Second Quarter 2009
ByQuarterly Review & Outlook
The bounce-back rally that began in mid-March continued through most of the 2nd quarter and helped push the broad averages into the black for the 1st half of 2009. Most of the gains for the 2nd quarter occurred in April and May as the S&P 500 was essentially flat for the month of June. Bonds also had a rewarding quarter as the credit markets continued to improve and credit spreads narrowed.
The market’s healthy rebound from the early March lows is largely attributable to; 1) a Newtonian reaction to the severe declines of the past two quarters and 2) a growing sense of optimism that the economy may be bottoming. There has been much said about the appearance of “green shoots” appearing on the economic landscape. The massive government stimulus and rescue packages to the banking community were bound to have a stimulative effect on the economy. At the very least, it did help to contain the damage and prevent the world economy from falling off a cliff.
A few examples of the “green shoots” are a surprising increase of 17% in new housing starts in May, lower (but still huge) new unemployment claims in June, and positive earnings surprises from the banking sector. We believe that all of these early harbingers should be taken with a grain of salt. Even with the increased housing starts, the housing market is unlikely to see much improvement for many years, the rate of the newly unemployed is still at extraordinarily high levels and the boost in bank earnings is largely attributable to changes in the “mark-to-market” component of their illiquid portfolios. As we mentioned in our last quarterly letter, the encouraging news is that the markets appear to be stabilizing and the economy is getting worse at a slower rate. We may well have an environment, in the next quarter or two, where the GDP experiences a modest level of growth.
Any level of economic growth would be a welcome relief, however; there are significant headwinds that the economy will be facing over the next few years. The de-leveraging of consumers and businesses still has a long way to play out. The increase in government regulations and direct government involvement in businesses has historically acted as a drag on economic growth. Additionally, the gigantic increase in the government borrowings and deficits are bound to have a negative impact at some point in the not too distant future. We think the economy is in the process of stabilizing during the 2nd half of this year but our concern is growing that we may see a “W” form of economic recovery whereby, after a modest recovery, the economy slips back into a recession in a year or two.
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 4th 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 = 25% (20%)
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 do not exceed the March lows (establish a new low with the S&P falling to near the 700 level). The S&P finishes 2009 within a range of plus or minus 5% (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 = 15% (20%)
After assigning weighted probabilities to these scenarios, we project an outlook for the equity markets that places it around a trading range of about 10% – 15% of the 900 range of the S&P500. We continue to feel that in this environment, it is prudent to maintain a high level of defensiveness. We still believe that the current rally is a bear market rally. We reduced some of the more volatile holdings in client portfolios in May and replaced them with a less volatile fund (Nakoma Absolute Fund).
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