January 14, 2009
Past Economic Outlooks have acted as a “most-likely” game-plan from which specific-client investment strategies were derived. This particular Economic Outlook is more of a compilation of considered research. Calendar Year 2009 is not a period in which we can confidently define a “most-likely” scenario. Instead, the correct strategy is to remain flexible and try to avoid a disastrous mistake. By definition this means lagging the stock market should stock prices rise this year – but the strategy is suited to avoid losing half of your portfolio (as many investment legends did in 2008), and not to bullishly leverage returns.
2008 was the worst year for the S&P 500 since 1931 (down about 39%). All of us at Berkshire Money Management had professional lives prior to the creation of BMM in 2001, but as a team we have now been tested by two recessions, a devastating terror attack, two wars, the popping of a technology bubble, the popping of a housing bubble, the popping of an oil bubble, a credit crisis, the crumbling and closing of Wall Street firms, and two life-altering stock market crashes. This is a lifetime of tests for a very young firm and we have come out of it greatly outperforming the stock market – making money for you in the up the years and protecting you in the down years.
According to the National Bureau of Economic Research (NBER), a U.S. recession started in December 2007. For no particular good reason, the NBER is donned the unofficial “official” arbiter of such proclamations. Given the positive GDP growth in the first half (1H) of 2008, it took the NBER about a year to make this official call. The recession took a firm grip of the nation in September 2008. In December 2007 BMM argued, incorrectly, that at the time it was “not a recession, but still lousy.” The good news is that BMM felt it was lousy enough to begin selling equity a month earlier, in November 2007, and continued to do so in 2008. BMM is now charged with the obligation of reintroducing risk (i.e. buying stocks and bonds) into portfolios.
A Bull Market in Lies
No, this segment is not about the Bernie Madoff scandal. Nor is it about how everyone in the world now finally believes and understands that portfolio returns are in no way consistent and linear.
No, this segment is not about how large-caps stocks became small-cap stocks. Nor is it about how A-rated bonds became C-rated bonds.
It is about a November 2008 conversation I, Allen Harris, had with my wife, Stacey Carver, at a local restaurant.
We were discussing some reports I had been reading regarding how individual investors “remember” things to their favor – it is called retroactive prescience. Somehow they remember beating the market consistently when, in fact, that is hardly ever done even by professionals. More timely, this conversation was about how, all of a sudden, individual investors were crawling out of the woodwork claiming they had jumped out of the market before the crash.
We were in the middle of that conversation when a local gentleman, knowing my profession, asked me how work had been going and proclaimed that he was “sure glad that I got out of the market in August…of last year!” Stacey and I understood – he had gotten crushed in the stock market and he did not want to admit it.
So this segment is about that conversation. It is about the investment legends that were caught off guard in 2008 and ruined their once stellar track records. It is about the recent Forbes article detailing all of the billionaires that have not only become “mere” millionaires but have, in at least one instance, lost everything. It is about the hundreds of hedge funds that closed in 2008 and the thousands that may have to close in 2009.
And it is about making you feel just a little bit better when your neighbor, doctor, golf partner, second-cousin-twice-removed and anybody else that proclaims just how happy and smart they were to “get out of the market in August…of last year!”
We decided to slip this segment into our Economic Outlook report when Barrons’s coincidentally published their December 29, 2008 article “A Bull Market in Lies.” Excerpts of it read as follows:
A neighbor says to the author of the article, Joe Queenan, “ ‘I don’t know what prompted me to do this, but I got everything out of the market in October of last year,” he crowed, I could see the whole thing was way overvalued, so I moved everything into bonds and cash. I’m really glad I made that move when I did.’”
“Not for a nanosecond did I believe him.”
“The same people who told you how rich they’d become when the NASDAQ was on its way up were only too happy to tell you how clever they had been to head for the exit before the index began its horrifying ride back down.”
“My neighbor’s duplicity is an example of a phenomenon that psychiatric specialists refer to as retroactive prescience, or rear-vision Cassandraism. This is a mindset in which a person who has been the victim of a catastrophe seeks to mitigate the trauma by denying that it every happened.”
“By petulantly denying that they have fallen into the same trap as the rest of us, the retroactively prescient want to make it look as though they are always the master of their fate – never victims of circumstance…”
“The worst thing about faux financial-fugitives is their absurd delusion that they are getting away with something. Sorry, Charley. The rest of us can see right through you.”
