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March, 2009
A MARKET COMMENTARY
From The Desk of William Potter, Chairman
ROSEBUD -Citizen Kane – Power Seeking - The Simplicity of the Past
The Present
Warren Buffet says in his latest
newsletter economic activity “has fallen off a cliff” and is not coming back
soon. Stock market declines are destroying $23 trillion in wealth. Auto production is down two thirds since
2005. Investment in developing countries has dropped from $929 billion in 2007
to $165 billion this year. In
China
,
20 million migrant laborers have lost their jobs. Pension systems are fragile
and household balance sheets are a wreck. In the
United States
, the real economy is
facing challenges not witnessed in a generation or more. The perfect storm
started with a downturn in the housing market. It then generated a collapse in
the securitized product market and over a period of months led to what can be
only termed the complete collapse of the modern banking model. This in turn has
led to the credit taps being turned off to the wider economy. The fall out from
all this financial market activity is that consumers and households have
naturally responded to what they have seen around them. After decades of
over-consumption the prospect of foreclosure and job loss has seen a dramatic
“buyers strike.” At the same time, corporate
America
has been forced to take
evasive action and reduce production. We are now at the point where the
financial storm, consumer strike, firm downsizing, and the asset market
re-price overlap. The only thing forecasters now worry about is how deep and
how long a recession will last and how offsetting the fiscal and monetary
responses. Inflation is likely to
collapse as the output gap grows
and lower oil prices feed through. Inflation expectations already reflect this
fact with ten year U.S breakevens recently bottoming at 0%. The question the market currently faces is
how much deflation will we witness and how long will it last? Government
policies will likely play an important role in determining this. The tight
financial conditions and weakening economic fundamentals have resulted in sharp
rate cuts from the Federal Reserve. Efforts to directly support the tightening
lending standards so far more than offset declining U.S Treasury yields as a
stimulus for the economy. The Federal Reserve has effectively adopted a zero
interest rate policy similar to that of Japan in the 1990s and there is so
little fire power left in terms of traditional monetary easing; the focus has
how turned to quantitative easing. The effectiveness of unorthodox policy
initiatives is now the key in avoiding deflation.
Poll of Forecasters – March average – source The Economist 3/7
| |
| |
| United States |
| Euro Area |
| Canada |
| Australia |
|
| Real GDP % Change |
| 2009 | 2010 |
| (2.2) | 1.9 |
| (2.4) | 0.7 |
| (1.5) | 1.7 |
| 0.3 | 1.6 |
|
| Consumer Price % Increase |
| 2009 | 2010 |
| (0.6) | 1.5 |
| 0.6 | 1.3 |
| 0.5 | 1.9 |
| 2.1 | 12.2 |
|
| Interest 10yr |
| Gov't Bond |
| 3.01 |
| 3.12 |
| 3.19 |
| 4.35 |
|
A Discussion - A History - A Debate
The ongoing credit contraction was caused by excess credit, overleveraging and ridiculous consumption and now the cures being offered are more debt, bigger deficits and even more consumption. It is inevitable that interest rates will go up in the next twenty-four to thirty-six months and that could wipe out a huge amount of capital in the bond market.
During the Great Depression, the Dow Jones Industrial average dropped by 17% in 1929, 34% in 1930, 53% in 1931 and 23% in 1932. Altogether, the Dow plunged 89% per cent from its 1929 peak to its 1932 trough. Following the election of FDR the stock market soared by 67% in 1933. The problem was the market gave up those gains and more from 1938 to 1942 not recovering until after WWII. Investors have been drawing parallels between the Obama election and the Roosevelt election and hoping the equity markets will recover as in 1933. There may be similarities; Mr. Roosevelt too, was elected when the economy was sliding into a long and painful recession with failing banks, bearish stock markets, home foreclosures, and rising unemployment. The recent selling panic in the equity markets is frequently being described as the worst crisis since the Great Depression. However, this hype does not imply that the economic outlook is that of the 1930’s. One of the biggest reasons for the Great Depression was the failure or inability of the money supply to expand in line with the need for this money. In the current situation, however, various central banks and government are throwing trillions of dollars into the monetary system and all bank deposits have been guaranteed. Government authorities, following the economics of Keynes, have made it clear if necessary they will print money until we run out of paper. Most analysts are of the view at this stage a 1929 style economic depression is unlikely. In 1929, the US economy contracted by 46% unemployment went over 25% and millions of Americans lost their savings as 10,000 banks failed. This time the US economy has barely shrunk, the unemployment rate at 8% is not even close to the 1982 recession and no one has lost money due to a bank run in the U.S. The current circumstances do not suggest a prolonged economic depression and are different.
