Identifying Short and Long Term Trends for 2009 - Part I
(December 28, 2008)
Dear Subscribers and Readers,
Rex (my business partner and webmaster of Marketthoughts.com) and I want to take this opportunity to wish all our subscribers a great New Year's and a great 2009! The year 2008 was the toughest year for investors in modern history. Year-to-date, the total return (performance of the index plus dividends) of the S&P 500 is -39.16%. According to Ibbotson, the only other worse performing year (utilizing stock market data going back to the 1820s) was 1931, when the S&P 500 declined by 43.3%. The decline in 1931 was preceded by the Bank of England leaving the gold standard, resulting in a general drain on gold reserves in both the US and other major countries. As a result, the Federal Reserve was forced to raise the discount rate from 1.5% to 3.5% in a sinking global economy in order to stem the gold outflows. This confluence of events set off a severe banking crisis and a crash in the U.S. stock market. While bank failures across the country averaged 100 a month during 1930, it rose to a monthly average of 320 from September 1931 to February 1932. The Dow Industrials and the S&P 500, meanwhile, both declined approximately 30% during September 1931 – its worst monthly decline in history as the country crashed into the Great Depression.
Only five broad asset classes were sound hiding places this year: 1) Cash, 2) U.S. Dollars (the U.S. Dollar Index is up more than 5% on a year-to-date basis), 3) the Japanese Yen, 4) Gold, and 5) U.S., German, and Japanese government bonds. According to Capital IQ, only one (biotech) out of 154 industries in the U.S. ended in the black this year. The top performing industries are Biotechnology (+9.4%), IT Services (-4.6%), Water Utilities (-5.3%), and Food and Staples Retailing (-12.9%). The worst performing industries are Thrifts and Mortgage Finance (-89.6%), Real Estate Management and Development (-81.1%), Automobiles (-72.3%), and Wireless Telecommunication Services (-70.0%). Even some short-sellers were burned this year, as the SEC and the Financial Services Authority in the UK banned short selling of the vast majority of financial stocks in mid September – prompting many hedge funds and short-sellers to cover their short positions at a loss as they faced a short squeeze. Both hedge funds and private equity funds also experienced their most dismal year ever – as lenders cut back on lending and as lending rates for risky investments soared (despite significant easing from the world's central banks) – destroying their appetite and need for leverage. Finally, even the hedge funds and mutual funds that did well in the last (2001 to 2002) bear market, such as SAC Capital, Tudor Funds, Legg Mason Value Trust, Longleaf Partners and Dodge & Cox Stock Fund, could not escape the 2008 bear, as they either experienced one of their worst years in relative performance or had to alter their fundamental investment philosophies.
I would now like to take this opportunity to again thank you for all your support in 2008, as well as say “thank you” to our regular guest commentators, Mr. Bill Rempel of http://billrempel.com and Mr. Rick Konrad of Value Discipline for their absolutely invaluable contributions to both our main site and in our discussion forum. Please keep these new ideas flowing as we head into 2009, and as we attempt to navigate what will be one of the more interesting years in modern history. Rex and I looking to serving you all in 2009 and beyond! Similar to last year (please see our December 27, 2007 commentary “Identifying Short and Long Term Trends for 2008 – Part I” and our January 6, 2008 commentary “Identifying Short and Long Term Trends for 2008 – Part II”), this commentary will be the first in our two-part commentaries where we will outline our investment and economic thoughts for 2009 and beyond. There will be no official commentary this Wednesday (New Year's Eve), although there's a chance I will send you an “ad hoc” commentary in lieu of an official commentary. The second part of our two-part commentaries will be in your mailbox next weekend. For this commentary, I would like to summarize most of our thoughts over the last few months and outline what I believe would be the most important trends to watch in the stock market for 2009 and possibly 2010. Without further ado, let us now dive right in.
I believe each one of us could take our own lessons from the Great Crash of 2008. The first (and obvious) lesson is that investing in stocks is a risky endeavor. Actually, this is more of a reminder, as historically, annual stock market returns have been less than -5% and greater than +15% more than half the time over the last 180 years. As John Pierpont Morgan says of the stock market many years ago: “It will fluctuate.” Moreover, as I first discussed in our August 29, 2004 “Special Report,” it is very important to take the time to learn more about your psychological makeup and how it has affected your investment or trading decisions over the years. What type of person are you when it comes to the market? Does your psychological make-up allow you to take short-term but significant losses in the hope of long-term and outsized investment gains? Or are you mostly a swing trader, or a day trader? More importantly, are you an independent thinker or merely a follower? Since the late September to early October crash in the stock market, I have received many emails from subscribers asking for advice or guidance – from the disciplined 25 year-old who shifted some of his bond holdings to stock index funds in his 401(k) plan during the decline to the retiree who was speculating on the stock market with leverage and trading financial ETFs with two times leverage. More often than not, it is the 25-year-old with the disciplined asset allocation and a long-term plan who will prosper in the long run. In order to succeed in investing, you need to understand your own risk tolerance, have a long-term plan, and have the right expectations for your investment strategies. This will not only ensure that you will not sell your stocks at the worst possible time, but that you will not be taken out by large losses. More importantly, assuming you have a proper asset allocation to begin with, you will be able to utilize any decline as an opportunity to put more of your investments into equities to take advantage of the great companies that are selling at large discounts to their historical valuations.