The Fall of Legends and Giants
Through the first nine months of 2008, 693 hedge funds shut down. Managers of hedge funds have, for years, been considered the brightest financial minds in existence, charging fees of 3 & 30 (3% of assets under management & 30% of all profits). The hedge fund world is comprised of many “short-only” funds, funds which struggle during up years for the market, but get gangbuster returns during market declines. Still, even with the inclusion of so many short-only funds, according to the Morningstar 1000 Index, the average hedge fund declined 21.7% in 2008 (that is based on the 1,000 largest funds, which account for ninety percent of hedge fund assets), showing how the giants of the financial industry were not able to avoid the worst bear market in three-quarters of a century.
Outside of the hedge fund world, and inside the world of long-biased equity mutual funds, returns were not any better. The mutual fund industry is a more fair comparison to most advisers (who do not publish aggregate annual returns) because, except in very rare instances, we in this industry are long-biased.
More than 60% of all mutual funds (including bond and short-only funds) did worse than the S&P 500 in 2008. As for diversified equity mutual funds, the best of the best – the top 5% of all mutual fund managers – lost an average of 27% in 2008.
Economic Outlook for 2009
The stock market is moving through a bottoming process.
Berkshire Money Management will increase equity exposure in portfolios ahead of a likely improvement in economic conditions. High beta sectors and asset classes are expected to outperform once those economic conditions do begin to improve.
Risks remain high, so new investments may be acquired in phases – moving from cash to a fully invested position will be a process, not an event. This will result in drastically underperforming the stock market should a bull market take hold soon. However, the strategy will allow for the type of risk management that prevents disastrous mistakes.
The S&P 500 could rally to 1,200 points in the first half (1H) of 2009. But without being accompanied by improving stock market technicals (breadth & volume) and/or improving fundamentals (stabilization in corporate earnings and house prices; reduced interest rate spreads between corporate bonds and Treasuries), such a rally could prove to be nothing more than a cyclical bull market within the context of an ongoing secular bear market (a.k.a. A Sucker’s Rally).
In spite of seemingly attractive valuations, this is not the year for uninhibited pursuit of high-risk opportunities.
The economic outlook for 2009 is highly uncertain. What makes the outlook so uncertain? We must consider both the intended and unintended consequences of just some of the things that happened in 2008:
A global credit crisis originated in the most advanced financial system in the world, the U.S.,
We went through a period of such rampant distrust that people were lining up around banks to withdraw money – not in some third-world country but in the U.S. and the U.K.,
The efficacy of trillions of dollars of bailouts, stimulus, and Fed balance sheet maneuvers is still in question as the U.S. economy has essentially slipped into freefall as of September 2008 and has yet to regain traction,
Major portions of the U.S. financial system are now nationalized.
Almost no living money manager has seen anything like this. The NBER has selected December 2007 as the start date of this current recession, putting its current duration at 13-months. If the recession goes past March 2009, which most believe it will, and thus stretches to 17-months, then this will be the longest recession since 1933 when the U.S. struggled through a 43-month killer. The U.S. dealt with two 16-month recessions, one in 1973-1975, the other in 1981-1982. Excluding those three and the current one, past recessions in the last 75-years have lasted only about eight months. This explains why professional forecasters are having trouble forecasting the stock market and the economy for 2009 (whether they want to publicly admit it or not).
Models developed in the more normal times of the last quarter-century (models based on such things as corporate-profits and interest rates) failed last year. The rare bear market over those decades witnessed sharp snap-backs. Those models came to believe that the service-based economy would no longer endure such protracted recessions as this one. These are the same models that allowed many money managers to confidently purchase new equity and bond investments all through 2008 only to regret doing so far too early.
How, in this environment, does one come up with a forecast that can be considered credible? Given that the stock market has rallied about 20% from its recent bottom, many professional forecasters have become more confident that the worst is over. We admit that it is difficult to envision a 2009 where the worst is yet to come. However, instead of trying to play a market rebound, Berkshire Money Management is considering what to do if the markets and the economy remain troubled for longer than the consensus expects. Instead of looking for a market bottom (speculative investment management), we are looking at how the credit and economic crises may morph next (prudent risk management).
The best we can do is follow the advice found in a John Maynard Keynes comment/question: “When the facts change, I change my mind. What do you do, sir?” Currently the best we can do is wait for, track, measure, and hopefully correctly interpret new data as it presents itself.
Even if we were confident to come up with a strong forecast, we would want to highlight that over-confidence hurts one’s ability to be open-minded and flexible. We at BMM did not have to be brilliant to stay out of the stock market in 2001 and 2002, get “long” in 2003, and then to start getting defensive again in late 2007. But we did have to remain open-minded and flexible. As when we began doing business as BMM in 2001, we start 2009 not with a forecast, but with a goal: avoid making a disastrous mistake.
