BEAR MOVES IN THE stock market have anticipated nine out of the past five recessions, as an economist once famously quipped. Rebounds in stock prices are no more reliable in anticipating economic recoveries.
The only way to tell if the recent rebound in stocks is truly signaling recovery is to look at supporting data. And those data continue to suggest a bottoming in the economy by the second quarter, which would then turn out to have been duly anticipated by a bottom in the stock market in early March, the first quarter's final month.
This hardly suggests the bull is about to roar. Growth of real gross domestic product in the second half of 2009 is likely to be modest, running at an annual rate of 2% to 3%. The level of real GDP by year end will still be lower than the recent peak. There is always a danger, then, that equity prices will run ahead of this modest outlook. But at least the outlook is beginning to look positive.
Among upside surprises reported last week, one was the widespread rebound in February of durable-goods orders, tracked monthly by the Census Bureau. A durable good, as you might imagine, is technically defined as a tangible item that lasts at least three years. As such, it includes items that consumers buy, like cars and computers (although not plastics like Tupperware), but mainly covers nonconsumer goods like machinery and equipment.
The Census report on durable-goods orders is therefore a useful look into the activities of the manufacturing sector. (Yes, Virginia, there really is a domestic-manufacturing sector, even if much of it is owned by foreign companies.) The February increase in orders followed six consecutive monthly decreases and only partially reversed the decline in January. It tended to confirm the picture of a manufacturing sector that is still contracting, but at a slower rate. If final demand for goods really is beginning to stabilize, then manufacturing activity should be due for a rebound.
THE STRONGER PATTERN OF final demand got further confirmation from data for real consumer spending, released Friday. In the first two months of this year, real personal consumption ran positive, virtually guaranteeing that it will be up in the first quarter relative to the fourth.
Even if consumption flattens in the second quarter, the excessive liquidation of inventories should mean that production will still be due for a pick-up. Despite crushing job losses, it is still possible consumption will trend upward.
Job losses are not the only decisive factor in determining the trend in consumption. Otherwise, we would have to wonder how consumer spending could be higher in the first quarter than it was in the fourth, when the jobless rate was lower. One key factor that should help to buoy consumption is mortgage refinancings, fueled by a mortgage interest rate of 4.85%, the lowest on record.
The low mortgage interest rate helped bring another upside surprise reported last week, the February increase in existing home sales. With strengthening home sales, the negative wealth effect from declining home prices should diminish. One key home price tracked by the Federal Housing Finance Agency actually showed an increase in January.
Already much diminished is the negative wealth effect from the decline in stocks. That, too, should help buoy consumption.
Showing posts with label Barron's. Show all posts
Showing posts with label Barron's. Show all posts
Monday, March 30, 2009
Saturday, February 28, 2009
Fix the bank
EVEN AFTER CITIGROUP'S HIGHLY DILUTIVE DEAL with the government on Friday, battered bank stocks managed to end the week up 11%, well above the lows set Feb. 20. One reason is that guidelines for the government's "stress test" for banks, unveiled Wednesday, proved less onerous than expected. A second reason is that capital levels at the nation's regional banks now look fairly sturdy.
The Citi deal has everyone on Wall Street suddenly talking about a measure of financial strength called tangible capital, which is a bank's tangible common equity divided by its tangible assets. Citi (ticker: C) ranks as one of the worst institutions by this measure, with a tangible-capital ratio of 1.5%. Now that Citi has announced that the government and private investors will have the opportunity to convert their preferred shares into common shares, Citi's tangible capital ratio looks likely to jump to 4%. Many analysts and investors think 4% will emerge as the government's targeted minimum.
Prior to the Citi deal, regulators had focused on Tier 1 capital, which includes preferred stock and has been criticized for overstating banks' financial strength.
John Kuczala for Barron's
Troweling on the dollars alone won't put a lasting patch on the broken banking system.
Citi's Tier 1 capital appears healthy at 11.9%, double the regulatory minimum despite the bank's major problems. Because all Tier 1 capital cannot be easily used to absorb losses, investors are looking beyond that measure to tangible common equity. Now it appears that regulators are doing the same.
As shown on the table below, the change shouldn't pose a problem for many of the nation's large regional banks, many of them with tangible-capital ratios exceeding 5%.
Among the largest banks, JPMorgan Chase (JPM) is nearly at the 4% threshold, with a tangible-capital ratio of 3.8%. JPMorgan could easily hit the 4% mark by building capital over time. It took a step in that direction last week, announcing plans to cut its dividend 87%. This should add $5 billion to Morgan's tangible capital this year, pushing it to the 4% mark.
The new emphasis on tangible capital is a thornier issue for Bank of America (BAC), with a 2.6% tangible-capital ratio, and Wells Fargo (WFC), with a 2.8% ratio. Like Citi, they could meet a 4% minimum by having the government or private investors convert some preferred shares to common. The problem is that such a conversion would leave current holders of common stock owning less of Bank of America and Wells Fargo.
Table: A Capital DebateFears of this dilution pushed Bank of America stock down 25% Friday to 3.95, while Wells shares fell 16% to 12.10.
Executives at both BofA and Wells have said they don't see the need to raise capital right now, and there may be merit to that view. They could argue that their assets have already been marked down in value more than the assets of other banks, in part because Bank of America recently acquired Merrill Lynch and Wells acquired Wachovia. Indeed, Merrill Lynch marked its assets down substantially before selling itself to Bank America, while Wells took large write-downs of Wachovia's assets while completing the acquisition.
What does all this mean for investors? For the brave and the bold, it could mean opportunity. Given many false dawns for bank stocks in the past year, it is hazardous to call a bottom. But there is a case to be made that last week's rally in bank stocks could continue. Most banks look inexpensive, based on the ratio of their stock prices to tangible book value, a conservative measure of shareholder equity that excludes goodwill from acquisitions. A sizable slice of the industry is trading below tangible book value for the first time since 1990, including Bank of America, Capital One (COF), KeyCorp (KEY), SunTrust Banks (STI) and Comerica (CMA).
No question, bank profits will be depressed this year, and perhaps into 2010, with many institutions showing losses in 2009, as banks set aside reserves for growing loan losses. Some investment pros are steering clear of the group in favor of other depressed financial outfits, including asset managers and insurers.
Dividends, once hefty throughout the banking sector, are likely to be trimmed, as even relatively strong institutions reduce payouts to bolster capital. Analysts say dividend cuts are possible at Wells Fargo, U.S. Bancorp (USB) and PNC Financial (PNC). Oddly enough, JPMorgan's dividend cut didn't hurt its stock. Investors have become less focused on dividends than financial strength, particularly tangible book value. Anything that enhances book, including a payout cut, has come to be seen as a plus.
Four banks -- Bank of America, Citigroup, JPMorgan and Wells Fargo -- now dominate the industry, with combined assets of $7 trillion. No. 5 PNC has less than a quarter of the assets of No. 4 Wells Fargo. Bernstein analyst John McDonald's favorite megabank is JPMorgan, because it has a very "attractive risk-reward" ratio. It is trading at 23, just above its tangible book of $22. McDonald thinks JPMorgan's profit in 2011, the year that many analysts have targeted for a full-fledged economic recovery, could top $4 a share. His one-year price target is $38.
Among JPMorgan's most valuable assets is Jamie Dimon, arguably the best chief executive at any big financial company. Such praise, however, might be going to Dimon's head. In announcing the dividend cut Monday, he lauded his bank's "fortress balance sheet." Yet JPMorgan is still leveraged more than 25-to-1, based on its tangible equity. At a true fortress like Warren Buffett's Berkshire Hathaway (BRK-A), the leverage is just 3-to-1.
McDonald's colleague at Bernstein, Kevin St. Pierre, favors Comerica and U.S. Bancorp among the regionals. Comerica is now headquartered in Dallas and has significant exposure to depressed Michigan, but it also has one of the industry's highest capital ratios, based on common equity. U.S. Bancorp historically has had some of the sector's highest returns and should be in the black this year, too.
Investors didn't react well to Citigroup's announcement Friday that the government would convert up to $25 billion of its current preferred-stock investment under the Troubled Asset Relief Program into Citi common shares, giving Uncle Sam a 36% stake in the beleaguered bank. That action, combined with Citi's offer Friday to exchange some $27.5 billion of private and publicly held preferred into common shares, sent Citi shares down 96 cents, or 39%, to $1.50 on enormous volume: nearly two billion shares.
Investors are worried about several issues, including dilution, corporate governance and future business mix. If all the preferred is converted into common, Citi's share count will balloon to 22 billion from about 5.5 billion, massively diluting the positions of existing common holders, who will own just 26% of Citi shares.
The bull case on Citi now is that it has dealt with its capital shortfall and that the stock is appealing, trading well below the likely new tangible book value of $3.70 a share. "Investors are asking: 'Is Citi investable?' " says Bernstein's McDonald.
One concern among investors is that more than half of Citi's prospective common equity of $81 billion will consist of a deferred tax asset of $44 billion, which would protect some future earnings from taxes. The worry is that a wounded Citi may not be able to earn enough to use that shield.
Citi's $15 billion of preferred shares rallied on the news, although they are trading way below their face value. The company's Series P preferred finished Friday at $8.05, up $2.57 on the session, but still a fraction of the face value of $25.
Citi's preferred exchange offer created considerable confusion among investors because important details weren't released Friday. Citi is offering to swap common shares for preferred stock held by the public, but the precise exchange ratio probably won't be known until this week. Citi's publicly held preferred could rally if the terms are as generous as those accepted by the government and private investors, who are converting into common at about 45 cents on the dollar. In contrast, the publicly held preferred, trading at $8, is now valued at just 33 cents on the dollar.
Preferred holders probably should convert because Citi will stop paying dividends on unconverted preferred. Citi will continue to pay dividends on some $23 billion of outstanding trust preferreds.
If Citi's public preferred holders fare worse than the government, expect investor complaints. Congressional critics of TARP, too, could be upset at the Treasury's initial 55% loss on the conversion.
The Citi deal has everyone on Wall Street suddenly talking about a measure of financial strength called tangible capital, which is a bank's tangible common equity divided by its tangible assets. Citi (ticker: C) ranks as one of the worst institutions by this measure, with a tangible-capital ratio of 1.5%. Now that Citi has announced that the government and private investors will have the opportunity to convert their preferred shares into common shares, Citi's tangible capital ratio looks likely to jump to 4%. Many analysts and investors think 4% will emerge as the government's targeted minimum.
Prior to the Citi deal, regulators had focused on Tier 1 capital, which includes preferred stock and has been criticized for overstating banks' financial strength.
John Kuczala for Barron's
Troweling on the dollars alone won't put a lasting patch on the broken banking system.
Citi's Tier 1 capital appears healthy at 11.9%, double the regulatory minimum despite the bank's major problems. Because all Tier 1 capital cannot be easily used to absorb losses, investors are looking beyond that measure to tangible common equity. Now it appears that regulators are doing the same.
As shown on the table below, the change shouldn't pose a problem for many of the nation's large regional banks, many of them with tangible-capital ratios exceeding 5%.
Among the largest banks, JPMorgan Chase (JPM) is nearly at the 4% threshold, with a tangible-capital ratio of 3.8%. JPMorgan could easily hit the 4% mark by building capital over time. It took a step in that direction last week, announcing plans to cut its dividend 87%. This should add $5 billion to Morgan's tangible capital this year, pushing it to the 4% mark.
The new emphasis on tangible capital is a thornier issue for Bank of America (BAC), with a 2.6% tangible-capital ratio, and Wells Fargo (WFC), with a 2.8% ratio. Like Citi, they could meet a 4% minimum by having the government or private investors convert some preferred shares to common. The problem is that such a conversion would leave current holders of common stock owning less of Bank of America and Wells Fargo.
Table: A Capital DebateFears of this dilution pushed Bank of America stock down 25% Friday to 3.95, while Wells shares fell 16% to 12.10.
Executives at both BofA and Wells have said they don't see the need to raise capital right now, and there may be merit to that view. They could argue that their assets have already been marked down in value more than the assets of other banks, in part because Bank of America recently acquired Merrill Lynch and Wells acquired Wachovia. Indeed, Merrill Lynch marked its assets down substantially before selling itself to Bank America, while Wells took large write-downs of Wachovia's assets while completing the acquisition.
What does all this mean for investors? For the brave and the bold, it could mean opportunity. Given many false dawns for bank stocks in the past year, it is hazardous to call a bottom. But there is a case to be made that last week's rally in bank stocks could continue. Most banks look inexpensive, based on the ratio of their stock prices to tangible book value, a conservative measure of shareholder equity that excludes goodwill from acquisitions. A sizable slice of the industry is trading below tangible book value for the first time since 1990, including Bank of America, Capital One (COF), KeyCorp (KEY), SunTrust Banks (STI) and Comerica (CMA).
