July 18, 2008
Bias: Market defensive
Overweight: Absolute Return Certificates of Deposits (Schwab Institutional accounts); cash (non-Schwab Institutional accounts); international relative to US equities
Underweight: US equities
Economy: Below-trend GDP growth in second half of 2008, but still no contraction/recession
Inflation: Food and energy pushing up overall inflation expectations, while core inflation remains subdued. The Federal Reserve’s timing of monetary tightening will dictate the direction of core and headline inflation. Oil is in a bubble (bubbles can go higher), and food is a problem.
Bond Exposure: Neutral-to-positive on junk bonds relative to investment-grade corporates.
US Dollar: Negative-to-neutral (watching Fed rhetoric as well as Fed actions).
- “Not a Recession, but Still Lousy” – the May 5 article found on www.BerkshireMM.com explained some coming concerns.
- As was suggested in the January Economic Outlook for 2008, we did not agree with the vast amount of calls for recession that we had heard over the previous six months. We did, however, argue that the first four-five months would be very weak for the economy, but would rebound in the second-half of the year. The latter half of that forecast seems to be supported by recent momentum.
- Averting a recession (if only by the technical measurements used by most economists) in 2007 and 2008 does not dismiss us from the potential to have a recession within the next few years. In fact, it is very likely.
The May 5 article talked about the mass predictions by economists and wannabe-economists for a recession in 2007 and/or 2008. Due to heavy leverage in the US, we economists find that the thin line between growth and contraction is an extremely important difference. So while economists making widespread conjecture about a looming recession recently have had to admit defeat on the technical side of the equation, most (myself included) still agree that it has been absolutely lousy for the average American household.
But the body of that article was not meant to be a published statement of “I told you so” to all those who talked us into a, I guess you could call it a non-technical recession. Instead, since at that time all of the magazines and daily rags were publishing such headlines as “Recession Averted”, I wanted to use that opportunity to predict – you guessed it – a recession (see “Consumer Spending to Push the US Toward Recession” – posted on July 3).
Granted, the May 5 article was a bit tongue-in cheek in forecasting a 2010 recession (it is impossible to properly time such things). Still, the point was that the US economy stumbled through a difficult and unusual period that required uncommon tools to remedy (or at least to start the healing). This was a mid-cycle slowdown caused by a credit crunch brought on by the bursting of a housing bubble and its implication on the liquidity of collateralized debt obligations (CDOs). This non-traditional problem required non-traditional solutions.
The good news (or, perhaps at best, not-as-bad news) is that we have largely moved from an unfamiliar concern (the aforementioned credit crunch) to a more familiar concern – a recession. At least with a recession we have a century worth of experience in combating that type of business cycle slowdown.
To be clear, what I am saying is that the problems of the credit crunch will “morph” to a recession.
- The credit crunch continues, and remains a threat to the US economy
- Despite some fantastic tricks engineered by the Federal Reserve, banks remain hesitant in expanding their lending
- The result will be not only slower consumer spending due to a squeeze on cash availability (see the aforementioned July 3 article), but that same reluctance of banks to loan has forced corporations to postpone expansions as well as layoff employees.
Forced write-downs of asset-backed securities have caused significant deterioration in the capital bases of financial institutions. Certainly the write-downs affect profits to the specific companies, but they also affect the US economy as these same firms first try to cut costs by reducing their payrolls. Additionally, these financial institutions must preserve their capital bases by tightening their lending standards, which means less capital availability to both consumers and corporations. This is not a forecast, it is already happening.
According to the Federal Reserve’s Senior Loan Officer Survey for the second quarter, a net 55% of domestic banks have already tightened their lending standards for commercial and industrial loans to large and mid-size companies. A net 62% of domestic banks have tightened their lending standards for even prime residential mortgages.
Although oil, the cost of energy, and overall inflation have crowded the credit crunch from the headlines, and although liquidity has gotten back into the credit market, the credit crunch is still a problem. And as the Fed fights inflation by raising interest rates, this will work against mending existing credit problems.
Regarding the morphing from a credit crunch to a recession…
When? As I suggested in the May 5 article (with tongue in cheek), 2010 seems about right. But it is worth re-reading that article as it explains the massive difficulty in calling a recession, especially with any level of precision.