Admittedly, this is not an overly lofty ambition. But sometimes it is just as important, if not more important, for BMM to be “risk” manager as well as “investment” manager. It is difficult for us to consider going into 2009 without an emphasis on risk management.
We expect a tug-of-war between continued tight credit conditions and massive liquidity and fiscal stimulus. Instinct would suggest that said massive stimulus could do nothing but make the economy grow – the concern is that, at least initially, the stimulus could actually “do nothing.” The extraordinary conditions present in the economy pose challenges for policy makers and, for us, raise concerns about a liquidity trap.
A liquidity trap exists when the central bank expands the money supply (as it has) but the extra cash fails to stimulate the economy because it fails to stimulate what we in the industry call the “velocity” of money, or its turnover (i.e. cash changing hands for goods and/or services). Money supply fails to get turned over if either banks refuse to lend and/or few consumers want to borrow.
The scenario of a liquidity trap is not either/or; it could be first/second. It is entirely possible that velocity in the shorter-term remains muted (first), but that in the longer-term (late-2009?) lower rates ignite both lending and spending (second). But for now, the economy enters the year in the throes of the most severe recession since 1982.
Recessions We Have Known
Recession Lengths (months)
December 2007-December 2008
March 2001-November 2001
July 1990-March 1991
July 1981-November 1982
January 1980-July 1980
November 1973-March 1975
December 1969-November 1970
April 1960-February 1961
August 1957-April 1958
July 1953-May 1954
November 1948-October 1949
Average for previous recessions
The economy is in recession, and declined in Q4 2008 at a significantly faster rate than it did in Q3. We expect further contraction in Q1 2009. The extent of, if any, contraction beyond that will depend on the efficacy of past and future monetary and fiscal stimulus.
Housing will continue to remain central to the economic outlook. Home prices could fall another 5-10% in 2009, depending on the measure. That will drive even more homeowners under water and increase the number of foreclosures. While 4.5% mortgage rates should help demand, price and inventory levels still need to adjust.
We expect the massive amounts of deployed fiscal and monetary stimulus to be felt by the second half (2H) of 2009. The biggest risk to our 2H 2009 expectation of a recovering economy (and thus improving stock and bond markets) is that the traction of such stimulus fails to materialize. Absent that possibility, after posting a sharp contraction in the first quarter (Q1) of 2009, the change in economic activity will begin to move toward zero in Q2, and finally improve in Q3. But clarity and confidence in the 2H outlook remains particularly poor.
The global bear market has, itself, been a forecast of global recession. The 2008-2009 recession of industrialized countries will likely turn out to be the most painful in decades. The coming year will be a bleak one for the world economy. However, the fear of such has brought about a united global policy response (rate cuts, quantitative easing, bailouts, fiscal stimulus, etc.) that will likely turn the global stock market trend higher in 1H 2009, anticipating improved economic performance in the second half of the year.
In keeping with historical tendencies, the crisis bred correlation. The U.S. bear market spread among virtually all regions and assets classes, leaving nowhere to hide. As volatility reached 76-year highs on the S&P 500, volatility also reached new highs among other global markets and asset classes. These extremely high correlations and extremely high levels of volatility reflect the extremely high levels of fear reached in October and November of 2008. The result was widespread liquidation of investment assets – the result was that anybody who wanted to sell has sold (i.e. “supply”, or selling, has all but evaporated).
Since the price of anything, including stocks and bonds, are ultimately a function of supply and demand (demand equals buying), the global markets are expected to rally strongly from these levels. The question is not “will the markets rally” – they will. The real question is “will the rally be sustainable.”
Will the rally be a selling opportunity before the bear market resumes? Or will the rally be the advent of a brand new multi-year bull-market -the likes of which, on average since World War II, have advanced the Dow Jones Industrial Average (DJIA) 123% over 46-months.
Given that Berkshire Money Management has a fairly favorable five-year view, you may ask yourself why we do not position portfolios into a fully invested position more immediately. Unfortunately, the status of the U.S. consumer gives us pause.
Consumer Health Report Card
Category Grade Comments Assets C- Falling home prices and equity prices need to stabilize Liabilities F Liabilities need to come down more in-line with assets Income C- Rising unemployment & inflation having negative impact Spending D A higher savings rate implies reduced consumption Overall D Falling Net Worth, Declining Real Wage Growth, Rising Unemployment, High Debt Service Burden, Tighter Credit, Lack of Home Equity Cash-Outs.
This report will highlight some of the research and some of the forecasts we have for 2009. We look forward to speaking with clients to detail specific investment strategies for accounts and portfolios. But as always, we will remain flexible in our management. After all, to paraphrase John Maynard Keynes, when the facts change we need to change our minds.