No question, bank profits will be depressed this year, and perhaps into 2010, with many institutions showing losses in 2009, as banks set aside reserves for growing loan losses. Some investment pros are steering clear of the group in favor of other depressed financial outfits, including asset managers and insurers.
Dividends, once hefty throughout the banking sector, are likely to be trimmed, as even relatively strong institutions reduce payouts to bolster capital. Analysts say dividend cuts are possible at Wells Fargo, U.S. Bancorp (USB) and PNC Financial (PNC). Oddly enough, JPMorgan's dividend cut didn't hurt its stock. Investors have become less focused on dividends than financial strength, particularly tangible book value. Anything that enhances book, including a payout cut, has come to be seen as a plus.
Four banks -- Bank of America, Citigroup, JPMorgan and Wells Fargo -- now dominate the industry, with combined assets of $7 trillion. No. 5 PNC has less than a quarter of the assets of No. 4 Wells Fargo. Bernstein analyst John McDonald's favorite megabank is JPMorgan, because it has a very "attractive risk-reward" ratio. It is trading at 23, just above its tangible book of $22. McDonald thinks JPMorgan's profit in 2011, the year that many analysts have targeted for a full-fledged economic recovery, could top $4 a share. His one-year price target is $38.
Among JPMorgan's most valuable assets is Jamie Dimon, arguably the best chief executive at any big financial company. Such praise, however, might be going to Dimon's head. In announcing the dividend cut Monday, he lauded his bank's "fortress balance sheet." Yet JPMorgan is still leveraged more than 25-to-1, based on its tangible equity. At a true fortress like Warren Buffett's Berkshire Hathaway (BRK-A), the leverage is just 3-to-1.
McDonald's colleague at Bernstein, Kevin St. Pierre, favors Comerica and U.S. Bancorp among the regionals. Comerica is now headquartered in Dallas and has significant exposure to depressed Michigan, but it also has one of the industry's highest capital ratios, based on common equity. U.S. Bancorp historically has had some of the sector's highest returns and should be in the black this year, too.
Investors didn't react well to Citigroup's announcement Friday that the government would convert up to $25 billion of its current preferred-stock investment under the Troubled Asset Relief Program into Citi common shares, giving Uncle Sam a 36% stake in the beleaguered bank. That action, combined with Citi's offer Friday to exchange some $27.5 billion of private and publicly held preferred into common shares, sent Citi shares down 96 cents, or 39%, to $1.50 on enormous volume: nearly two billion shares.
Investors are worried about several issues, including dilution, corporate governance and future business mix. If all the preferred is converted into common, Citi's share count will balloon to 22 billion from about 5.5 billion, massively diluting the positions of existing common holders, who will own just 26% of Citi shares.
The bull case on Citi now is that it has dealt with its capital shortfall and that the stock is appealing, trading well below the likely new tangible book value of $3.70 a share. "Investors are asking: 'Is Citi investable?' " says Bernstein's McDonald.
One concern among investors is that more than half of Citi's prospective common equity of $81 billion will consist of a deferred tax asset of $44 billion, which would protect some future earnings from taxes. The worry is that a wounded Citi may not be able to earn enough to use that shield.
Citi's $15 billion of preferred shares rallied on the news, although they are trading way below their face value. The company's Series P preferred finished Friday at $8.05, up $2.57 on the session, but still a fraction of the face value of $25.
Citi's preferred exchange offer created considerable confusion among investors because important details weren't released Friday. Citi is offering to swap common shares for preferred stock held by the public, but the precise exchange ratio probably won't be known until this week. Citi's publicly held preferred could rally if the terms are as generous as those accepted by the government and private investors, who are converting into common at about 45 cents on the dollar. In contrast, the publicly held preferred, trading at $8, is now valued at just 33 cents on the dollar.
Preferred holders probably should convert because Citi will stop paying dividends on unconverted preferred. Citi will continue to pay dividends on some $23 billion of outstanding trust preferreds.
If Citi's public preferred holders fare worse than the government, expect investor complaints. Congressional critics of TARP, too, could be upset at the Treasury's initial 55% loss on the conversion.
Sunday, February 8, 2009
Recession? No, It's a D-process, and It Will Be Long
NOBODY WAS BETTER PREPARED FOR THE GLOBAL market crash than clients of Ray Dalio's Bridgewater Associates and subscribers to its Daily Observations. Dalio, the chief investment officer and all-around guiding light of the global money-management company he founded more than 30 years ago, began sounding alarms in Barron's in the spring of 2007 about the dangers of excessive financial leverage. He counts among his clients world governments and central banks, as well as pension funds and endowments.
Matthew Furman for Barron's
"The regulators have to decide how banks will operate. That means they are going to have to nationalize some in some form." -- Ray Dalio
No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%. In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%.
Here's what's on his mind now.
Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.
Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.
Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?
Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.
You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.
You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?
The D-process is a disease of sorts that is going to run its course.
When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?
The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.
Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.
As goes GM, so goes the nation?
The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.
This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.
We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money.
It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.
Isn't the process of restructuring under way in households and at corporations?
They are cutting costs to service the debt. But they haven't yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.
What are you suggesting?
An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.
So where do things stand in the process of restructuring?
What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.
The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.
However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.
Is a restructuring of the banks a starting point?
If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.
On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something.
But the future of banking is going to be very, very different. The regulators have to decide how banks will operate. That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?
Nationalization is the most likely outcome?
There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?
Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down. Does this give you comfort?
Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.
To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending. So whose money is it, and who is protecting that money?
The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.
Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn't have lent to them before, how can you possibly lend to them now?
I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them.
Those examples exist, but they aren't, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.
By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.
At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.
In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933.
Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?
The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.
Are you a fan of gold?
Yes.
Have you always been?
No. Gold is horrible sometimes and great other times. But like any other asset class, everybody always should have a piece of it in their portfolio.
What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.
Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn't mean necessarily that the bond market is bad.
I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.
Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive. Other currencies will decline in relationship to the yen and in relationship to gold.
And China?
Now we have the delicate China question. That is a complicated, touchy question.
The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus. China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.
From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.
But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.
And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive.
You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?
A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years.
Given this outlook, what is your view on stocks?
Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.
Thanks, Ray.
Matthew Furman for Barron's
"The regulators have to decide how banks will operate. That means they are going to have to nationalize some in some form." -- Ray Dalio
No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%. In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%.
Here's what's on his mind now.
Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.
Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.
Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?
Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.
You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.
You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?
The D-process is a disease of sorts that is going to run its course.
When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?
The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.
Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt. Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.
As goes GM, so goes the nation?
The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.
This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.
We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money.
It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.
Isn't the process of restructuring under way in households and at corporations?
They are cutting costs to service the debt. But they haven't yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.
What are you suggesting?
An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.
So where do things stand in the process of restructuring?
What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.
The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.
However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth. There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.
Is a restructuring of the banks a starting point?
If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.
On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something.
But the future of banking is going to be very, very different. The regulators have to decide how banks will operate. That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?
Nationalization is the most likely outcome?
There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?
Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down. Does this give you comfort?
Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.
To the extent we are going to have nationalized banks, we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending. So whose money is it, and who is protecting that money?
The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.
Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn't have lent to them before, how can you possibly lend to them now?
I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them.
Those examples exist, but they aren't, by and large, the big picture. There are too many nonviable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.
By the way, in the bear market from 1929 to the bottom, stocks declined 89%, with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.
At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.
In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933.
Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?
The Federal Reserve is going to have to print money. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression. We are in a position where that will eventually create a problem for currencies and drive assets to gold.
Are you a fan of gold?
Yes.
Have you always been?
No. Gold is horrible sometimes and great other times. But like any other asset class, everybody always should have a piece of it in their portfolio.
What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.
Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity. While the dollar is bad, it doesn't mean necessarily that the bond market is bad.
I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.
Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive. Other currencies will decline in relationship to the yen and in relationship to gold.
And China?
Now we have the delicate China question. That is a complicated, touchy question.
The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus. China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.
From the U.S. point of view, we want a devaluation. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.
But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.
And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive.
You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?
A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years.
Given this outlook, what is your view on stocks?
Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.
Thanks, Ray.
Saturday, December 20, 2008
Out with the Old
BECAUSE 2008 ALREADY SUFFERS A SURFEIT of gloom, let's begin with a little good news: Wall Street's top strategists believe -- or hope -- that the U.S. stock market has already absorbed the worst of the selling pressure this year, and will start to recover in 2009.
John Patrick for Barron's
2009 Outlook: Stocks will scale sharp peaks and brave deep valleys to reach higher ground in 2009.
The not-so-great news: Any progress might be limited.
That's not to say there won't be violent rallies and sharp pullbacks along the way. An urgent scramble to dump risky assets and hoard capital this year triggered a crisis of credit -- and confidence -- that wiped out more than half of the stock market's value. And while stocks quickly rebounded 18% from their late-November low, the dozen strategists and chief investment officers surveyed by Barron'sexpect the Standard & Poor's 500 index to finish 2009 near an average of 1045, or 18% above today's level of 888.
Such a forecast may not seem very modest at first -- until you consider strategists' vocationally bullish bent, how this volatile market can easily cover 18% in mere days, and all those statistics promising massive gains a year after stocks first slip into -- and presumably bounce out of -- a bear market. In fact, a majority of the surveyed strategists have pinned their 2009 year-end targets within a narrow 50 points of the 1,000 mark as though there's safety in numbers.
The source of their circumspection: the uncertain economy. Nearly everyone expects the U.S. economy to worsen as companies cut costs and lay off workers (on top of the 1.25 million jobs already eliminated from September to November), and as economists pencil in gross domestic product declines of 4% or more for the fourth quarter of 2008 and early 2009. And while the consensus hopes for a second-half rehabilitation, no one knows when a lasting recovery will take hold. Indeed, 10 of the 12 firms surveyed see the U.S. economy contracting in 2009.
So why should stocks rise in the face of such ambiguity? For a start, the strategists hope that a stock market that has already fallen 52% from its 2007 peak to its Nov. 20 low has discounted much of the deterioration still to come. With more than 37% of mutual-fund assets recently parked in money-market funds, the highest level since 1991, there's ample cash for bargain hunting should stocks dip below a certain threshold. Hopes run high that cheaper energy costs will support consumer spending, and -- most important -- that the deep freeze in the credit markets triggered by Lehman Brothers' collapse will continue to thaw. And everyone is counting on the government's aggressive policies to help stop the rot.
"The size of global policy response to stabilize both the financial system and the growth outlook is virtually unprecedented," says Morgan Stanley chief global equity strategist Abhijit Chakrabortti. "It does not appear likely to us that equity markets will fall substantially from here, given growth expectations have been substantially lowered, growth data are depressed and there is a high level of skepticism surrounding the ability of policy-makers to salvage the financial system and stabilize growth."
A year earlier, forecasters made the mistake of placing too much faith in the Fed -- back then, they believed the Federal Reserve's interest rate cuts and thriving foreign economies could help the U.S. stave off a recession. This time around, their trust may be more justified: at least the government is no longer in denial about the economic threat, and fighting deflation has become the urgent priority for governments around the world. Just last week, the Fed cut benchmark rates below a historic 0.25% and promised a vast array of lending programs to consumers and businesses.
AT THE SAME TIME, investor expectations have been quashed -- the bar is set low when today's yardstick is the Great Depression. Witness the lunge for safety and near-zero yields on short-term Treasuries. "People are practically paying the government to hold their money -- if that's not a sign of negative sentiment, I don't know what is," says Jason Trennert of Strategas Research Partners.
No one thinks wild swings will subside quickly from record 5%-a-day moves in October, but the downward plunges have at least been replaced by volatility of the sideways variety. "The market can rally fiercely and then pull back some," says Citigroup's chief investment strategist Tobias Levkovich. Over the eight years after the 1932 bottom, there were at least five rallies that averaged 93%. The 1974 bear-market bottom spawned no fewer than six rallies over the next eight years averaging 32.5%. The surges, however, were followed by retreats, and Levkovich sees the choppy S&P 500 ending 2009 at 1,000.
IF THESE STRATEGISTS ARE RIGHT, the 39% gain from the Nov. 20 low of 752 to 1045 might mark the tentative start of a new bull market -- or a big bounce within an extended bear market. Even those who expect the S&P 500 to hold its Nov. 20 low see that threshold being tested in 2009 -- not immediately, since fresh allocations toward decimated stocks will provide a momentary lift. But buyers' resolve will be tested as early as February, when companies reporting messy fourth-quarter earnings offer a peek at the damage they've sustained.
Also, "I think a lot of bad decisions might have been made in the record volatility of this year's second half, and odds are there could be another surprise," warns Thomas Lee of JPMorgan. Potential threats that might rattle the market include a collapse of, say, a big U.S. industrial company or a foreign bellwether, or debt defaults by a sovereign power. Lee sees a range-bound first half, before a possible second-quarter test spawns a constructive second half. All through 2009, Wall Street expects the Fed to keep borrowing costs at extremely hospitable levels to goose spending, and at least nine strategists (or their economists) see benchmark rates kept below 1% even a year from today.