Why? Recessions tend to occur 1) after an oil price spike (check) and/or 2) at the end of a Fed tightening cycle. The Fed has cut the Federal Funds rates by 3.25 percent. They are almost certainly finished dropping rates as the Fed Chairman Ben Bernanke has gone so far to signal that fighting inflation (i.e. raising interest rates) is becoming a greater priority as the economy is righting itself. To give the inflation concern some perspective, the National Federation of Independent Businesses’ May survey of small businesses sent a negative message on inflation. The percent of respondents saying inflation was their most important business problem was higher than at any time since the early 1980s. They are reacting by raising prices or saying they plan to raise prices.
Policymakers appear to be preparing financial markets for a rate hike, which will be forthcoming if inflation expectations become untethered. The Fed will sacrifice near-term growth to achieve stable prices and for the economy’s longer-term prospects.
Given the Fed’s history, and given that the rest of 2008 will very likely experience some good growth, we could very well see the Fed start tightening again in early 2009 (heading towards 2010, remember).
Why else? It is all about housing. A study by the International Monetary Fund (IMF) found that house price busts in industrialized countries in the postwar period, although less frequent, lasted almost twice as long as equity busts – five rather than 2 ½ years – and were associated with output losses that were twice as large (on average, about eight percent of GDP, or about 1.36 trillion dollars). Look for housing to be a problem for the next year, at least, before becoming, at best, a neutral contributor to GDP.
The credit crunch started with housing, and it will end with housing. The aforementioned deterioration in asset backed securities, while true for nearly all types of credit, has largely been driven by huge increases in home foreclosures. Foreclosures in the last year were so abundant that nationally almost one-third of current existing home purchases are of foreclosed homes, which accelerates additional house price declines, which leaves more homeowners owning more than the value of their homes, which compels borrowers to cut their losses and to stop making mortgage payments, which in turn raises foreclosures. That vicious cycle is knows as a negative-feedback loop.
Further “Morphing” Comments
So how else will the credit crunch morph into a recession?
- The remnants of the credit crunch will continue to impact the economy. This is particularly true of the US, where income-deficient, housing-dependent consumers are caught in a vice between a cyclical erosion of wage income and the bursting of the housing bubble. This will drive down corporate earnings.
- As discussed in our May 12 article “The US is Negatively Affecting the Global Economy”, the world is a lot flatter than it used to be and, as such, the world economy has become tightly linked through cross-border flows of trade and financial capital. There is no such thing as de-coupling; if the US economy slows so, too, does most of the globe – and that creates a negative feedback loop that, in turn, re-affects the US.
- Until now, financial intermediaries have been hit mainly by credit-crisis-related disruptions. Credit is still much tighter than it was a year ago, but as is typically the case when the economy slows (even if not contracting) we can expect a cyclical turndown in loan availability.
- The credit crunch encouraged the Fed to flood the financial system with liquidity. Because the economy did not slow to the point of contraction the excess liquidity has caused very high inflation expectations. The Fed will now be forced to raise rates to fight inflation just as the economy is improving, but still in close proximity to that “lousy” description. If it were not for inflation the Fed could hold interest rates at these levels for up to twenty-four months (the long end of its historical range) before raising rates after an easing cycle. But now they will likely have to do so by the year’s end.
- Look for a political backlash to the credit crisis and high commodity costs in the form of over-regulation that stifles the flexibility of free market capitalism.
Oil Is Not Your Biggest Problem, it is Housing
Although oil, most certainly, is a problem. Every penny increase in a gallon of gas costs American consumers just over $1 billion in the following year. The average cost of a gallon of gas has increased about 100 pennies year-over-year, which translates to about a $100 billion tax on American consumers. The incredibly well timed fiscal stimulus rebate checks (I don’t think I have ever been able to describe a government stimulus plan in such a manner) will absorb that hit – this year – and keep us out of a recession in 2008.
To accept the chance of a 2010 recession as a credible one, then we must accept that there is another year of bad news out there for the housing market. What makes us believe this is so?
- Home prices are falling at an accelerating pace. The infamous 2nd derivative (the rate of the rate) hasn’t even begun to improve. In other words, not only have prices not yet bottomed but the pace of decline is not slowing.
- Conference Board surveys continue to reveal limited interest by potential homebuyers to act in the next six months.
- Not only is there currently an 11.5 month supply of housing inventory compared to the more normal five months (high supply equals lower prices), but foreclosure-homes will continue to come onto the market over this buying season (obviously at discounted prices).