Stock Market Bottoming Process
- The S&P 500 was never positive in 2008. It fell about 11% in the first fourteen trading days of the year. And it really never got much better.
- The aforementioned fears (ineffective policy responses, continued dire credit conditions, the global economic contraction, etc.) that forced investment asset liquidation in late 2008 have likely been priced into the markets.
- Risk appetite will be revived as the markets become more susceptible to positive surprises. Stocks would then be likely to snap back versus Treasury bonds, commodities would be likely to rally, and small-caps and emerging markets would be likely to outperform.
Based on the one-year seasonal cycle, the four-year presidential cycle, and the ten-year decennial cycle, the 2009 composite cycle predicts a stock market uptrend into the third quarter (Q3) of 2009. The composite cycle is coincident with massive oversold levels as well as enormous fiscal and monetary stimulus. The market should anticipate that the stimulus would have an economic impact and lift the economy out of recession by the second half of the year.
This bottoming process has already started. Since the October and November 2008 selling climaxes there have been positive breadth thrusts (granted, under less than ideal situations). Downside risks have diminished. With more upside momentum and improved breadth we would be looking to add equity exposure to growth-oriented portfolios on the evidence that the bottoming process has given way to a new uptrend.
Such reversals have tended to occur around major market bottoms. Two of those bottoms stand out for their similarity to the current probable outcome – those of 1938 and 1974. The table below compares the bottoms, indicating that all three lows were reached after similar percent declines and nine years into secular (i.e. long-term) bear markets. They also occurred 10-12 months into recessions.
November 2008 Low vs. Bottoms of 1938 and 1974
Preceding Cyclical Bear Market
DJIA % Decline
Concurrent Secular Bear Market
Years From Start
Years To End
Months From Start
Months To End
Subsequent Advance to High
The table also indicates that the recession ended three months after the 1938 bottom and four months after the 1974 bottom, consistent with the possibility that the current recession could end four months after the November 2008 low, or March 2009.
After both bottoms, the DJIA rallied for eight months to its subsequent high, up by 51% after the 1974 bottom and by 60% after the 1938 bottom. So the advance could be expected to last until the third quarter (Q3) of 2009 and bring the DJIA to 12,000 points (or about 1,200 points on the S&P 500). For more details, consider the following:
- The bottom of 1974 emerged as most similar among the post-war cases. The low occurred about 12-months into the recession after a drop of -45% on the DJIA. If the November 20, 2008 low turns out to be the bottom of the current bear market, then it will have been reached about 11 months into the current recession after a DJIA decline of -47%. The lows in both 1974 and 2008 occurred close to nine years after the start of their respective secular (i.e. long-term) bear markets, 3222 days after the secular high of February 9, 1966 and 3,233 days after the secular highs of January 14, 2000. From the DJIA low, the DJIA rallied 51% to its 1975 high 7.5 months later on July 16, before correcting -10% over the next 2.5 months. The DJIA then advanced to a cyclical high in 1976.
- The bottom of 1938 also carries similarities. It occurred 10-months into a recession, ended a bear market of -49% on the DJIA, and was reached 8.5 years after the secular top of September 3, 1929 (3,131 days). The cyclical bear of 1937-1938 was also similar to the recent bear market for its duration – it lasted 386 days, close to the 408-day duration of the latest cyclical bear. From the low, the DJIA advanced by 60% to its cyclical high 7.5 months later. The DJIA then corrected by -14% over the next 2.5 months, though it did not recover to reach a new high as it did after the high in 1975.
Even excluding economic commentaries, it is still possible for the stock market to rally explosively given its extreme oversold conditions. The market could rally for a variety of reasons, including that the consensus expects U.S. economic growth to pick up in 2H 2009. If this were to occur then it would be historically correct to expect the massive amounts of stimulus to make the economic rebound significant, and for the stock market to appreciate in a similar significant manner in anticipation.
Further Support for a First-Half Advance
BMM began selling equity positions in November 2007, about 15 months ago. Globally there were additional massive liquidations in all of 2008 as investors pulled out a net $320 billion from mutual funds, a record in both dollar terms and well as as a percentage of assets.
Stock prices, like prices of anything, are a function of supply (selling) and demand (buying). For the last three months supply (selling) has been virtually non-existent. This allows for higher prices on even low levels of volume (light demand). Under more ideal situations demand (buying) would come back into the market on very high volume so as to indicate investors are seeing stock prices so cheaply valued that they are worthy of long-term accumulation.