The flight to quality that drove 10-year Treasuries' yield down toward 2% last week also smacks of "a crowded trade and feels a little overdone," says Alison Deans, Neuberger Berman's chief investment officer. The firm's portfolio managers increasingly are scouring investment-grade corporate debt -- sporting attractive yields above 7% -- to park their money while browsing for stocks. In fact, 10 of the 12 strategists expect Treasuries to back off next year and for the 10-year yield to reverse its slide; the holdouts are JPMorgan, whose bond strategists see the benchmark yield finishing 2009 at 1.65%, and Merrill Lynch. (For Barron's bond-market outlook, see Current Yield.)
Anyone looking for change in 2009 will not be disappointed. As America weans itself off debt, and as the government begins to own banks, insurers or even automakers, a "tectonic shift occurs with the transfer of leverage from the private to the public sector," says Christopher Hyzy, chief investment officer of U.S. Trust, Bank of America's private wealth-management unit. The world's gross imbalances will begin to moderate. For example, developing Asia will see savings decline and spending rise, while the West, anxious to mend its balance sheets, will save more and spend less.
Top strategists and chief investment officers on whether the market has hit bottom yet. (Dec. 20)
The clearest consensus about this period of rebalance and repair is for stocks to suffer limited downside risk, but also capped upside gains. But when pressed to pick which one of these two notions they feel more confident about, the strategists become quite evenly divided.
BULLS WHO THINK THIS TIGHTLY wound market is more likely to surprise to the upside point out how cheap stocks have become. "Bottom-up" predictions by Street analysts for the S&P 500 to earn $78 a share next year seem naïve, and surely will be slashed toward less-deluded "top-down" estimates from strategists who have factored in the weakening economy and who peg profits at $60.20.
David Kostin, Goldman Sachs' chief investment strategist, expects operating earnings to slip 33% this year to $55 a share, then fall another 5% next year to $53 before rebounding in 2010 to $69. While he steers clients toward more defensive companies with strong balance sheets and reliable dividend growth, he says that an overall market trading at 1.7 times book value -- half the 10-year average of 3.4 times -- is a sign "the equity market is undervalued from a long-term perspective."
Studying how far multiples shrank during previous swoons, Kostin pegs the trough for the S&P 500 at 850 if this proves to be an average bear market. But if this bear market plays out to a worst-case scenario, the bottom could be a lot lower, at about 630.
Valuation multiples expanded relentlessly in the 1980s and 1990s as long-term interest rates fell. Stocks won't enjoy the same lift today, with the 10-year yield already near 2%. Still, price-to-earnings multiples "are well below where they should be, given where interest rates are and where inflation is," argues Larry Adam of Deutsche Bank Private Wealth Management. He thinks multiples can expand as investors' appetite for risk returns.
"The S&P 500 also is at its most broadly diversified in at least a decade," Adam adds. Technology hogged 30% of the benchmark's weight in 1999, while financials took up more than 22% in 2006, but today the most prominent segments -- technology, consumer staples -- represent no more than 15% of the increasingly balanced market.
James Paulsen of Wells Capital Management says the U.S. was dealt a below-the-belt blow from which it can bounce back. "The one policy that had been tremendously effective was the well-orchestrated fear-mongering campaign" waged by the Treasury and the Fed to persuade Congress to pass a $700 billion bailout bill, Paulsen says.
The bad news: the resulting crisis of confidence frightened perfectly healthy corporations and consumers into suspending economic activity. "But the good news also is that it is a crisis of confidence," Paulsen says. "Just as we're surprised by the crisis' depth and severity going in, we might be surprised by how sharp the rebound can be going out."
Concerns about the collapse of consumer spending -- the engine that drives the U.S. economy -- also may have been exaggerated. "Credit won't grow at the rate we're accustomed to, but there's still pent-up demand from deferred purchases," says Jerry Webman, Oppenheimer Funds' senior investment officer. And let's not forget the boost that comes from $40 oil.
SO WHAT'S HOLDING STOCKS BACK? "If you have to point to one constant in the market, it is uncertainty," says Hyzy. More cautious strategists think the S&P 500 will struggle to sustain rallies above 1050, since investors will be asked to pay more than 15 times for per-share earnings of $70 or more.
Many strategists, of course, hope housing demand will recover as mortgage rates fall and as the new administration pushes consumer-friendlier reform. Unemployment might not peak until late-2009 near 9%, but it is a lagging indicator, since employers typically hold off new hires until they are convinced things are looking up. Still, weaker operating leverage, compressed profit margins, a stronger dollar and anemic foreign growth could all cap rallies.
Among the more prescient calls from last year's forecast was Merrill Lynch's prediction of "the first consumer-led recession since 1991," even if the firm, too, underestimated the severity of this year's selloff. While others were anticipating a profit rebound, Merrill also was among the first to forecast weaker profits in 2009 -- a view that has since become consensus.
Today, the firm still hews to its defensive crouch, although chief investment strategist Richard Bernstein reckons "2009 is likely to be better than 2008 for investors." Among other things, he preaches patience in the rush to pick a market bottom, "since the opportunity cost is low and there's a stiff penalty for being early and wrong." Merrill economist David Rosenberg thinks fiscal stimulus can help "cushion the blow but will not reverse the business cycle." Spirited consumption by baby boomers kept recent recessions short and mild. But now, "the average boomer is in his 50s and after two decades of spending, the boomer is done."
With this decade's booms -- in commodities, real estate, hedge funds and private equity -- all swelled by cheap money, Bernstein says the violent market shakeup and bursting of the credit bubble will pave the way for new market leaders. Defensive segments like consumer staples and health care may prove to be more than a temporary shelter, and could outperform even over the longer run.
Asked what it'll take before he turns more bullish, Rosenberg flags three markers that could signal a sustainable economic expansion: the rise of the U.S. personal savings rate to 8% from 2%; a decline in the glut of unsold new homes, currently at 11 months' supply, to about eight months' worth; and for the percentage of household after-tax income spent servicing debt to fall from more than 13% to about 10.5%.
Where lurk the potential shocks? For many strategists, the happiest surprise is if the financial system gets fixed swiftly. That could drive the S&P 500 to 1190, and Chakrabortti pegs the chances of that at 20%.
By early next year, the losses suffered by banks and brokerages also will pass the $1 trillion mark, and "odds are good that markdowns and provisioning have already peaked," says Chakrabortti, who warned more than a year ago that downturns led by housing -- the world's slowest-moving assets -- tend to be prolonged. Improving value for deeply discounted loans might even trigger "write-backs," where financial firms that haven't dumped their debt get to bump up the value of their loan portfolios.
Table: 2009 ForecastsOn the other hand, policy failure and dislocated financial markets could send the S&P 500 to 400, the odds of which Chakrabortti pegs at 25%. "Another potential downside surprise is if Asian or emerging-market consumption falls sharply -- I don't think that has been discounted by the market."
Meanwhile, inflation -- so feared just a few months ago -- goes virtually unremarked these days, even though the government bluntly promises it will print as much money as necessary to keep the financial systems functioning. "The trade of 2009 will be to figure out when to stop playing deflation and begin playing inflation again," Trennert says.
AGAINST THIS UNCERTAINTY, model portfolios must walk a delicate balance between guarded and bold: The three sectors favored by BlackRock's global chief investment officer Robert Doll are health care, with its strong cash flow and its defensive stance; technology, which straddles the divide between stability and cyclicality; and energy, which is the most economically sensitive.
Forcing borrowing rates down to zero will need time to work. In this climate, Hyzy prefers "the top of the capital structure" -- essentially more secure senior debt -- and keeping an eye on small- to mid-cap stocks that could outperform if the Obama administration manages to stimulate job creation. He also emphasizes infrastructure and defense stocks. "There is a propensity for violence during tough times, and conflicts can arise as the global economic downturn picks up steam," he says. "We must be prepared for that."
While the market has flocked toward quality -- strong balance sheet, robust cash flow, predictable profits -- investors should keep an eye out for improving credit spreads and a return of risk appetite. "At some point, the argument for quality could become long in the tooth, and lower quality will do just fine -- thank you very much," Doll says. When that happens, investors might shift some money from big pharmaceuticals toward HMOs within health care, from software toward select chip makers, and from big integrated oil companies toward explorers and refiners. Ditto a shift from the currently popular domestic focus back toward multinationals with international clout.
No surprise: health care is the new year's most crowded trade, with the sector beloved by 10 of 12 strategists.
Curiously, technology was favored by five out of the six buy-side CIOs, but not one sell-side strategist. Deutsche's Adam, for one, likes tech companies' cash stash and self-sufficiency from the debt market. Inventory is disciplined after the bloated bubble years, and technology improves productivity of companies operating with leaner staff. Our next president, Barack Obama, is a tech-savvy broadband geek, and even his health care reform includes tech-reliant proposals like the modernizing of medical records.
The knock on the sector, however, is how companies might find it easier to slash capital spending than lay off workers. Credit-market indicators suggest that payrolls will shrink another 3% by the summer, but capital spending could be cut 15%, says Citi's Levkovich. "Companies that sell to consumers could suffer, but companies that sell to other companies will be worse off," he says. His picks include retailers, where "expectations are already extraordinarily poor."
A chasm also has opened up in financials, which is favored by four sell-side strategists. "America's private debt -- the aggregate value of household and corporate debt -- is trading at 70 cents on the dollar, and that's not the right price," says JPMorgan's Lee, who expects this fear-driven discount to narrow after the rush to delever. Tightening credit spreads and a steeper yield curve also should help financial firms.
ODDLY ENOUGH, NOT ONE of the surveyed buy-side managers is ready to warm up to financials. Like tech stocks earlier this decade and energy stocks in the early 1980s, financial stocks need a lot more time to recover from the pricking of the credit bubble. "More capacity needs to be taken out, which means more bad debt, write-offs and consolidation," Doll says. "Policy is an ameliorating factor and it is targeted at financials, the sickest part of the market. But if it works, it will benefit the whole economy." In other words: why risk betting on financials?
Meanwhile, the sectors that led the most recent bull market have become its new pariahs: Energy is recommended by just two strategists, and materials by only one. "While demand for commodities will be hurt in a global recession, we have done virtually nothing to solve our oil dependence," says Doll, who sees energy stocks bouncing should the economy return to any semblance of normalcy. Crude oil has also fallen more than 70% to below $40 a barrel, and Doll sees the $40 level "as a flashpoint below which oil-producing countries will curtail supply." (OPEC, in fact, voted last week to reduce supply.)
In contrast, four strategists suggest avoiding energy, four are dissing materials and five suggest steering clear of industrials. Quite remarkably, 12 of these 13 negative calls against these commodity-driven sectors are from the sell-side. Materials and industrial companies, for instance, are famously capital-intensive. They suffer big depreciation expenses that erode earnings and pressure margins, and commodity prices are still falling. "The bar is set very high for companies that led the previous bull market," Lee says, "and it's rare for old leaders to re-assert themselves."
For that matter, even the vanquished bull market itself will need a little help -- and a little hope -- to reassert itself in the year ahead.
Sunday, October 12, 2008
Closer to the bottom
FOR THE TENS OF MILLIONS OF INVESTORS WHO HAVE been nervously watching the U.S. stock market's 40% decline in the past 12 months, and it's 18% drop in the past week alone, history holds some solace: There is a case to be made that the averages will hit bottom sometime in the next few months, even if the economy is in the middle of a recession.
Indeed, stocks showed some signs of finding a bottom late Friday, with the Dow Jones industrial average closing down just 128 points on the day, after having plummeted about 700 points earlier in the session. The Nasdaq Composite even managed a small gain on the day. Investors will be watching for a possible market bounce that could occur early this week, especially if any new measures to ease the global economic crisis emerge from the weekend's meeting in Washington of the finance ministers of the so-called G-7 industrial nations.
Scott Pollack for Barron's
The lesson of history is this: The average U.S. recession since the late 1940s has lasted 10 months, and stocks typically hit their low point about three months before the recession ends. So, if the U.S. entered a recession on July 1, as many economists now suggest, and the recession was to last until April 2009, a typical bottom for stocks would occur some time in the next few months.
Granted, much depends on the ability of the Federal Reserve and the U.S. Treasury to put rescue measures in place that will unlock today's frozen capital markets. And there are nagging concerns that the next disaster may lurk in the unregulated $60 trillion market for credit-default swaps. But the fear that sent the market down so sharply last week may have driven stocks close to their ultimate lows.
"I don't think this is the end of America as we know it," says Byron Wien, chief investment strategist at Pequot Capital Management. "I think it's conceivable that the markets will bottom before year end."
