this “semi-frozen” state for the balance of 2009. Volatility increases to levels seen in the October – November 2008 period. Corporate profits plummet, unemployment reaches 12%, government stimulus has little effect and we are in a worldwide mini-depression. Credit market returns would be coupon minus defaults. Equity markets suffer another steep decline with the S&P reaching the 600 level. Traditional “growth” assets (houses, stocks, private equity, business values, etc.) continue to experience substantial declines in market values.
Assigned probability = 20% (15%)
After assigning weighted probabilities to these scenarios, we project an outlook for the equity markets that places it around the range that they are now. If things settle down, the environment for the bond markets will be favorable. Under any of the above scenarios, the equity markets would eventually set the stage for above average levels of returns when looking out over a 5+ year time horizon. We feel that in this environment, it is prudent to maintain a high level of defensiveness. We believe that the current rally is a bear market rally and we anticipate that we will become more defensive in client portfolios should the S&P 500 continue to advance.
As always, should you have any questions concerning our outlook or your portfolio, please do not hesitate to give us a call.
Sincerely,
James A. Martin, III