But still, even light demand (buying) with the backdrop of little or no supply (selling) can force stock prices higher. Higher prices by themselves can often be a catalyst for further buying. This is especially true given the $3.7 trillion of total money market assets ($422 billion of which was added to that total in 2008) compared to the $9 trillion capitalization of the companies that comprise the Wilshire 5000 Index (this index is often used to calculate the value of U.S. traded stocks). This means that money market assets represent about 41% of the Wilshire 5000. Going back to 1981 the average has been about 10.7%; this ratio reached about 24% in both 2002 and 1982.
An alternative metric, the Federal Reserve’s most recent numbers show that in November 2007, the amount of money held in US money market funds (again, $3.7 trillion) exceeded the amount held in equity mutual funds ($6.9 trillion), for the first time in fifteen years.
That is not to say that all of this cash will find its way back into the stock market, but this is an incredibly bullish amount of cash on the sidelines.
So while the backdrop is less than perfectly bullish with eager buyers stepping up to the plate, we will remain flexible and follow the tape should sellers remain on the sidelines. Sometimes, in the stock market, higher prices are reason enough to improve demand.
Also while not perfect, the stock market has generally followed the script for a bottoming process. The waterfall decline that ended October 10th followed by multiple attempts to re-test that low on diminished selling pressure (evident in the volume and breadth statistics) is something you would expect to see during a bottoming process.
If the market were moving into another sustained downleg, as opposed to working itself through a bottoming process, it would most likely happen with a breakdown in advancing volume, a breakout in declining volume, and new recent-highs in total volume. We would also expect to see the 90-day advance/decline ratio drop back to new lows, along with renewed expansion in the percentages of stocks at new lows. But at this point, we can say that we have not had bearish confirmation from the volume and breadth statistics, supporting our case that the market remains in a bottoming process.
What if We Are Wrong?
It is also possible that what we have seen since October 2008 is not a bottoming process, but rather a temporary consolidation to be followed by another global downleg. Such a downleg would occur on a new wave of heavy downside volume, expanding new lows, and global confirmation. Such an occurrence would rule out the case for an economic recovery in 2009, instead anticipating global deflation and making comparisons to the Great Depression more relevant.
While possible, that scenario is not probable. Monetary and fiscals lessons learned from the 1930s make a repeat performance extremely unlikely. But we will not fight our models or the tape should matters take a turn for the worse (or to borrow an already used phrase, “we will remain flexible in our management”).
Obviously, much depends on correctly timing the bear market and recession bottoms. Given that we are using history as our guide but that monetary and fiscal policy are now in unchartered territory, the risks of unintended consequences are quite high. As a result, risk management is prudent, and much of our research in this Outlook will change and need updating as the weeks and months pass by.
If 2009 does not start with the indicator and model improvement that we expect/hope for, we will stay objective and flexible and abandon our growing bullishness.
Risks and Rewards
Just as the economic outlook for 2009 is highly uncertain, so too is the outlook for the U.S. stock market. For as long back as I can remember, in the first week of each new calendar year professional money managers have made public their year-ahead stock market forecasts. And, as if it were law, they would collectively argue for a 10-15% gain. Surprise! We’re seeing Wall Street’s best do the same thing again this year.
The risks are far too complex to narrow down to calendar year 2009. For example, one risk is that the U.S. remains in a secular (i.e. long-term) bear market that started in 1999 and could continue until, say, 2015 (past secular bear markets have lasted about 16-years). Another risk is that the U.S. enters an era like that of the 1990s in Japan where the country dances around the recession line for a decade.
The Japanese-style risk is unlikely given that it was fueled by deflation where, by contrast, inflation is a significant risk for the U.S. in the months and years to come.
The secular bear-market risk is a “true” risk only if you do not remain flexible in management. In bull markets stock prices go up and stock prices go down – the same is true in bear markets. In bear markets you can have huge rallies that advance stock prices 50-100%. The only difference is that the holding period for bear markets tends to be shorter (think 4-6 months as opposed to 4-6 years).
The risk for calendar year 2009 is that we continue to be in the midst of secular bear market. The reward for such a scenario (and the reward that could ultimately define the most bullish of all reward scenarios for this year) is that in the first half of 2009 experiences what we have called in earlier www.BerkshireMM.com articles “The Mother of All Bear Market” rallies.
Given this odd risk/reward combination (“odd” if only because the consensus is for a miserable first half of 2009 followed by a booming stock market and economy in the second half), after a Q3 2009 high, the market would start to discount poor-to-mild economic performance and enter another bear market.