Wien cites a number of positive events in recent weeks. The Treasury now has the ability, through the $700 billion Troubled Asset Relief Program (TARP), to start buying distressed assets from banks. There is speculation the federal government will come up with yet another program to help the housing market. Oil prices have fallen below $80 a barrel from levels above $140, a slide that on its own should boost economic growth. And smart investors have started buying at what they hope are good prices. Barclays (ticker: BCS) purchased Lehman Brothers' investment-banking operations in the U.S. Warren Buffett took stakes in General Electric (GE) and Goldman Sachs (GS). Citigroup (C) and Wells Fargo (WFC) actually fought over the right to buy Wachovia (WB).
Recessions certainly have been both shorter and longer than the 10-month average. On a positive note, five recent recessions were shorter. The 1980 recession lasted a mere six months, and there were four recessions that lasted only eight months, according to data from Bespoke Investment Group.
But a mild recession wasn't what the market feared last week. Investors were worried the current economic slump will be "different" from those in the past. American consumers are carrying more debt this time around, and the banking system is in much more fragile shape.
THOUGH A TYPICAL RECESSION would end by next spring, economists are paying increasing attention to longer downturns, specifically the two recessions since 1940 that each lasted 16 months. The November 1973 to August 1975 downdraft was sparked by the Arab oil embargo, while the July 1981 to November 1982 recession was triggered by the Federal Reserve hiking interest rates dramatically to curtail runaway inflation. In each case stocks bottomed about three months before the recession ended.
The good news today is that stocks appear to have gotten out ahead of any recession, falling so sharply that they might already have priced in pretty horrible times ahead. The Dow is down almost as much in the past year as the 45% it fell in the 1973-1975 recession, and its 12-month decline far exceeds the 24% it lost in the period leading up to and during the 1981-1982 recession, according to Birinyi Associates.
Today's 40% drop also far surpasses the average bear-market slide of 30% since 1940. Markets that decline for more than a year average a loss of 42%, says Paul Desmond, President of Lowry Research Corp. The Dow has fallen by more than 40% 10 other times, with all but one such drop occurring between 1900 and 1930. It slid by more than 50% only once, between 1929 and 1932, when it shed 89%. That bear was bracketed by the Great Depression, which lasted for 44 months.
A recession is labeled a depression when economic activity shrinks by 10% or more. From August 1929 to March 1933 U.S. economic output contracted by more than 30%. That's what made it "Great."
Table: Stocks and Recessions: What History Tells UsBut back in the 'Thirties, the financial markets lacked many of today's safety nets, like deposit insurance, and the Federal Reserve didn't loosen the purse strings quickly, as the Fed lately has done. Also, the stock-market rally leading up to the Depression was much more frenzied. From 1921 to 1929, the market rose almost 500%. In the rally from 1987 to 2000, stocks jumped 574%, but did so over a much longer period. From 2002 to the market's peak in October 2007, the Dow rose 94%.
Given stocks' swoon in the past 12 months, prices look much more reasonable today. The companies in the Standard & Poor's 500 trade for an average of 11.6 times the profits that analysts expect them to earn next year. And the index trades at 17.1 times the companies' most recent earnings. That's only slightly below the market's 60-year average price/earnings multiple of 17.8, according to Birinyi Associates.
The current P/E is still high compared to the low P/Es of previous major recessions. During the '74, '80 and '82 recessions, the S&P's trailing P/E dropped to between 6.8 and 7.2. But in the '70, '90 and '01 economic downturns, the P/E ranged from 12.9 to 23.5.
The Bottom Line
Though dangers aplenty still lurk for the economy and the market, studies of stock-market performance through recessions suggest the Dow could see its low shortly.One person who fears further market declines is Wayne Nordberg, chairman of Hollow Brook Associates. "This is the end of the great credit supercycle," he says. "It takes a very long time to unwind."
Or, as Doug Cliggott, manager of the Dover Management Long-Short Sector Fund, put it with regard to the TARP, "we're fighting a forest fire with a garden hose."
But such gloomy sentiments aren't a reason to get out of the stock market. It could be quite the opposite, in fact. Consider that $1 invested in stocks from February 1966 through May 2007 would have grown to $16.58 in that period. That's a 7% annual return. By contrast, investors who were out of the market in the five best days each year during that span were left with only 11 cents.
That's a pretty good case for the buy and hold philosophy, or, if you're out of the market, for getting back in soon.
Indeed, stocks showed some signs of finding a bottom late Friday, with the Dow Jones industrial average closing down just 128 points on the day, after having plummeted about 700 points earlier in the session. The Nasdaq Composite even managed a small gain on the day. Investors will be watching for a possible market bounce that could occur early this week, especially if any new measures to ease the global economic crisis emerge from the weekend's meeting in Washington of the finance ministers of the so-called G-7 industrial nations.
Scott Pollack for Barron's
The lesson of history is this: The average U.S. recession since the late 1940s has lasted 10 months, and stocks typically hit their low point about three months before the recession ends. So, if the U.S. entered a recession on July 1, as many economists now suggest, and the recession was to last until April 2009, a typical bottom for stocks would occur some time in the next few months.
Granted, much depends on the ability of the Federal Reserve and the U.S. Treasury to put rescue measures in place that will unlock today's frozen capital markets. And there are nagging concerns that the next disaster may lurk in the unregulated $60 trillion market for credit-default swaps. But the fear that sent the market down so sharply last week may have driven stocks close to their ultimate lows.
"I don't think this is the end of America as we know it," says Byron Wien, chief investment strategist at Pequot Capital Management. "I think it's conceivable that the markets will bottom before year end."
Wien cites a number of positive events in recent weeks. The Treasury now has the ability, through the $700 billion Troubled Asset Relief Program (TARP), to start buying distressed assets from banks. There is speculation the federal government will come up with yet another program to help the housing market. Oil prices have fallen below $80 a barrel from levels above $140, a slide that on its own should boost economic growth. And smart investors have started buying at what they hope are good prices. Barclays (ticker: BCS) purchased Lehman Brothers' investment-banking operations in the U.S. Warren Buffett took stakes in General Electric (GE) and Goldman Sachs (GS). Citigroup (C) and Wells Fargo (WFC) actually fought over the right to buy Wachovia (WB).
Recessions certainly have been both shorter and longer than the 10-month average. On a positive note, five recent recessions were shorter. The 1980 recession lasted a mere six months, and there were four recessions that lasted only eight months, according to data from Bespoke Investment Group.
But a mild recession wasn't what the market feared last week. Investors were worried the current economic slump will be "different" from those in the past. American consumers are carrying more debt this time around, and the banking system is in much more fragile shape.
THOUGH A TYPICAL RECESSION would end by next spring, economists are paying increasing attention to longer downturns, specifically the two recessions since 1940 that each lasted 16 months. The November 1973 to August 1975 downdraft was sparked by the Arab oil embargo, while the July 1981 to November 1982 recession was triggered by the Federal Reserve hiking interest rates dramatically to curtail runaway inflation. In each case stocks bottomed about three months before the recession ended.
The good news today is that stocks appear to have gotten out ahead of any recession, falling so sharply that they might already have priced in pretty horrible times ahead. The Dow is down almost as much in the past year as the 45% it fell in the 1973-1975 recession, and its 12-month decline far exceeds the 24% it lost in the period leading up to and during the 1981-1982 recession, according to Birinyi Associates.
Today's 40% drop also far surpasses the average bear-market slide of 30% since 1940. Markets that decline for more than a year average a loss of 42%, says Paul Desmond, President of Lowry Research Corp. The Dow has fallen by more than 40% 10 other times, with all but one such drop occurring between 1900 and 1930. It slid by more than 50% only once, between 1929 and 1932, when it shed 89%. That bear was bracketed by the Great Depression, which lasted for 44 months.
A recession is labeled a depression when economic activity shrinks by 10% or more. From August 1929 to March 1933 U.S. economic output contracted by more than 30%. That's what made it "Great."
Table: Stocks and Recessions: What History Tells UsBut back in the 'Thirties, the financial markets lacked many of today's safety nets, like deposit insurance, and the Federal Reserve didn't loosen the purse strings quickly, as the Fed lately has done. Also, the stock-market rally leading up to the Depression was much more frenzied. From 1921 to 1929, the market rose almost 500%. In the rally from 1987 to 2000, stocks jumped 574%, but did so over a much longer period. From 2002 to the market's peak in October 2007, the Dow rose 94%.
Given stocks' swoon in the past 12 months, prices look much more reasonable today. The companies in the Standard & Poor's 500 trade for an average of 11.6 times the profits that analysts expect them to earn next year. And the index trades at 17.1 times the companies' most recent earnings. That's only slightly below the market's 60-year average price/earnings multiple of 17.8, according to Birinyi Associates.
The current P/E is still high compared to the low P/Es of previous major recessions. During the '74, '80 and '82 recessions, the S&P's trailing P/E dropped to between 6.8 and 7.2. But in the '70, '90 and '01 economic downturns, the P/E ranged from 12.9 to 23.5.
The Bottom Line
Though dangers aplenty still lurk for the economy and the market, studies of stock-market performance through recessions suggest the Dow could see its low shortly.One person who fears further market declines is Wayne Nordberg, chairman of Hollow Brook Associates. "This is the end of the great credit supercycle," he says. "It takes a very long time to unwind."
Or, as Doug Cliggott, manager of the Dover Management Long-Short Sector Fund, put it with regard to the TARP, "we're fighting a forest fire with a garden hose."
But such gloomy sentiments aren't a reason to get out of the stock market. It could be quite the opposite, in fact. Consider that $1 invested in stocks from February 1966 through May 2007 would have grown to $16.58 in that period. That's a 7% annual return. By contrast, investors who were out of the market in the five best days each year during that span were left with only 11 cents.
That's a pretty good case for the buy and hold philosophy, or, if you're out of the market, for getting back in soon.
Still Holding Back
FOR THREE YEARS, HE'S CAUTIONED INVESTORS TO AVOID RISK. Jeremy Grantham, chairman of institutional money manager GMO in Boston, was early, but eventually right.
Grantham told Barron's in February of 2006 that "housing is a classic bubble" and that "this feels like the end of a cycle." Known for his insights on global investing, Grantham, 70, co-founded GMO, which has a value framework combining quantitative and fundamental analysis. It oversees assets of about $120 billion.
For Grantham's latest views on the fallout from the financial crisis and what investment opportunities he sees, please read on.
Shawn Henry
"I can't say we are going to be in a great hurry, but our next move…will be back to emerging-market equities and small-cap international value." – Jeremy Grantham
Barron's: How much will the recent $700 billion bailout plan approved by Congress help stabilize the economy and the financial markets?
Grantham: It certainly doesn't hurt. It is an amazingly complicated situation. But I do believe we have passed the point where we have to worry about moral hazard. When Bear Stearns was in trouble, I used to worry about moral hazard.
What is your sense of how this crisis has been handled by those in charge?
It's been a haphazard response, and the next time something happens, you can't be sure what will happen. In one deal they protect the bonds, while in the next deal the bonds go. Then in the next deal they protect the foreign bonds but not the domestic bonds. My guess is that people will be nervous that they will be at the bad end of one of the tough deals, rather than one of the more gentle deals.
Everyone is shaking in their boots. The awareness of risk has come back with a terrifying surge, and it is not going to go away too quickly.
With the Fed and other central banks lowering rates last week, are you worried about inflation?
My view is, "Forget inflation, guys." This is serious, the real McCoy, and you don't have to worry about little things like inflation. Global growth will slow down, commodities will be weaker for a while, and inflation is a thing of the past. Now we are talking about getting the financial machinery to work and just keeping [gross domestic product] grinding along.
What was at the core of what got the financial system into this crisis?
It was the belief by a lot of people who counted that financial bubbles did not have to addressed. The thinking was that...you could step in and, by scattering a bit of money around, ease the downside consequences. Therefore, you could let the tech bubble run amok and wait for it to burst and step in. And you could let the housing bubble run amok and step in.
At the center of this crisis was a bubble in risk-taking. The risk premiums dropped off the cosmic scale, the lowest ever recorded. On our seven-year forecast data, we reckoned that between June of '06 and June of '07, people were actually paying for the privilege of taking risk. Our constant theme for the last three years was avoid risk, avoid risk, avoid risk.
How much further do we have to go to get through this downturn?
Great bubbles like the one in 2000 take a long time to wash through the system, and you shouldn't really expect a low much before 2010. The fair value on the [Standard & Poor's 500 index] is about 1025 [versus 910 late last week].
This was not only a monetary event, but it coincided with the first truly global bubble in all assets. You had inflated housing in almost every country in the world, except for Japan and Germany. You had overpriced stocks in every country in the world. And you had too much money and too-low interest rates. I was confident about very little, but I was confident that this would be different from anything we had seen before, and potentially more dangerous. It should have been treated with more care.
Is this crisis playing out the way you thought it would?
No. I threw in the towel three months ago, and wrote a quarterly letter saying I thought I was the bear around this joint.
But this is much worse than I thought. All the fundamentals are turning out worse than I thought they would. All the competencies of the senior people at the Fed, Treasury and [firms like Merrill Lynch and Lehman Brothers] have turned out to be much less than I had expected; that's very disappointing.