Fiscal stimulus is the answer to the malaise in economies and markets. It will, however, need to be sustained over the medium term if the US and the world at large are to avoid the Japanese 90’s experience of a prolonged deflationary rut. As the private sector moves to pare debt, even at zero interest rates, new savings and debt repayments enter the banking system but are not relent because of a dearth of borrowers. In the US private sector, demand for funds in the first quarter has plunged as it did in previous crisis such as the bursting of the technology bubble. The difference between the tech bubble of 2000 and today is that, previously, rising US home prices provided a cushion of wealth. Now this has collapsed along with other assets. The economy, as Nomura Research Institute Chief economist Richard Koo (“The Holy Grail of Macroeconomics” study of Japanese in the 90’s) has penned, falls into a “balance sheet recession.” Fiscal policy becomes the main economic tool to maintain demand as everybody pays down debt and monetary policy stops working. Eventually the private sector finishes its debt repayments which, over time, ends the “balance sheet recession” but a “phobia about leverage” develops and interest rates remain low and the economy does not rebound. The end of the “phobia” allows the economy to recover and monetary policy to act as a policy economic tool to contract fiscal deficits. If the deficits are not controlled, however, either another bubble develop or high interest rates destroy wealth.
Stocks or Bonds?
Benjamin Graham, the father of value investing and mentor of Warren Buffet would find most US stocks expensive today even after the S&P 500drop of 56% over the past 17 months. Graham measured equities against a decade of profits to smooth out distortions, a method that shows the S&P 500 trading at 13.2 times earnings. At the bottom of the three worst recessions since 1929 the average earnings ratio fell below 10 times. To reach that level, as of mid March 2009, the S&P 500would have to fall another 27 per cent. At the moment, the US stock market is torn between the reality; that the economy is contracting at an accelerating pace and the knowledge Obama is coming, with the cavalry.
Money supply as measured by M2 is growing at 22% annually today but when will the fiscal effect impact? When will the stimulus effect earnings and the market? How do we time the bottom? Barton Biggs, formerly chief global strategist for Morgan Stanley, in February has stated; “the market is very close to an important bottom”. He may be right; by some measures, US stocks are cheap. Profits as a percentage of the S&P index’s value increased according to Bloomberg to 6.96% above 10 year Treasuries, the largest advantage since 1962. This may justify investing in companies with strong balance sheets, good management and solid business models such as, Kellogg, Verizon IBM, Monsanto, Nestle and China Mobile.
If, however, Graham’s statistics may be right and the equity markets are still volatile with a bias downward then yield and safety are the mantra and bonds are king. In an era of falling prices a
penny earned is a penny earning money. If prices are declining 2% and treasuries earn 1% real purchasing power is 3% per annum less tax. The safest bonds, Treasury’s were great buys until October 08’ but with yields on ten year T-bonds below 3% there is not much for price improvement. The risk of a price decline, on the contrary, may be high if the Treasury is to fund big deficits. Investment grade corporate bonds with relatively short maturities, especially industrial and financial issues offer premium yields because of blind fear gripping the markets. Investment grade financial bonds offer yields from 7% to 14%. The safest financials are those entities in which the government has injected capital. The Federal Reserve is likely to dilute equity holders and cut preferred dividends for these issuers but unlikely to stiff senior bond holders since to do so could refreeze bond markets. Municipal bonds with relatively short maturities for the same reasons also look attractive with taxable and non-taxable yield differential at historic levels. Short dated government bond yields remain anchored to official rates while long-dated yields remain volatile. Security selection in a taxable or non-taxable environment, where the U.S. alone will borrow in excess of $1.75 trillion in fiscal 2009 and Western European counties will need another $ 1 trillion to cover their budget deficits and bank bailouts, is critical.
“The investment world has gone from under pricing risk to over pricing it.
This change has not been minor, the pendulum has covered an extraordinary arc.
A few years ago, it would have seemed unthinkable that yields like today could
have been obtained on good grade municipal or corporate bonds”…
Warren Buffett Newsweek 3/9/09
We may be entering an era where the simple fundamental analysis of the past may be a
precursor to establishing value. – Rosebud
William
Potter Bing
Garrido
Chairman Managing
Director, Fixed Income
Meredith
Portfolio Management
600
Lexington Avenue FL 29
New
York, NY 10022
Tel: 212-969-9292
800-944-4491
Fax: 212-247-3840
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