The consensus also argues that because 2008 was such a bad year, that 2009 must be good. It is argued that all of the bad news is priced in. We actually agree that the bad news has been priced in, making the stock market fairly cheap. However, there are two concerns to this. First, a cheap stock market can get cheaper. Second, valuations have never (never ever) been a good timing tool for the stock market.
Still though, there are a lot of very smart people who are trying to convince you and us that since 2008 was so bad that 2009 must (must!) be an up year for the stock market.
Unfortunately, the magnitude of the decline aside, history shows us that whether or not the stock market gains or loses in a given year has little to do with whether it gained or lost in the previous year. Sometimes the stock market does bounce back after having a bad year, but on other occasions it continues to go down.
Let us get a little more specific about returns during a calendar year. In Q4 2008 the S&P 500 was down 22.45%. Including 2008 there have been nine occasions in which the S&P 500 dropped ten-percent or more in Q4.
Fourth Quarters Losing 10% or more
Date of Low
YTD Decline at Low
Aug 29-March 33
Aug 29-March 33
Aug 29-March 33
Aug 29-March 33
May 37-June 38
Nov 73-Mar 75
Average when economic contraction
*Dates in bold are bear market lows
Excluding the Depression Era years, the subsequent decline following Q4s with losses greater than 10% was still 17.85% (not shown in table). Including or excluding those Depression years, the worst declines following these Q4s occurred when an economic contraction was in progress (-33.9%) – as is currently the case. Given this small sample size, we do not feel that this data has any sort of predictive power. It does, however, assist us in discrediting the loud and persistent calls that because 2008 was so bad that 2009 is virtually risk free.
To put it another way, the risk for 2009 is that we get a tremendous “Sucker’s Rally” that tempts investors to jump back in to the market too soon and too aggressively, only to get crushed. History’s worst bear markets were punctuated by rallies that made a lot of money for those lucky enough to time them correctly, or unfortunate enough to have remained in stocks up until that point. The fall of the DJIA after 1929, and the NASDAQ after 2000, both saw at least four rallies of more than 20% before they hit bottom.
Stock Market Valuations
Before we get into some details regarding the price-to-earnings (P/E) valuations of the U.S. stock market, two facts must be considered. First, valuations are a horrible timing tool. They may tell you about the risk vs. reward of investing for the next five years, but valuations tell us absolutely nothing about where stocks will go in the next five months (a cheap market can get cheaper; a pricey market can get pricier).
Second, forward looking P/E ratios are only as good as the forecast of expected earnings. If you don’t know what a company is going to earn, it is tough to tell what its stock is worth.
Unfortunately, trailing earnings can also be complex. There are “operating earnings” which are the earnings publicly traded companies publish in accordance to SEC regulation. Operating earnings are the figures that a public company tells you and me they made. Sometimes they are referred to as earnings “without the bad stuff” as they exclude certain (and many) “nonrecurring” expenses. In theory, these should give investors an idea of the underlying profitability of a company.
And then there are “as reported” earnings, which are a little closer to Generally Accepted Accounting Principles (GAAP). This is the stuff that is reported to the IRS, and so they are designed to be reduced as far as possible so as to mitigate tax cots.
The argument can be made that, perhaps, the “E” to be used in the P/E ratio is somewhere in between the two types of earnings. BMM would argue that operating earnings are a ridiculous measurement – expenses are expenses and should not be excluded just because they are nonrecurring. After all, every year there are certain expenses that are classified as nonrecurring; they may or may not be the same expenses as the year before but “nonrecurring” expenses have this uncanny habit of occurring every year.
For companies that comprise the S&P 500 Index, in 2008 (using three quarters of actual earnings plus estimates for Q4), operating earnings were $65.79; as reported earnings were $48.05.
In stable times those two figures should come closer together as more unusual and uncommon (aka “nonrecurring”) losses fade. That they have not done so obviously casts doubts on the reliability of operating earnings. The average gap between operating earnings and as reported earnings over the last fifteen years has been about 13% – it was closer to 40% last year.
As mentioned above, if you don’t have an idea of what a company is going to earn, it’s tough to tell what its stock is worth. For the past thirty years the trailing P/E ratio (the price of stocks compared against the earnings of the trailing 12-months) has been about 15.6. So using $65.79 as the “E”, we could expect the S&P 500 to be trading at about 1,026 points (15.6 X $65.79).
But we need to figure out what the earnings will be in the next 12-months. For the past thirty years, stocks have traded at an average of about 13.7 times expected earnings. The emphasis is on “expected” earnings (as opposed to what the actual earnings turned out to be).