And, therefore, how could one's confidence that the senior people would get us through the storm be very high? Prior to three months ago, we were investing in emerging-market equities. Then we battened down the hatches, and I changed my view from avoid all risk except emerging markets to avoid all risk, period.
The terrible thing -- after all this pain -- is that the U.S. equity market is not even cheap. You would imagine that, given the amount of panic, that it would be. But it started from such a high level in 2000 that it still has not yet worked its way down to trend, although it is getting close. But the really bad news is that great bubbles in history always overcorrected. So although the fair value of the S&P today may be about 1025, typically bubbles overcorrect by quite a bit, possibly by 20%. That is very discouraging.
What about equities outside the U.S.?
Things are getting cheaper. We score the EAFE [the Europe, Australasia and Far East Index] as absolutely cheap, and it's offering a 7% real annual return over seven years. Emerging-market equities are a bit cheaper, and we see a 9.5% annual real return over the same period.
The problem, though, is that we have so much downside momentum, so many financial problems and so many interlocking relationships, that it is hard to imagine this crisis subsiding because stock prices are digging in their heels and approaching fair value.
What happens to hedge funds in the wake of this crisis?
A year ago, I said that half of all hedge funds would go out of business in five years, and I would certainly stand by that today. Unfortunately, like a lot of my dire projections, that may turn out to be conservative.
I also said that at least one major bank will fail. I got a lot of grief for that, and now it looks like I could have said at least a dozen major banks will fail.
As for the broad, typical opinion that we would muddle through this crisis, it just shows you what a dangerous optimistic bias the advisory business has built into it.
Do you think we will learn anything from all of this turmoil?
We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.
Let's talk about your asset allocations.
In a nutshell, we are as conservative as we can possibly get. One bet that has been very successful for us, touch wood, has been long high-quality, blue-chip stocks, particularly in the U.S., and short risky companies. We have been screaming against risk-taking for a long time, and in recent weeks, it has paid off enormously.
What about looking ahead in terms of asset allocation?
Going forward, you can think about slowly moving back into the cheapest pockets of global equities. So the next move that we make will be back to moderate neutral in emerging-market equities and small-cap international value. I can't say we are going to be in a great hurry, but that will be our next move. We had finished selling almost everything except emerging markets two years ago. We finished selling emerging-market equities three months ago.
But the next move will be buying, and we are encouraged that there are a few pockets that are cheap on an absolute basis. We are not encouraged that they will rally immediately. But we will be looking to buy the cheap pockets of global equities as our next move some time in the next several months.
Why emerging markets and small-cap international value?
Just value and because they have been hit the most. Emerging equities are down almost 50% since late last year, and some of small-cap international is down more than 40%. That big a drop has this wonderful effect of making these categories look cheap pretty fast. You can buy, but it doesn't mean it is their low, and I strongly suspect it is not.
The great trap is to buy too soon and, in the big move, to sell too soon. I've been saying since '98-'99 that my next major-league error will be buying too soon -- but we will not buy quite yet. But when we do, I suspect it will be too soon again.
What do you see ahead for commodities?
Commodities have a great long-term future, now that the long-term trend has shifted from falling commodity prices to rising commodity prices. Having said that, the next couple of years will be quite different. We are in a global slowdown, which I think will be worse than expected even today, and it will be longer than expected -- so this is not a healthy environment for commodities. Over a shorter horizon, I would be getting out of the way of commodities or I would be short commodities. I'm personally short oil; the firm is short copper.
What about some other trades?
I'm speaking for the asset-allocation unit at the firm. We have been substantially long the safe-haven currencies. We have been very long the yen and somewhat long the Swiss franc and short sterling, which is one of our favorite bets. We have been short the euro for three months, and slightly long the U.S. dollar. One of the paradoxes is, if the world is worse than people expect, the U.S. dollar will outperform.
Why are you shorting the euro?
It just ran too far. It went from 85 cents on the U.S. dollar to $1.60; it more or less doubled, which I don't think reflects reality. But the biggest lay-up of any idea over the last three or six months was shorting the pound.
The U.K. housing market was dreadfully overpriced. I felt nearly certain that the U.K. housing market would come back to a more normal multiple of family income, which is a very big decline of 40% if you did it in a hurry -- or you can sit back for many years and wait for income to catch up. But you should really count on that market coming down over a couple of years painfully.
Do you have any closing thoughts about how we got into this financial state?
I ask myself, "Why is it that several dozen people saw this crisis coming for years?" I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke -- none of them seemed to see it coming.
I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained -- but we end up with an army of left-brained immediate doers.
So it's more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored.
If you look at the people who have been screaming about impending doom, and you added all of those several dozen people together, I don't suppose that collectively they could run a single firm without dragging it into bankruptcy in two weeks. They are just a different kind of person.
So we kept putting organization people -- people who can influence and persuade and cajole -- into top jobs that once-in-a-blue-moon take great creativity and historical insight. But they don't have those skills.
Where do you see all of this going?
I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it hadn't happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect.
Grantham told Barron's in February of 2006 that "housing is a classic bubble" and that "this feels like the end of a cycle." Known for his insights on global investing, Grantham, 70, co-founded GMO, which has a value framework combining quantitative and fundamental analysis. It oversees assets of about $120 billion.
For Grantham's latest views on the fallout from the financial crisis and what investment opportunities he sees, please read on.
Shawn Henry
"I can't say we are going to be in a great hurry, but our next move…will be back to emerging-market equities and small-cap international value." – Jeremy Grantham
Barron's: How much will the recent $700 billion bailout plan approved by Congress help stabilize the economy and the financial markets?
Grantham: It certainly doesn't hurt. It is an amazingly complicated situation. But I do believe we have passed the point where we have to worry about moral hazard. When Bear Stearns was in trouble, I used to worry about moral hazard.
What is your sense of how this crisis has been handled by those in charge?
It's been a haphazard response, and the next time something happens, you can't be sure what will happen. In one deal they protect the bonds, while in the next deal the bonds go. Then in the next deal they protect the foreign bonds but not the domestic bonds. My guess is that people will be nervous that they will be at the bad end of one of the tough deals, rather than one of the more gentle deals.
Everyone is shaking in their boots. The awareness of risk has come back with a terrifying surge, and it is not going to go away too quickly.
With the Fed and other central banks lowering rates last week, are you worried about inflation?
My view is, "Forget inflation, guys." This is serious, the real McCoy, and you don't have to worry about little things like inflation. Global growth will slow down, commodities will be weaker for a while, and inflation is a thing of the past. Now we are talking about getting the financial machinery to work and just keeping [gross domestic product] grinding along.
What was at the core of what got the financial system into this crisis?
It was the belief by a lot of people who counted that financial bubbles did not have to addressed. The thinking was that...you could step in and, by scattering a bit of money around, ease the downside consequences. Therefore, you could let the tech bubble run amok and wait for it to burst and step in. And you could let the housing bubble run amok and step in.
At the center of this crisis was a bubble in risk-taking. The risk premiums dropped off the cosmic scale, the lowest ever recorded. On our seven-year forecast data, we reckoned that between June of '06 and June of '07, people were actually paying for the privilege of taking risk. Our constant theme for the last three years was avoid risk, avoid risk, avoid risk.
How much further do we have to go to get through this downturn?
Great bubbles like the one in 2000 take a long time to wash through the system, and you shouldn't really expect a low much before 2010. The fair value on the [Standard & Poor's 500 index] is about 1025 [versus 910 late last week].
This was not only a monetary event, but it coincided with the first truly global bubble in all assets. You had inflated housing in almost every country in the world, except for Japan and Germany. You had overpriced stocks in every country in the world. And you had too much money and too-low interest rates. I was confident about very little, but I was confident that this would be different from anything we had seen before, and potentially more dangerous. It should have been treated with more care.
Is this crisis playing out the way you thought it would?
No. I threw in the towel three months ago, and wrote a quarterly letter saying I thought I was the bear around this joint.
But this is much worse than I thought. All the fundamentals are turning out worse than I thought they would. All the competencies of the senior people at the Fed, Treasury and [firms like Merrill Lynch and Lehman Brothers] have turned out to be much less than I had expected; that's very disappointing.
And, therefore, how could one's confidence that the senior people would get us through the storm be very high? Prior to three months ago, we were investing in emerging-market equities. Then we battened down the hatches, and I changed my view from avoid all risk except emerging markets to avoid all risk, period.
The terrible thing -- after all this pain -- is that the U.S. equity market is not even cheap. You would imagine that, given the amount of panic, that it would be. But it started from such a high level in 2000 that it still has not yet worked its way down to trend, although it is getting close. But the really bad news is that great bubbles in history always overcorrected. So although the fair value of the S&P today may be about 1025, typically bubbles overcorrect by quite a bit, possibly by 20%. That is very discouraging.
What about equities outside the U.S.?
Things are getting cheaper. We score the EAFE [the Europe, Australasia and Far East Index] as absolutely cheap, and it's offering a 7% real annual return over seven years. Emerging-market equities are a bit cheaper, and we see a 9.5% annual real return over the same period.
The problem, though, is that we have so much downside momentum, so many financial problems and so many interlocking relationships, that it is hard to imagine this crisis subsiding because stock prices are digging in their heels and approaching fair value.
What happens to hedge funds in the wake of this crisis?
A year ago, I said that half of all hedge funds would go out of business in five years, and I would certainly stand by that today. Unfortunately, like a lot of my dire projections, that may turn out to be conservative.
I also said that at least one major bank will fail. I got a lot of grief for that, and now it looks like I could have said at least a dozen major banks will fail.
As for the broad, typical opinion that we would muddle through this crisis, it just shows you what a dangerous optimistic bias the advisory business has built into it.
Do you think we will learn anything from all of this turmoil?
We will learn an enormous amount in a very short time, quite a bit in the medium term and absolutely nothing in the long term. That would be the historical precedent.
Let's talk about your asset allocations.
In a nutshell, we are as conservative as we can possibly get. One bet that has been very successful for us, touch wood, has been long high-quality, blue-chip stocks, particularly in the U.S., and short risky companies. We have been screaming against risk-taking for a long time, and in recent weeks, it has paid off enormously.
What about looking ahead in terms of asset allocation?
Going forward, you can think about slowly moving back into the cheapest pockets of global equities. So the next move that we make will be back to moderate neutral in emerging-market equities and small-cap international value. I can't say we are going to be in a great hurry, but that will be our next move. We had finished selling almost everything except emerging markets two years ago. We finished selling emerging-market equities three months ago.
But the next move will be buying, and we are encouraged that there are a few pockets that are cheap on an absolute basis. We are not encouraged that they will rally immediately. But we will be looking to buy the cheap pockets of global equities as our next move some time in the next several months.
Why emerging markets and small-cap international value?
Just value and because they have been hit the most. Emerging equities are down almost 50% since late last year, and some of small-cap international is down more than 40%. That big a drop has this wonderful effect of making these categories look cheap pretty fast. You can buy, but it doesn't mean it is their low, and I strongly suspect it is not.
The great trap is to buy too soon and, in the big move, to sell too soon. I've been saying since '98-'99 that my next major-league error will be buying too soon -- but we will not buy quite yet. But when we do, I suspect it will be too soon again.
What do you see ahead for commodities?
Commodities have a great long-term future, now that the long-term trend has shifted from falling commodity prices to rising commodity prices. Having said that, the next couple of years will be quite different. We are in a global slowdown, which I think will be worse than expected even today, and it will be longer than expected -- so this is not a healthy environment for commodities. Over a shorter horizon, I would be getting out of the way of commodities or I would be short commodities. I'm personally short oil; the firm is short copper.
What about some other trades?
I'm speaking for the asset-allocation unit at the firm. We have been substantially long the safe-haven currencies. We have been very long the yen and somewhat long the Swiss franc and short sterling, which is one of our favorite bets. We have been short the euro for three months, and slightly long the U.S. dollar. One of the paradoxes is, if the world is worse than people expect, the U.S. dollar will outperform.
Why are you shorting the euro?
It just ran too far. It went from 85 cents on the U.S. dollar to $1.60; it more or less doubled, which I don't think reflects reality. But the biggest lay-up of any idea over the last three or six months was shorting the pound.
The U.K. housing market was dreadfully overpriced. I felt nearly certain that the U.K. housing market would come back to a more normal multiple of family income, which is a very big decline of 40% if you did it in a hurry -- or you can sit back for many years and wait for income to catch up. But you should really count on that market coming down over a couple of years painfully.
Do you have any closing thoughts about how we got into this financial state?
I ask myself, "Why is it that several dozen people saw this crisis coming for years?" I described it as being like watching a train wreck in very slow motion. It seemed so inevitable and so merciless, and yet the bosses of Merrill Lynch and Citi and even [U.S. Treasury Secretary] Hank Paulson and [Fed Chairman Ben] Bernanke -- none of them seemed to see it coming.