- Traditional home value metrics are based on a multiple of rent they would fetch (a version of the price/earnings multiple). Using this metric, according to a study created by current and former Fed economists, house prices would have to fall another fifteen percent over five years, assuming rents rose at 4% per year, in order to fall back in line with historical multiples.
We are not yet in a recession, but it is coming. This period of economic growth/stagnation is not your typical mid-cycle slowdown. It is a bubble gone bust. Actually, it is a bubble going bust. Contrary to the common theme that the worst is behind us in terms of home price deflation, by any reasonable metric this bubble has substantially farther to deflate. Simply for home prices to return to their twenty-year average ratio of 3.4-times median household income, average home prices would have to fall to $171,000, or about another fifteen percent.
Falling home prices cause a negative-feedback loop. As prices fall, more families see the value of their homes decline to less than their mortgage amounts. As we have seen in recent quarters, the existence of negative equity gives owners an incentive to walk away from their homes (and their mortgage payments), leaving vacant foreclosed houses. This puts more pressure on home prices, drawing more households into that loop.
In turn, housing turmoil causes consumers to pull back. This hurts the broader economy (which, by itself, does nothing to help home prices). Banks worry about homeowner earnings and their mortgages going bad, so they tighten lending standards. This shuts out new buyers from entering the market and further depresses home prices.
The Bottom Line: The road to recovery must go through housing. As long as foreclosures rise and home prices sink, the economy won’t find its footing. Housing will not improve for at least a year. The economic recovery we have expected to start occurring in September/October (as opposed the correlative stock market recovery in April/May) will still come. But it may be a short-lived rebound in the economic cycle, perhaps 12-24 months, compared to the average 44 months.
The Recession That Wasn’t vs. The Recession that is Coming
- The economy displayed very modest growth in Q4 2007 and Q1 2008.
- The June employment report confirmed that labor market slack is building quickly.
- The average American household’s real (after inflation) income and net worth are down from a year ago.
- Households are trapped between a tough job market that is holding down wages and higher costs for food and fuel.
- The Federal Reserve will sacrifice growth for the sake of stable prices.
Recent data has confirmed that the US economy is certainly bent, but it has not broken. The details of the June employment report signal a recession, even if not by economist’s standards. In particular, in May, temporary employment fell by 30,000, reversing improvement in this leading indicator in March and April.
The weak labor market will depress wages as workers lose bargaining power. Real average hourly earnings have declined for four consecutive months and are down nearly one percent on a year-ago basis. The unemployment rate has increased a full percentage point over the past year and is now at its highest rates since 2004. The economy has shed on average 65,000 jobs per month since January, compared with an average job decline of 181,000 during the 2001 recession. Nonetheless, the deterioration exists and is, in part, behind households’ declining real incomes. The other main part is, obviously, surging energy and food costs.
Not only are consumers’ real incomes eroding, but so, too is their collective net worth. Undermining households’ net worth are plunging house prices and a weak stock market. Housing wealth has fallen about $3 trillion since peaking about two years ago, with most of the declines occurring since late 2007. This translates into a loss of more than $30,000 in equity for the average homeowner.
High inflation will stymie further rate cuts by the Federal Reserve. Policy makers worry that record oil prices and rising food costs are aggravating inflation expectations and will result in a broader acceleration in inflation. Policy makers clearly don’t feel comfortable cutting rates further. They have gone so far as to use rhetoric to prepare financial markets for a rate hike. The Fed’s assault on inflation will negatively affect the growth of the US economy, at least in the short term.
An economy already contending with the dangerous trifecta of a continued housing downturn, a stall in job growth, and surging energy and food prices will have difficulty absorbing higher interest rates.
It is literally impossible to consistently and accurately forecast GDP growth as far as a year out – especially for the first year of a new President as we don’t know what the fiscal policies will be. Nonetheless, just months ago real GDP growth for 2009 had been largely expected to be greater than 3%. That consensus view has more recently dropped to an expectation of 2.7%. Unless oil prices soon recede and unless Washington comes up with a way to fix the housing mess, then the outlook for 2009 will certainly weaken in coming months.
- Much of what I have to say in regards to the mid-year update of the global outlook can be summed up in the title of our May 12 website article – “The U.S. is Negatively Affecting the Global Economy”.
- The slowdown has so far been confined to advanced economies.
- Global economic conditions remain surprisingly resilient, especially in light of surging energy costs and a weak U.S. economy.
- The impact of tighter credit conditions on the economy will intensify during the remainder of the year.