From 2007 to 2008 operating earnings dropped 20% and as reported earnings dropped 27%. In each of the past three recessions (1982, 1990, and 2001) earnings fell about 22% from peak-to-trough. Also, including up to Q3 2008 (where we have actual numbers) the companies of the S&P 500 have reported shrinking per-share earnings for five straight quarters, tying the record set in 2001-2002. That suggests the bulk of earnings damage has been done.
If we take the $48.05 as reported earnings for 2008 and make the thirteen percent adjustment (for the typical difference between operating earnings and as reported earnings), we get $54.30. If earnings are not expected to grow whatsoever in 2009 then we could argue for an S&P 500 of about 744 points ($54.30 of profits X average multiple of 13.7). That is good news in so much that the S&P 500 closed at 752-points on November 20, 2008 and thus hit a very likely bottom for this market cycle.
(However, it is important to note that the average P/E during a recession is just 11; when you remove the outlier of 2001, it is just 10. So even by historical standards we are not necessarily out of the woods just yet.)
Unless the recession lasts longer than expected (through all of 2009 as opposed to just the first half), then valuations argue we are moving through a bottoming process. Although this is encouraging for investors, given the current fragility of the U.S. credit markets and the lack of any traction yet taking hold in the U.S. economy, current valuations do not warrant jumping right back into the market at full force. Valuations do, however, warrant the consideration of a phased approach to putting risk back into portfolios.
We at Berkshire Money Management believe in buying stocks for the long run, but only if we are able to identify purchasing them at the right price. As investors we aim to be rewarded for our purchases and that occurs when we select a starting price that correctly forecasts expected profits. To do so requires some semblance of clarity. The lack of such clarity defines the line between speculation and investing.
Style Outlook – Small-Cap Outperformance Likely
Once we have confirmation that the market has completed its bottoming process, we anticipate outperformance from small-caps and mid-caps relative to large-caps. With monetary conditions favorable and the recession entering its late stages, small-caps could be poised to outperform once credit spreads start dropping and the market starts to maintain strong upside momentum. Small-caps remain in their long-term trend of relative strength that started in 1999, consistent with their tendency to outperform during secular bear markets.
Growth has also tended to outperform Value after market bottoms, but the case is stronger for small-caps to outpace large-caps. With monetary conditions favorable and the recession entering its late stages, small-caps could be poised to outperform once credit spreads (interest rates on corporate bonds versus interest rates on Treasuries) start dropping decisively and the market starts to maintain strong upside momentum.
We would also keep in mind that after bottoms, the Growth relative strength has not tended to last as long as the small-cap relative strength.
Fixed Income Outlook
Fixed income, except for Treasuries, turned out to be no place to hide in 2008. Bonds got crushed.
Although volatility and uncertainty in the fixed income markets in 2009 have the potential to be as bad as 2008, we don’t think they will be. Liquidity facilities appear to be helping unfreeze the funding markets, as spreads have fallen in recent weeks. With near-term inflation risks low and the Federal Reserve determined to keep the federal funds target rate near zero for a considerable period of time, the Fed will begin to implement quantitative easing (i.e. buying assets), flooding the market with more liquidity. With plenty of excess capacity in the economy, the Fed will maintain an easy monetary policy throughout the year.
The last time long-term Treasury yields were at this level was 1954 – a bubble has formed/is forming. But from November 1936 until April 1951, long-term yields remained in a 60-basis point (six tenths of a percentage point) range. Similarly, three-month Treasury-bill yields remained near zero from May 1931 until June 1947. So prolonged stretches of low yields do have precedent.
Should we be close to the end of the recession, the most attractive portions of the fixed-income market are not Treasuries or CDs, but rather what we call in the industry, “spread product.” This includes, but is not limited to, investment grade bonds, junk bonds, mortgage backed securities, bank loans, etc.
There have been improvements in most funding markets. This, combined with stalling of economic deterioration as well as current generous yields, makes us attracted to several spread products and we could very well begin to acquire them in both conservative as well as growth-oriented portfolios in Q1.
Emerging Market debt should be attractive once commodity prices show signs of rebounding and the global economic recovery takes hold.
On a valuation (i.e. relative yields) basis alone, municipals remain compelling for long-term oriented investors. Along almost the entire municipal curve, yields in most cases are three times more than comparable points along the Treasury curve. Although municipal default rates have been historically low, the absence of an explicit backstop along with funding pressures for some state and local governments make this a tricky area to maneuver. Such investments into municipals should consider ETFs or mutual funds, as opposed to holding individual issues.
Even Treasury Inflation Protected Securities (TIPS), which have no credit risk, are sporting unheard of yield differentials. Should the economy get a whiff of inflation then this asset class would become even more attractive.