I have a theory that people who find themselves running major-league companies are real organization-management types who focus on what they are doing this quarter or this annual budget. They are somewhat impatient, and focused on the present. Seeing these things requires more people with a historical perspective who are more thoughtful and more right-brained -- but we end up with an army of left-brained immediate doers.
So it's more or less guaranteed that every time we get an outlying, obscure event that has never happened before in history, they are always going to miss it. And the three or four-dozen-odd characters screaming about it are always going to be ignored.
If you look at the people who have been screaming about impending doom, and you added all of those several dozen people together, I don't suppose that collectively they could run a single firm without dragging it into bankruptcy in two weeks. They are just a different kind of person.
So we kept putting organization people -- people who can influence and persuade and cajole -- into top jobs that once-in-a-blue-moon take great creativity and historical insight. But they don't have those skills.
Where do you see all of this going?
I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don't. And I have no idea, really, how this will work out. I certainly wish it hadn't happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect.
Saturday, July 12, 2008
Where Do Stocks Go From Here?
YOU DON'T NEED ME to tell you, but it was an awful June, quarter, and first half of the year.
The 10.2% loss turned in by the Dow Jones Industrial Average during June was the third worst for that month in this index's history, eclipsed only by 1930 and 1896.
The Dow's loss during the second quarter is not ranked quite as close to the bottom as June's, but still low: Only 15 other years out of the last 112 have had second quarters with worse returns.
So where do we go from here? Is the stock market destined for much bigger losses, now that some of the major market averages are in official bear market territory?
For insight, I decided to turn to the top-performing stock-market-timing newsletters. I defined this group to be the 10 services with the best risk-adjusted market-timing returns over the last 15 years, according to the Hulbert Financial Digest.
As I often advise my subscribers to do when they engage in such an exercise themselves, it's important to define the group of top performers by focusing on performance over a long enough period to include both a bull and a bear market. That way you eliminate newsletters that are either bullish or bearish stopped clocks.
For example, we would not satisfy this requirement if we were to focus on market-timing performance over just the last 10 years. As measured by the Dow Jones Wilshire 5000 total-return index, the market has gained just 3.6% annualized over the last 10 years, far lower than the long-term average. Focusing on top timers over this 10-year period therefore runs the risk of having a bearish stopped clock appear at the top of the rankings.
That's why for this column I chose to focus on 15-year performance. Over that longer period, the Dow Jones Wilshire 5000 index produced a 9.3% annualized return, which is within shouting distance of the stock market's historical average.
I eliminated one of the 10 top performers because it is a purely mechanical model based on the calendar. Its good performance notwithstanding, its current posture tells us little about the market's prospects.
That leaves nine newsletters in this group of top timers. What follows is a brief synopsis of what each of them is currently saying about the stock market. (The newsletters are listed alphabetically.)
• Blue Chip Investor: Bullish. Editor Steven Check's valuation model, based on a comparison of the earnings yield of the stock market and the yield on corporate bonds, shows stocks currently to be in the "Very Undervalued." In his July issue, Check cautioned subscribers against giving too much credence to those who, in effect, say "this time is different." "Of course every decline has its own set of problems and concerns," Check writes. "Think back, however: We had strikingly similar problems in 1990. That was just before the first Iraq war. Oil prices were rising. The savings-and-loan crisis was in full swing and the real-estate market was struggling. The economy was officially in a recession, and the market fell 20% from July 16 to October 11. What happened next? Stocks gained 30% in 1991." Check's model portfolio is close to being fully invested in stocks.
• Bob Brinker's Marketimer: Bullish. In his most recent issue, which was published in early July, Editor Bob Brinker reported that his stock-market timing model remains in favorable territory. However, he cautioned that oil's price constitutes a "wild card." "In the event oil prices continue to rise, consumers and the stock market will be held hostage to the cost of energy. This would provide a strong headwind against the economic recovery process. If oil prices stabilize or decline from current levels, we believe stock prices can make progress into 2009." Brinker is recommending that subscribers' stock portfolios be fully invested.
• Chartist. Bearish. Editor Dan Sullivan turned bearish on the stock market in mid-January. Earlier this week, Sullivan wrote to his subscribers: "The economic news continues to paint a bleak picture with unemployment creeping higher, the housing market still weakening and inflation around the globe skyrocketing… [A] positive note is that when things look the bleakest the future returns are the brightest. At some point we are going to have another excellent buying opportunity. But for now we continue to recommend 100% money market funds."
• Growth Fund Guide. Bearish. Editor Walter Rouleau believes that the investment markets over the next several years will be dominated by a trend away from financial assets such as stocks and toward inflation hedges such as gold and other hard assets. "While we, nor anyone else, can tell you exactly where the gold market or the S&P 500 are in their super bull and super bear markets, our analysis suggests these trends could last for years. One possible target date we have repeated several times…is 2012 for a low in the S&P 500." Rouleau's model portfolios currently have an average equity allocation that is 14% short.
• Investor's Guide to Closed-End Funds: Bullish. Editor Thomas Herzfeld's "U.S. Equity Funds" model portfolio is around 92% invested.
• No-Load Fund Investor: Neutral to moderately bullish. Editor Mark Salzinger's so-called "Wealth Builder" portfolio, his letter's most aggressive, currently allocates 70% to U.S. equities and another 15% to international stocks.
• Timer Digest: Neutral to moderately bearish. Editor Jim Schmidt bases this newsletter's market-timing model on a consensus of the top market timers. His consensus of the top 10 based on performance over the last 52 weeks is neutral, with four bulls, four bears, and two neutral. His consensus of the top 10 for performance over the last two years is bearish, with two bulls, seven bears, and one neutral. The newsletter's model portfolios currently are about 64% invested in stocks, on average.
• Vantage Point: Bearish. Editor John Harris writes that "Until the price of energy levels off, inflation will be a threat and the Fed will have some tough monetary policy challenges to weigh. The long-term moving averages, which define the long-term trend, are bearish for the major averages. Risk levels are such that a defensive 50% to 67% cash."
• Vickers Weekly Insider Report. Bullish. The ratio of insider sales to insider purchases remains well below historical norms, which is a bullish omen, according to this newsletter. The services' two model portfolio are, on average, about 87% invested in U.S. stocks.
The picture is mixed, to be sure. Just four of these nine top timers are bullish, while four more are bearish and the ninth classified as neutral to moderately bullish. The average equity allocation among all nine is 60%.
The moral of the story, if it were to end here, it would be to be only moderately bullish at best.
But the story doesn't end here. Contrast the 60% average recommended equity allocation among the top timers with the comparable average among the 10 market-timing newsletters with the very worst records over the last 15 years. Those worst timers currently are 2% short the market, on average, or 62 percentage points less than the average of the top timers.
That is a bullish contrast. It means that to bet that the stock market will decline from here, you have to bet that the timers with the worst records over the last 15 years will be more right than those with the best records.
Anything can happen, of course. And, indeed, throughout the decline that began last fall, the best performers have been more bullish than their poorer-performing brethren. So, at least in recent months, the profitable bet has been the one that has gone against the top performers.
Still, successful investing requires a disciplined paying attention to the odds. And the odds favor the past's winners when, as I have in this column, measured performance over a long-enough period that winning and losing is unlikely to have been caused by mere luck alone.
The bottom line? The average top-performing market-timing letter has pulled a few chips off the table. But he remains far more bullish than the timers with the worst records.
The 10.2% loss turned in by the Dow Jones Industrial Average during June was the third worst for that month in this index's history, eclipsed only by 1930 and 1896.
The Dow's loss during the second quarter is not ranked quite as close to the bottom as June's, but still low: Only 15 other years out of the last 112 have had second quarters with worse returns.
So where do we go from here? Is the stock market destined for much bigger losses, now that some of the major market averages are in official bear market territory?
For insight, I decided to turn to the top-performing stock-market-timing newsletters. I defined this group to be the 10 services with the best risk-adjusted market-timing returns over the last 15 years, according to the Hulbert Financial Digest.
As I often advise my subscribers to do when they engage in such an exercise themselves, it's important to define the group of top performers by focusing on performance over a long enough period to include both a bull and a bear market. That way you eliminate newsletters that are either bullish or bearish stopped clocks.
For example, we would not satisfy this requirement if we were to focus on market-timing performance over just the last 10 years. As measured by the Dow Jones Wilshire 5000 total-return index, the market has gained just 3.6% annualized over the last 10 years, far lower than the long-term average. Focusing on top timers over this 10-year period therefore runs the risk of having a bearish stopped clock appear at the top of the rankings.
That's why for this column I chose to focus on 15-year performance. Over that longer period, the Dow Jones Wilshire 5000 index produced a 9.3% annualized return, which is within shouting distance of the stock market's historical average.
I eliminated one of the 10 top performers because it is a purely mechanical model based on the calendar. Its good performance notwithstanding, its current posture tells us little about the market's prospects.
That leaves nine newsletters in this group of top timers. What follows is a brief synopsis of what each of them is currently saying about the stock market. (The newsletters are listed alphabetically.)
• Blue Chip Investor: Bullish. Editor Steven Check's valuation model, based on a comparison of the earnings yield of the stock market and the yield on corporate bonds, shows stocks currently to be in the "Very Undervalued." In his July issue, Check cautioned subscribers against giving too much credence to those who, in effect, say "this time is different." "Of course every decline has its own set of problems and concerns," Check writes. "Think back, however: We had strikingly similar problems in 1990. That was just before the first Iraq war. Oil prices were rising. The savings-and-loan crisis was in full swing and the real-estate market was struggling. The economy was officially in a recession, and the market fell 20% from July 16 to October 11. What happened next? Stocks gained 30% in 1991." Check's model portfolio is close to being fully invested in stocks.
• Bob Brinker's Marketimer: Bullish. In his most recent issue, which was published in early July, Editor Bob Brinker reported that his stock-market timing model remains in favorable territory. However, he cautioned that oil's price constitutes a "wild card." "In the event oil prices continue to rise, consumers and the stock market will be held hostage to the cost of energy. This would provide a strong headwind against the economic recovery process. If oil prices stabilize or decline from current levels, we believe stock prices can make progress into 2009." Brinker is recommending that subscribers' stock portfolios be fully invested.
• Chartist. Bearish. Editor Dan Sullivan turned bearish on the stock market in mid-January. Earlier this week, Sullivan wrote to his subscribers: "The economic news continues to paint a bleak picture with unemployment creeping higher, the housing market still weakening and inflation around the globe skyrocketing… [A] positive note is that when things look the bleakest the future returns are the brightest. At some point we are going to have another excellent buying opportunity. But for now we continue to recommend 100% money market funds."
• Growth Fund Guide. Bearish. Editor Walter Rouleau believes that the investment markets over the next several years will be dominated by a trend away from financial assets such as stocks and toward inflation hedges such as gold and other hard assets. "While we, nor anyone else, can tell you exactly where the gold market or the S&P 500 are in their super bull and super bear markets, our analysis suggests these trends could last for years. One possible target date we have repeated several times…is 2012 for a low in the S&P 500." Rouleau's model portfolios currently have an average equity allocation that is 14% short.
• Investor's Guide to Closed-End Funds: Bullish. Editor Thomas Herzfeld's "U.S. Equity Funds" model portfolio is around 92% invested.
• No-Load Fund Investor: Neutral to moderately bullish. Editor Mark Salzinger's so-called "Wealth Builder" portfolio, his letter's most aggressive, currently allocates 70% to U.S. equities and another 15% to international stocks.
• Timer Digest: Neutral to moderately bearish. Editor Jim Schmidt bases this newsletter's market-timing model on a consensus of the top market timers. His consensus of the top 10 based on performance over the last 52 weeks is neutral, with four bulls, four bears, and two neutral. His consensus of the top 10 for performance over the last two years is bearish, with two bulls, seven bears, and one neutral. The newsletter's model portfolios currently are about 64% invested in stocks, on average.
• Vantage Point: Bearish. Editor John Harris writes that "Until the price of energy levels off, inflation will be a threat and the Fed will have some tough monetary policy challenges to weigh. The long-term moving averages, which define the long-term trend, are bearish for the major averages. Risk levels are such that a defensive 50% to 67% cash."
• Vickers Weekly Insider Report. Bullish. The ratio of insider sales to insider purchases remains well below historical norms, which is a bullish omen, according to this newsletter. The services' two model portfolio are, on average, about 87% invested in U.S. stocks.
The picture is mixed, to be sure. Just four of these nine top timers are bullish, while four more are bearish and the ninth classified as neutral to moderately bullish. The average equity allocation among all nine is 60%.
The moral of the story, if it were to end here, it would be to be only moderately bullish at best.
But the story doesn't end here. Contrast the 60% average recommended equity allocation among the top timers with the comparable average among the 10 market-timing newsletters with the very worst records over the last 15 years. Those worst timers currently are 2% short the market, on average, or 62 percentage points less than the average of the top timers.
That is a bullish contrast. It means that to bet that the stock market will decline from here, you have to bet that the timers with the worst records over the last 15 years will be more right than those with the best records.