The global economy is slowing, but the pace of activity remained surprisingly resilient in the opening quarter of 2008, underpinned by robust growth in developing economies. While global economic conditions have deteriorated, the slowdown in economic activity has so far been mostly confined to advanced economies, particularly the U.S. and Western Europe. Most developing economies and emerging markets continue to expand at an impressive pace. Robust domestic activity has helped sustain growth in these economies, but exports have also held up reasonably well, in part due to their greater trade diversification.
Global corporate balance sheets are generally in good shape, but rising input and credit costs along with weaker demand will hold back investment and hiring plans in coming months. An uncertain global environment will also weigh on business confidence in the near term. Also, in response to global inflation risks, further tightening in global credit markets would mean higher borrowing and capital costs, which could further dampen business’ hiring and capital expansion plans and further constrain global demand.
- Exit Strategy: See the June 10, 2008 www.BerkshireMM.com article “Cut and Run at 1312”
- Rebound / Entrance Strategy: See the July 18, 2008 www.BerkshireMM.com article “1969 revisited”
- Inflation is becoming a bigger problem than growth, which worries us that the Bear Stearns’ collapse may not have been the market’s washout-moment.
- The stock market is close to being fairly valued, so the stock market will be extra sensitive to positive and negative surprises/shocks.
We encourage you to read our “Cut and Run at 1312” article. I won’t bother to repeat the details here, but the bottom line is that while we have been constructive on the stock market in the second-half of the year, our job as risk managers is to consider not just the probabilities, but also the possibilities.
The most likely probability has been a stock market rebound in the second-half of the year and into 2009. And those probabilities have helped to forge BMM’s 2008 outlook and the resultant investment decisions for your portfolio. The possibilities are that 1) the probabilities work against us, and 2) that we incorrectly interpreted that data.
Both of those unfortunate scenarios are always a possibility. As such it is important to have an exit strategy. Admittedly, sometimes that exit strategy isn’t always graceful, but then again, neither is the stock market.
On the subject of probabilities versus possibilities, it had appeared obvious to us that the collapse of Bear Stearns marked the historically typical calamitous event that forced maximum pessimism and maximum selling into the market and thus identified a market bottom. However, the rally that developed from that point has not been the type of rally we would have expected to see from the bottom of a stock market crash.
The longevity of a rally is directly correlated to the strength of investor demand (i.e. buying). If demand is broad and persistent, then gains can be significant. But, if demand is weak or selective, then the rally could falter and not renew. For the Bear Stearns rally, investor demand started strong but weakened toward the end.
Another factor to consider is the significance of the June 6th 90% Downside Day cited in the “Cut and Run at 1312” article. You might recall that when the market started to turn down from its July 2007 peak, there was a total of four 90% Downside Days before the next worthwhile rally. When the market turned down from its October 2007 peak, there was three 90% Downside Days during that decline. When the December 2007 rally failed, there was another four 90% Downside Days. And when the February 2008 rally attempt broke down, there was yet another four 90% Downside Days before the March 2008 lows.
There was another 90% Downside Day on June 26th, making it two for the most recent decline. If recent history is any guide to future events, the breaking below the 1273-1312 level on the S&P 500 should set the stage for a string of more selling. This, in part, is why in the aforementioned July 18th article we cited some level of skepticism regarding the impressive bounce from the S&P 500 lows of 1,200 points on Tuesday, July 15th.
Inflation Affects Stock Market Valuation
While stocks are close to fairly valued (based on an aggregation of several metrics), we are cognizant of factors affecting fair value and do not take any of them for granted.
Part of the headwind the market is experiencing is directly attributable to inflation. To be fair, the inflation outlook is especially complex. Most of the inflation is coming from food and from energy, as opposed to consumers rushing the stores and bidding up prices of retail goods and services with excessive buying. High energy costs will cut into profits, especially in industries that consume a lot of fuel and in companies that use oil-based products for raw materials. So current high energy prices may be affecting inflation expectations, but it could likely be recessionary and, ultimately, deflationary.
Stock multiples can be higher when inflation is low. The “rule of 20” that the price-to-earnings ratio (p/e) should be obtained by subtracting the expected inflation rate from 20 works fairly well in many instances. Obviously this is not a perfect gauge because it does not take into consideration other important variables (earnings growth, interest rates, dividend yields, etc.), but all other things being equal, inflation is an enemy to stock market returns.