The overall inflation rate has peaked for this business cycle. On a year/year basis inflation should turn into deflation in 1H 2009 due to lower commodity prices, a firmer dollar, deleveraging, and anemic economic growth. However, inflation could become a problem longer-term.
The seeds of inflation are being planted. Inflation is the result of too much money chasing too few goods. Clearly money supply, based on any metric, has exploded. And this has occurred even before President-Elect Obama’s projected near-trillion dollar deficit stimulus. The “too much money” component of the equation is present.
Regarding the “too few goods” part, inventory-to-sales are still too high. But with manufacturing crumbling, we believe that it will not be too long until inventories are cut enough to spark inflation.
This would be a potential catalyst for considering TIPS as well as commodities.
Europe’s economic and financial landscape deteriorated sharply in the last few months of 2008. The outlook for 2009 is bleak. Industry surveys and forward indicators show most major European economies – including Germany, U.K., France, Italy, and Spain – in recession.
Western European central banks have improved liquidity through the use of substantial monetary and fiscal policies. Despite policymaker’s concerted and unprecedented efforts to loosen the credit markets, credit markets remain tight and under considerable stress as the cost of new capital remains elevated.
As in the U.S., a dramatic increase in liquidity has not translated to similar increases in borrowing nor lending (i.e. velocity of money). Many indicators of consumer and business confidence linger near record low levels. Europe, like the U.S., has entered an era of deleveraging. Deleveraging has resulted in muted demand for loans from both corporations and households as both pay down debt and attempt to rebuild their balance sheets.
Events in Eastern Europe will largely influence how deep and long the European recession will be. Unlike most of the European countries on the Western side of the continent, few Eastern European countries have the balance sheets to mount the type of major fiscal stimulus, both enacted and anticipated, by their Western counterparts.
Shrinking demand in the east will exacerbate the downturn already underway in the west. Most major Western European countries will remain in recession well into 2009 amid a slide in exports, investment, and private consumption.
Disappearing export orders and falling capacity utilization rates will continue to reduce the need for new fixed investment. In addition, the medium-term outlook for corporate earnings is weak, further suppressing expectations for business investment. Increased government consumption will help, but there is significant risk of corporate bankruptcies and higher unemployment. While most European economies will gain traction in 2H 2009, economic activity is expected to be weaker than that of the U.S.
Weakening global conditions will certainly be felt in the region in 2009, but stronger macroeconomic fundamentals and reduced vulnerability to external shocks will keep the region afloat.
Deteriorating international economic conditions have threatened every region of the world. It is important to note that countries are being hit in different degrees depending on local fundamentals and macroeconomic management. Latin America has thus far been relatively resilient to the external shock.
During the first three quarters of 2008 the region’s growth showed no signs of significant deceleration. In fact, over the first half of the year the region grew about as fast as it did a year earlier. In the third quarter, however, a few countries (Argentina, Columbia, Mexico, Venezuela) started to show signs of slowing. Other countries (Brazil, Chile, and Peru) reaccelerated or remained strong. Thus the region expanded at an average rate of 5% in the first three quarters of 2008, compared with 5.3% in the same period a year before.
Financial markets, on the other hand, have not escaped the global turmoil. Latin America does not have the same problems to contend with as U.S. or Europe. The relative resilience shown by local financial institutions is a result of low exposure to risky assets as well as higher standards of government imposed supervision and regulation. Still though, markets have been hit by contagion effects as scared investors sought the perception of safer havens.
Due to the global credit and financial crisis the forecast for the region must remain subdued in terms of levels of optimism. However, favorable macroeconomics will mitigate the effects from abroad and will keep the region growing.
The Bottom Line: In past years our annual Economic Outlook reports have been used to layout to clients the most likely financial scenarios for the year ahead. This year, 2009, BMM’s efforts are less so directed toward forecasting and more so directed toward investment strategy. Specifically, Berkshire Money Management clients are going into 2009 with substantial cash reserves and efforts must be made to determine the when and the how of getting clients reinvested.
BMM’s early intentions are to deploy a strategy of purchasing riskier assets in a manner that is consistent with the adjectives “small” and “slow.” However, any number of things (including, but not limited to, testing the stock market’s 2009 lows, a bigger-than-expected fiscal stimulus package, or a material reduction of credit spreads) could influence to purchase investment assets in a manner better described as “big” and “fast.”
Whatever the shape or speed of the ultimate reinvestment process, BMM goes into 2009 openly acknowledging that should the stock market turn around and rally that client returns will be left behind. BMM views 2009 not as a year in which investors should accept risk in anticipation of animal spirits lifting the investment markets, but rather BMM views 2009 as a year in which investors should consider avoiding disastrous mistakes.