Anything can happen, of course. And, indeed, throughout the decline that began last fall, the best performers have been more bullish than their poorer-performing brethren. So, at least in recent months, the profitable bet has been the one that has gone against the top performers.
Still, successful investing requires a disciplined paying attention to the odds. And the odds favor the past's winners when, as I have in this column, measured performance over a long-enough period that winning and losing is unlikely to have been caused by mere luck alone.
The bottom line? The average top-performing market-timing letter has pulled a few chips off the table. But he remains far more bullish than the timers with the worst records.
Some Relief Possible Following Painful Week
PLUCKY BOUNCE late Friday lifted the Dow Jones Industrial Average back above 11,000 after it had plummeted below that threshold for the first time in two years. But is it a sign the fever gripping the stock market has finally broken?
Investors are praying that the thermometer measuring the market's misery surely must have peaked: The Standard & Poor's 500 fell into bear-market territory last week and had skidded almost 22% from its peak. It has gone 36 days without as much as a reflexive 2% bounce. The discomfort also has spread, with the bear mauling nearly 60% of 84 stock markets around the globe (and sparing only the oil-rich states), according to Bespoke Investment Group. The 6.67 billion shares of New York Stock Exchange stocks that traded Friday was the third highest ever.
If that doesn't say anguish, consider this: Each time the stock market eked out an advance, it tumbled by a bigger margin the next day, and this particularly blood-curdling species of "Bounce Interruptus" was spotted 16 times over the past 50-day period -- the most in 70 years. "If the market were a book, its title would probably be The Little Engine That Couldn't," says Bespoke analyst Justin Walters. He adds that the deepening slide has led him to anticipate a short-term rally of 5% to 10% within the longer-term decline.
The S&P 500 and the Nasdaq Composite Index both fell for the sixth straight week, while the Dow's losing streak stretched to four. The Dow ended the week down 188, or 1.7%, to 11,101, after falling as low as 10,978 Friday. The S&P 500 lost 23, or 1.9%, to 1239, its lowest finish since July 18, 2006. The Nasdaq gave up six, or 0.3%, to 2239. Only the Russell 2000 snapped its five-week losing streak and gained nine, or 1.4%, to 675.
The stock market increasingly is oversold, with traders now flinching even before the connected blow of bad news. Stocks careened up and down with the fluctuating prospects for mortgage giants Fannie Mae (ticker: FNM) and Freddie Mac (FRE) -- see "Fannie and Freddie" -- while muted forecasts from Alcoa (AA) and Marriott (MAR) drove home the grim reality.
By Friday, the casualty list was staggering: More than 85% of S&P 500 stocks have slumped below their 50-day averages -- compared with 96% in the consumer discretionary sector, 97% in financials, 87% in technology and even 79% in the energy group. These take the market closer to at least a temporary rally.
What might provide the cue? "The market wants clarity from financials, and it wants to see first that financials have bottomed," says Peter Green, publisher of GreenScreen, which takes a broad overview of the equity markets. A decisive 8% to 10% rally by the Financial Select SPDR (XLF), especially in the face of bad news, would constitute a clear sign the group has bottomed. In fact, the covering of short bets on Friday -- before bellwethers like JPMorgan Chase (JPM) and Citigroup (C) report earnings this week -- showed some traders bracing for this possibility.
But why not a more lasting rally? For all the pain, one wonders if the market has seen the kind of unconditional surrender that marks an enduring turn. For instance, anxiety as measured by the VIX volatility index flirted Friday with 29, almost but not quite near peaks above 30 seen in January and in March. Also, VIX futures suggest traders expect this fear gauge to quickly relax to about 25 by August -- and for stocks to stabilize soon. Meanwhile, the fundamental picture remains bleak, with nearly every yardstick of consumer wealth -- jobs, real estate, stock portfolio, access to credit -- heading in the wrong direction, with no turn in sight.
Investors are praying that the thermometer measuring the market's misery surely must have peaked: The Standard & Poor's 500 fell into bear-market territory last week and had skidded almost 22% from its peak. It has gone 36 days without as much as a reflexive 2% bounce. The discomfort also has spread, with the bear mauling nearly 60% of 84 stock markets around the globe (and sparing only the oil-rich states), according to Bespoke Investment Group. The 6.67 billion shares of New York Stock Exchange stocks that traded Friday was the third highest ever.
If that doesn't say anguish, consider this: Each time the stock market eked out an advance, it tumbled by a bigger margin the next day, and this particularly blood-curdling species of "Bounce Interruptus" was spotted 16 times over the past 50-day period -- the most in 70 years. "If the market were a book, its title would probably be The Little Engine That Couldn't," says Bespoke analyst Justin Walters. He adds that the deepening slide has led him to anticipate a short-term rally of 5% to 10% within the longer-term decline.
The S&P 500 and the Nasdaq Composite Index both fell for the sixth straight week, while the Dow's losing streak stretched to four. The Dow ended the week down 188, or 1.7%, to 11,101, after falling as low as 10,978 Friday. The S&P 500 lost 23, or 1.9%, to 1239, its lowest finish since July 18, 2006. The Nasdaq gave up six, or 0.3%, to 2239. Only the Russell 2000 snapped its five-week losing streak and gained nine, or 1.4%, to 675.
The stock market increasingly is oversold, with traders now flinching even before the connected blow of bad news. Stocks careened up and down with the fluctuating prospects for mortgage giants Fannie Mae (ticker: FNM) and Freddie Mac (FRE) -- see "Fannie and Freddie" -- while muted forecasts from Alcoa (AA) and Marriott (MAR) drove home the grim reality.
By Friday, the casualty list was staggering: More than 85% of S&P 500 stocks have slumped below their 50-day averages -- compared with 96% in the consumer discretionary sector, 97% in financials, 87% in technology and even 79% in the energy group. These take the market closer to at least a temporary rally.
What might provide the cue? "The market wants clarity from financials, and it wants to see first that financials have bottomed," says Peter Green, publisher of GreenScreen, which takes a broad overview of the equity markets. A decisive 8% to 10% rally by the Financial Select SPDR (XLF), especially in the face of bad news, would constitute a clear sign the group has bottomed. In fact, the covering of short bets on Friday -- before bellwethers like JPMorgan Chase (JPM) and Citigroup (C) report earnings this week -- showed some traders bracing for this possibility.
But why not a more lasting rally? For all the pain, one wonders if the market has seen the kind of unconditional surrender that marks an enduring turn. For instance, anxiety as measured by the VIX volatility index flirted Friday with 29, almost but not quite near peaks above 30 seen in January and in March. Also, VIX futures suggest traders expect this fear gauge to quickly relax to about 25 by August -- and for stocks to stabilize soon. Meanwhile, the fundamental picture remains bleak, with nearly every yardstick of consumer wealth -- jobs, real estate, stock portfolio, access to credit -- heading in the wrong direction, with no turn in sight.
Saturday, July 5, 2008
The Bear is back
IT'S OFFICIAL: THE BEAR HAS ARRIVED. The Dow Jones Industrial Average last week qualified for the widely accepted definition of a bear market of a 20% drop from the highs. The good news is that once the decline reaches that arbitrary 20% mark, based on history, the market has suffered most of its losses. The bad news is that the decline typically drags on for some time, and time may be the worst enemy. Investors may initially try to grab erstwhile highfliers that have crashed and burned but rarely regain their former status. And as the decline wears down investors' psyches, they tend to bail out at the market's nadir, when things look bleakest -- and when the greatest opportunities present themselves.
The post-1940 average bear market (as defined by the Standard & Poor's 500 index) produced a decline of 30.4% from a peak that took 386 days to reach its trough, according to data compiled by Bespoke Investment Group. By the time the market was down the requisite 20%, the average bear market was 74% completed. Based on those averages, the bear market would have another 118 days to run and would face losses of another 14% from current levels.
Rarely does the market get a short, sharp shock, as in 1987, when the bear market lasted just 101 days -- with most of the total damage of 22.51% done on Black Monday, Oct. 19. The longest march downward was the 1973-74 decline, which took 630 days and sliced 48.2% off the S&P.
BUT BESPOKE DEFINES two separate bear markets following the bursting of the technology bubble -- an initial 36.77% drop from March 2000 to September 2001, punctuated by a brief, post-9/11 recovery until the next decline of January-July 2002 of 31.97%. In the minds of most investors who suffered through that period, it was three long years of false starts and frustration until the recovery really got under way, in March 2003.
Signs of bear-market fatigue already are becoming evident. Investors have yanked more than $80.4 billion from domestic equity funds in the past 12 months, according to Investment Company Institute data parsed by Bianco Research. Overseas funds drew $75.7 billion from American mutual-fund investors, leaving a net equity fund outflow of $4.7 billion.
What's more, there have been few hiding places other than commodities, observes Jack A. Ablin, chief investment officer at Harris Private Bank. Even Warren Buffett isn't immune, with Berkshire Hathaway (ticker: BRKA) off 21% from its peak.
The foreign stocks Americans have been flocking to lost nearly as much as U.S. equities, despite help from the falling dollar. The MSCI EAFE, the benchmark for developed markets outside the U.S., suffered a negative 10.58% total return in the first half, according to Bianco Research, compared with a negative 11.91% for the S&P. Emerging markets were slightly worse than the EAFE, with a negative 11.64% return, according to MSCI's measure. Even the once hotter-than-hot China market has gone into a deep-freeze; the iShares FTSE/Xinhua exchange-traded fund (FXI), a popular way for Americans to play that market, is down 43% from its high last October. Bonds other than Treasuries lost money in the first half, especially corporates, junk bonds and municipals. Meanwhile, the Dow Jones-AIG Commodity Index returned 27.23% in the first six months of 2008.
Yet there's little prospect for relief in the near term, especially as the second-quarter earnings reporting season is about to kick off. Despite its near 20% retreat, the S&P 500 remains too high relative to prospective earnings, says Ablin. Even though analysts have slashed their 2008 earnings forecasts to just 5.8% gains from 15% at the beginning of the year, he thinks they're still too optimistic. Based on his estimated profit gains this year of 3%, and an earnings yield (the inverse of the price-earnings multiple) equal to triple-B corporate bonds' 6.8%, Ablin's model indicates the S&P should shed another 5%.
But others see the current decline as another phase in a longer-term secular bear market. "We are still in the super bear of 2000," asserts Jeremy Grantham, chairman of money manager GMO. In a bear market, stocks fall back to, or below, their long-term trend line. But after the great bull market from 1982 to 2000, equities never flushed out their excesses "because of the Greenspan-inspired chain of bubbles, from growth stocks to real estate to commodities," referring to former Federal Reserve Chairman Alan Greenspan.
"Great bear markets always take their time, and the most likely end is 2010," Grantham continues. If the S&P 500 were to fall to 1100 in 2010, that would be about a 13% decline from here, about 1263, and would put the index back on its long-term trend line. He adds: "Chances are we will overshoot on the downside. We always do. We will be lucky if it is 1100."
Like Tolstoy's unhappy families, every bear market is different, observes John De-Gulis, a portfolio manager at the Sound Shore Fund. Citing data from Ned Davis Research, he notes that the S&P has been down an average of 4.83% six months after the start of a recession and up 3.15% 12 months on. "Of course, we haven't entered the recession officially yet," he adds, which may happen late this year or early 2009. But, he adds, "the two recessions where the market was down big time 12 months after the recession started were '73, minus 27%, and '81, down 18% -- both periods when oil prices spiked."
What seems consistent among bear markets is the tendency of investors to despair in their later stages, dumping everything indiscriminately. For instance, Bespoke Investment found that in the early stages of a decline, from the peak to the down-20% bear print, the traditional defensive redoubts -- consumer staples and health care -- hold up relatively well, shedding about 4% each. But after the bear market becomes "official" at minus 20%, the two actually do slightly worse through the rest of the decline -- down 11.6% for consumer staples and down 13.9% for health care, versus minus 10% for the S&P at that stage, as investors tend to dump anything and everything.
There's no surprise about what did best during past bear markets tracked by Bespoke. During the first phase on the way to the minus-20% mark, gold prices were virtually unchanged while oil was up 18.7%. Bond yields, as measured by the 10-year Treasury, actually were up by about 7% in the early phase, which would result in negative returns. But after the S&P was down 20%, gold gained an average of 6.6%, oil was up 19%, and bond yields were down 0.5% for a positive return.
WHAT'S LESS CLEAR IS what will be the signal leader when a new bull phase starts. Rarely, however, is it the group that led the previous advance. Energy stocks, for instance, did not return to the lead position until the recent bull run, about a quarter century after their last heyday. After the dot-com bust, technology stocks did not take the lead in the subsequent bull market; indeed, the Nasdaq recovered only a bit more than half its decline from its bubble peak of 5048.