Trailing p/e ratio implied by a given level of inflation*
Annual % Change
* Monthly data from January 1973 – February 2008
Equities are correctly regarded as a hedge against inflation over the long term. And not only in terms of capital appreciation; in the US, dividends have generally grown faster than the rate of inflation since the 1950s. Yet periods of rising consumer price inflation are bad news for stock markets. In the 1970s, to use an extreme example, when inflation rose from 5 to 16 percent in the developed world, global share values dropped by two-thirds in real terms.
But as I said, other variables are also important. There have been past periods when the stock market has fared well during inflationary periods (in particular during the 1950s, and much of this decade).
Performance of stocks during inflationary periods relative to cash
Q3 1929 – Q1 1930
Q1 1934 – Q3 1934
Q4 1939 – Q4 1941
Q1 1946 – Q2 1947
Q3 1950 – Q2 1951
Q3 1955 – Q2 1957
Q2 1959 – Q1 1970
Q3 1972 – Q1 1975
Q1 1977 – Q2 1980
Q1 1987 – Q4 1990
Q2 1998 – Q1 2000
Q3 2002 – Q1 2008
Gain per annum
Nonetheless, inflation has become a major headwind. What is providing little to no headwind, nor tailwind, are valuations. If you read financial newspapers or watch financial news, you may hear one p/e ratio used one day, and then a half dozen other p/e ratios being used another day. That’s because, depending on whether you want to make a bullish or a bearish case, you can use expected earnings, trailing earnings, “operating” earnings (which exclude write offs), or “as reported” earnings (which include write offs).
Of course, when using trailing earnings you then have two from which to choose (operating vs. as-reported). However, expected earnings can cite not only either of those methods, but also whatever expectations, or predictions, a person may have (which can be wildly inaccurate).
So let’s just split the difference and use an average of the past operating and the past as-reported numbers, which gives us 12-months of trailing earnings of about $66.50 for S&P 500 companies. That calculates to a p/e of about 18 (assuming the recent low of 1,200 points).
Using the rule-of-20 as well as the above historical chart, we can expect a p/e of about 14-15 with the inflation rate at 5% (the latest annual CPI figure), and we can expect a p/e of about 16 with the inflation rate at 4%.
Headline inflation is about 5%, and the core rate of inflation is about 3%. There is some question about earnings growth expectations, as well as what the future rate of inflation may be. But there is no question the yield of the 10-year note is almost half of its average rate since 1978. So we can torture the data a little this way, or a little that way. At the end of the day, if you aren’t trying to build a bearish or a bullish case, the stock market looks fairly valued. But we cannot ignore the inflation problem.
What do we know about a fairly valued stock market? Positive surprises (earnings firming, the economy gaining traction, etc) make stocks go up. Negative surprises (oil keeps going up, it looks as if fiscal policy is likely to raise taxes) make stocks go down. And moves in both directions become accentuated.
You will notice in the examples of “negative surprises” I slipped in a little something about fiscal policy. That, of course, portends a conversation about the upcoming election. That won’t be a comfortable conversation. Why? Remember Taxi?
Taxi was a wonderfully written and excellently acted sitcom starring Judd Hirsch and Danny DeVito. The sitcom ran what seems a long time ago, from 1978 – 1982, but I still remember this one episode where Louie De Palma (Devito) was mentoring a rookie cabbie named Bobby (the wavy haired Jeff Conaway). Louie explained to Bobby that there are only three things you say to your fares – “where ya going”, “uh-huh”, and “you don’t say?”. And you never, ever under any circumstances discuss sports, religion, or politics.
The idea was that you didn’t want to upset your fare and ruin your potential for a hefty tip. Thirty years later I still remember the moral of that story – don’t upset the hand that feeds you (not using mixed metaphors, I think, was the moral of another episode). Nonetheless, I am your money manager and you deserve to know what I think. And what I think is that no matter who becomes President – Democrat or Republican – the Growth & Reconciliation Acts of 2001 & 2003 (aka the Bush Tax Cuts) will expire and not be renewed on December 31, 2010. And I don’t care what side of the aisle you lend your loyalties, raising taxes on dividends and on capital gains is bad, bad, bad news for stocks.
The only way the news could be worse for the stock market is if the incoming administration not only allowed the tax cuts to expire, but was also pushing for a near doubling of the capital gains rate. And, unfortunately, that has been a topic of conversation.
Our next Quarterly Report will, in large part, cover politics, fiscal policy, my amateur election guess, and how all of these will affect the economy, stocks, and bonds.