The late bull market was, of course, led by financial stocks -- on the way up as well as down. Critics charge that was because the Fed slashed rates too far, to 1% at their low, and kept them too low for too long. This effectively free money fueled the subprime mortgage bubble and bust, which reverberated throughout the credit markets and eventually led to the emergency rescue of Bear Stearns in March.
But after numerous declarations that the worst of the credit crisis is over, and with the latest round of "kitchen sink" write-downs of bad assets by banks and brokers, few pros at this point want to bottom-pick in financials. "I know what I don't want to own," says David Sowerby, portfolio manager of Loomis Sayles -- "toxic subprimes," which one day will be "great trades," but not yet.
Bank stocks are nowhere near as cheap as in the early '90s, contends Frederic Marks, president of Cheviot Value Management, which manages $236 million in separate accounts. For instance, Wells Fargo (WFC) had been cut in half by the fall of 1990 to just 75% of its book value. Today, Wells' shares trade for closer to 1.75 times book, and book values are less than certain, given the potential for write-downs. Wells traded in 1990 at about six to seven times its long-term earnings power (not that year's published earnings), compared with 12 times long-term earnings today.
Barron's Online Editor Randall W. Forsyth warns investors about the bear wear. Keep cash ready, he suggests. (July 5)
Despite the ongoing housing woes and credit strains, inflation has moved to the top of the Fed's worry list. So, too, with the stock market. "The critical variable lies with the [consumer-price index]. It's the biggest driver of the market multiple for the S&P 500," says Francois Trahan, strategist with ISI Group.
He adds that if gains in the CPI slacken in the second half, "then multiples start to expand. Some 80% looks great, like rents and wages, but 20% -- oil and food and import prices -- looks horrible. If commodities just level off, then the CPI will come down." On that score, the Economic Cycle Research Institute's Future Inflation Gauge, a leading indicator for the CPI, fell to a four-year low in June.
WITH CRUDE SOARING past $145 a barrel and prices at the gas pump well past $4 a gallon, investor and consumer psychology is the glummest in decades. So much so, in fact, that the market might be setting itself up for a short-term trading bounce, says Woody Dorsey, proprietor of Market Semiotics. It would be akin to the short-lived rebound from the March lows following the passing of the Bear Stearns phase of the credit crisis.
Marks of Cheviot, who says his composite portfolio of client accounts is up 4% in the past 12 months' 13% slide in the S&P, has had one-third in precious metals and other vehicles that benefit when the dollar or the market declines, one-third in cash, and one-third in strong U.S. companies not tied to the domestic economy. Two exceptions are Wal-Mart Stores (WMT), "which is one of our largest holdings a couple of years running because of our thesis that buyers will be more price conscious and will be more attracted than ever to this store." Another retailer Cheviot has been buying recently is Walgreen (WAG), says Marks, because "two-thirds of its revenues are from pharmacy sales, the company is enormously profitable with zero debt, and its shares are as cheap as they've been in well over a decade."
Down, but Not There Yet: Despite being down 8.2% in June and nearly 20% from its peak, the S&P 500 remains overvalued by 5% reckons Jack Ablin of Harris Private Bank, given 2008 earnings estimates that are "unrealistically" high.
BCA Research's Global Investment Strategy Weekly Bulletin advises subscribers to batten down the hatches to ride out the "perfect storm" resulting from spiking oil prices by reducing equities and boosting bonds, especially European securities. (The SPDR Lehman International Treasury Bond ETF [BWX] provides exposure to foreign government bonds.) "This latest oil surge is canceling out the impact of the Federal Reserve's policy easing, crippling economic growth and causing share prices to relapse," writes Chen Zhao, BCA's managing editor. It is no time for heroics, he adds.
The key to surviving bear markets is capital preservation, concludes GMO's Grantham. You want to "live to fight another day. You may see amazingly cheap asset opportunities in the next couple of years as distressed pricing might become more commonplace. It would be nice to have the money to take advantage."
The post-1940 average bear market (as defined by the Standard & Poor's 500 index) produced a decline of 30.4% from a peak that took 386 days to reach its trough, according to data compiled by Bespoke Investment Group. By the time the market was down the requisite 20%, the average bear market was 74% completed. Based on those averages, the bear market would have another 118 days to run and would face losses of another 14% from current levels.
Rarely does the market get a short, sharp shock, as in 1987, when the bear market lasted just 101 days -- with most of the total damage of 22.51% done on Black Monday, Oct. 19. The longest march downward was the 1973-74 decline, which took 630 days and sliced 48.2% off the S&P.
BUT BESPOKE DEFINES two separate bear markets following the bursting of the technology bubble -- an initial 36.77% drop from March 2000 to September 2001, punctuated by a brief, post-9/11 recovery until the next decline of January-July 2002 of 31.97%. In the minds of most investors who suffered through that period, it was three long years of false starts and frustration until the recovery really got under way, in March 2003.
Signs of bear-market fatigue already are becoming evident. Investors have yanked more than $80.4 billion from domestic equity funds in the past 12 months, according to Investment Company Institute data parsed by Bianco Research. Overseas funds drew $75.7 billion from American mutual-fund investors, leaving a net equity fund outflow of $4.7 billion.
What's more, there have been few hiding places other than commodities, observes Jack A. Ablin, chief investment officer at Harris Private Bank. Even Warren Buffett isn't immune, with Berkshire Hathaway (ticker: BRKA) off 21% from its peak.
The foreign stocks Americans have been flocking to lost nearly as much as U.S. equities, despite help from the falling dollar. The MSCI EAFE, the benchmark for developed markets outside the U.S., suffered a negative 10.58% total return in the first half, according to Bianco Research, compared with a negative 11.91% for the S&P. Emerging markets were slightly worse than the EAFE, with a negative 11.64% return, according to MSCI's measure. Even the once hotter-than-hot China market has gone into a deep-freeze; the iShares FTSE/Xinhua exchange-traded fund (FXI), a popular way for Americans to play that market, is down 43% from its high last October. Bonds other than Treasuries lost money in the first half, especially corporates, junk bonds and municipals. Meanwhile, the Dow Jones-AIG Commodity Index returned 27.23% in the first six months of 2008.
Yet there's little prospect for relief in the near term, especially as the second-quarter earnings reporting season is about to kick off. Despite its near 20% retreat, the S&P 500 remains too high relative to prospective earnings, says Ablin. Even though analysts have slashed their 2008 earnings forecasts to just 5.8% gains from 15% at the beginning of the year, he thinks they're still too optimistic. Based on his estimated profit gains this year of 3%, and an earnings yield (the inverse of the price-earnings multiple) equal to triple-B corporate bonds' 6.8%, Ablin's model indicates the S&P should shed another 5%.
But others see the current decline as another phase in a longer-term secular bear market. "We are still in the super bear of 2000," asserts Jeremy Grantham, chairman of money manager GMO. In a bear market, stocks fall back to, or below, their long-term trend line. But after the great bull market from 1982 to 2000, equities never flushed out their excesses "because of the Greenspan-inspired chain of bubbles, from growth stocks to real estate to commodities," referring to former Federal Reserve Chairman Alan Greenspan.
"Great bear markets always take their time, and the most likely end is 2010," Grantham continues. If the S&P 500 were to fall to 1100 in 2010, that would be about a 13% decline from here, about 1263, and would put the index back on its long-term trend line. He adds: "Chances are we will overshoot on the downside. We always do. We will be lucky if it is 1100."
Like Tolstoy's unhappy families, every bear market is different, observes John De-Gulis, a portfolio manager at the Sound Shore Fund. Citing data from Ned Davis Research, he notes that the S&P has been down an average of 4.83% six months after the start of a recession and up 3.15% 12 months on. "Of course, we haven't entered the recession officially yet," he adds, which may happen late this year or early 2009. But, he adds, "the two recessions where the market was down big time 12 months after the recession started were '73, minus 27%, and '81, down 18% -- both periods when oil prices spiked."
What seems consistent among bear markets is the tendency of investors to despair in their later stages, dumping everything indiscriminately. For instance, Bespoke Investment found that in the early stages of a decline, from the peak to the down-20% bear print, the traditional defensive redoubts -- consumer staples and health care -- hold up relatively well, shedding about 4% each. But after the bear market becomes "official" at minus 20%, the two actually do slightly worse through the rest of the decline -- down 11.6% for consumer staples and down 13.9% for health care, versus minus 10% for the S&P at that stage, as investors tend to dump anything and everything.
There's no surprise about what did best during past bear markets tracked by Bespoke. During the first phase on the way to the minus-20% mark, gold prices were virtually unchanged while oil was up 18.7%. Bond yields, as measured by the 10-year Treasury, actually were up by about 7% in the early phase, which would result in negative returns. But after the S&P was down 20%, gold gained an average of 6.6%, oil was up 19%, and bond yields were down 0.5% for a positive return.
WHAT'S LESS CLEAR IS what will be the signal leader when a new bull phase starts. Rarely, however, is it the group that led the previous advance. Energy stocks, for instance, did not return to the lead position until the recent bull run, about a quarter century after their last heyday. After the dot-com bust, technology stocks did not take the lead in the subsequent bull market; indeed, the Nasdaq recovered only a bit more than half its decline from its bubble peak of 5048.
The late bull market was, of course, led by financial stocks -- on the way up as well as down. Critics charge that was because the Fed slashed rates too far, to 1% at their low, and kept them too low for too long. This effectively free money fueled the subprime mortgage bubble and bust, which reverberated throughout the credit markets and eventually led to the emergency rescue of Bear Stearns in March.
But after numerous declarations that the worst of the credit crisis is over, and with the latest round of "kitchen sink" write-downs of bad assets by banks and brokers, few pros at this point want to bottom-pick in financials. "I know what I don't want to own," says David Sowerby, portfolio manager of Loomis Sayles -- "toxic subprimes," which one day will be "great trades," but not yet.
Bank stocks are nowhere near as cheap as in the early '90s, contends Frederic Marks, president of Cheviot Value Management, which manages $236 million in separate accounts. For instance, Wells Fargo (WFC) had been cut in half by the fall of 1990 to just 75% of its book value. Today, Wells' shares trade for closer to 1.75 times book, and book values are less than certain, given the potential for write-downs. Wells traded in 1990 at about six to seven times its long-term earnings power (not that year's published earnings), compared with 12 times long-term earnings today.
Barron's Online Editor Randall W. Forsyth warns investors about the bear wear. Keep cash ready, he suggests. (July 5)
Despite the ongoing housing woes and credit strains, inflation has moved to the top of the Fed's worry list. So, too, with the stock market. "The critical variable lies with the [consumer-price index]. It's the biggest driver of the market multiple for the S&P 500," says Francois Trahan, strategist with ISI Group.
He adds that if gains in the CPI slacken in the second half, "then multiples start to expand. Some 80% looks great, like rents and wages, but 20% -- oil and food and import prices -- looks horrible. If commodities just level off, then the CPI will come down." On that score, the Economic Cycle Research Institute's Future Inflation Gauge, a leading indicator for the CPI, fell to a four-year low in June.
WITH CRUDE SOARING past $145 a barrel and prices at the gas pump well past $4 a gallon, investor and consumer psychology is the glummest in decades. So much so, in fact, that the market might be setting itself up for a short-term trading bounce, says Woody Dorsey, proprietor of Market Semiotics. It would be akin to the short-lived rebound from the March lows following the passing of the Bear Stearns phase of the credit crisis.
Marks of Cheviot, who says his composite portfolio of client accounts is up 4% in the past 12 months' 13% slide in the S&P, has had one-third in precious metals and other vehicles that benefit when the dollar or the market declines, one-third in cash, and one-third in strong U.S. companies not tied to the domestic economy. Two exceptions are Wal-Mart Stores (WMT), "which is one of our largest holdings a couple of years running because of our thesis that buyers will be more price conscious and will be more attracted than ever to this store." Another retailer Cheviot has been buying recently is Walgreen (WAG), says Marks, because "two-thirds of its revenues are from pharmacy sales, the company is enormously profitable with zero debt, and its shares are as cheap as they've been in well over a decade."
Down, but Not There Yet: Despite being down 8.2% in June and nearly 20% from its peak, the S&P 500 remains overvalued by 5% reckons Jack Ablin of Harris Private Bank, given 2008 earnings estimates that are "unrealistically" high.
BCA Research's Global Investment Strategy Weekly Bulletin advises subscribers to batten down the hatches to ride out the "perfect storm" resulting from spiking oil prices by reducing equities and boosting bonds, especially European securities. (The SPDR Lehman International Treasury Bond ETF [BWX] provides exposure to foreign government bonds.) "This latest oil surge is canceling out the impact of the Federal Reserve's policy easing, crippling economic growth and causing share prices to relapse," writes Chen Zhao, BCA's managing editor. It is no time for heroics, he adds.
The key to surviving bear markets is capital preservation, concludes GMO's Grantham. You want to "live to fight another day. You may see amazingly cheap asset opportunities in the next couple of years as distressed pricing might become more commonplace. It would be nice to have the money to take advantage."
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