Dear Subscribers and Readers, one of your goals for the first few weeks of 2009 is to read or re-read Peter Lynch's “One Up on Wall Street.” Not only does this book tell you some common sense ways to beat the S&P 500 and professional money managers through individual stock picking, it also discusses if you should invest in equities or buy individual stocks in the first place. Quoting the book:
Before you think about buying stocks, you ought to have made some basic decisions about the market, about how much you trust corporate America, about whether you need to invest in stocks and what you expect to get out of them, about whether you are a short- or long-term investor, and about how you will react to a sudden, unexpected, and severe drops in price. It's best to define your objectives and clarify your attitudes (do I really think stocks are riskier than bonds?) beforehand, because if you are undecided and lack conviction, then you are a potential market victim, who abandons all hope and reason at the worst moment and sells out at a loss. It is personal preparation, as much as knowledge and research, that distinguishes the successful stockpicker from the chronic loser. Ultimately, it is not the stock market nor even the companies themselves that determine an investor's fate. It is the investor.
Peter Lynch penned these words in 1989, with the 1987 stock market crash fresh in his (and everybody else's) mind. With the 2008 crash fresh in our minds, it is time to go through this exercise again. I first read “One Up on Wall Street” as a teenager. At the time, I did not quite get this particular piece of advice – and quickly skimmed through the above paragraph. I want to emphasize again how important the above paragraph is – read it, and read it twice, and think over it again. Another reason for reading “One Up on Wall Street” again is because I expect a bull market in U.S. stocks to emerge from the ashes of the 2008 crash sometime in 2009. However, what emerges from these ashes will be different. With credit still tight and with overcapacity in many industries, I expect the next bull market to be more of a “stock picker's market” relative to the bull market that began in 2003 – when almost every stock in every industry surged in the first leg up from March 2003 to January 2004. For those who are going to buy individual stocks, I highly suggest buying companies that are dominant in their industries – with high barriers to entry. I also suggest buying companies with pricing power – not only over their customers but over their suppliers as well. These companies don't need to be in high-growth industries, as long as they are not doing business in declining industries such as newspaper publishing, textile manufacturing, or shipbuilding.
The State of the U.S. Stock Market and Economy
As I have discussed in our commentaries and on the MarketThoughts.com discussion forum, my belief is that the global equity market crash since the end of 2007 has as much to do with "global overcapacity" and the lack of investment/growth opportunities as much as an unwinding in excess leverage in both the financial markets and in the “real economy.” In fact, the two go together, as both financial and non-financial companies needed much more leverage in order to achieve the ROEs the market demanded of them over the last few years, given the lack of "easy pickings" such as the great growth stories spurred on by the many seminal events during the 1980s to 1990s, including the commercialization of the PC/internet, the huge disinflationary tailwind that began in 1980s, the fall of Communism in 1989, and the opening up of China in 1978 and India in 1991. In other words, the potential/sustainable growth rate of the global economy, short of a significant technological breakthrough, had been shrinking over the last few years. In retrospect, there were many obvious and troubling signs, such as:
- The unprecedented rise in energy and industrial commodity prices. In order for global economic growth to be anything like the past, the world needs cheap and abundant energy. Ominously, new sources, such as oil sands or deep see oil drilling had marginal costs of production in the $50 to $70 a barrel range. The technology to develop the natural gas in Marcellus Shale was still in its infancy. More ominously, much of the U.S. dollars used to pay for oil imports were being shipped to countries that had no capability or the history to innovate or to commercialize productivity-enhancing technologies. Even the optimists – those who were hoping for a rapid adoption of efficient alternative sources of energy, such as solar power, wind power, and cellulosic ethanol – had to admit defeat when no such technologies had been widely commercialized even as the crude oil bull market entered its fifth year and surpassed $100 a barrel for the first time in early 2008.
- While many analysts and investors would agree that Ricardian growth has not reached its limits, the long-term sustainable Ricardian growth had been shrinking. Some examples include the high environmental costs incurred by China as a result of its rising domestic productivity (which is a detriment to long-term sustainable economic growth), rising labor costs in China and India, and the rise in transportation costs stemming from a rise in fuel and shipbuilding costs.
- Many industries/sectors in the US economy suffered from overcapacity and/or gross misallocations of capital, including the retail industry, hotels, the gaming sector, restaurants, and of course, the financials and homebuilding industries. Even in the healthcare sector, much of the investments made over the last decade or so have been all for naught, with the exception of R&D in the largest biotech firms and various medical device companies. And Intel – one-half of the “Wintel duopoly” which played a large role in both the PC and internet eras – had been having problems with increasing the effective speed of their microprocessors since 2002 (programming for multi-core processors is not exactly an easy task). Moreover, it wasn't clear that the housing market was the last “big shoe to drop,” as there is definitely excess capacity and leverage within the commercial real estate market as well. In the coming year, a record amount of real estate in the hotel and retail industries will be coming online, just as the travel and retail industries enter one of their worst years ever. For those that are invested in commercial REITs, I highly recommend taking a hard look at those underlying holdings.
That being said, I am bullish on the U.S. stock market over the next few years, given the very decent valuations and the potential for enormous Schumpeterian-driven growth (as I have discussed in our recent commentaries). That said, I am still wondering whether there will emerge huge "tailwinds" for the stock market – such as the adoption of the PC/internet, the fall of Communism, the opening up of China and India, and the global recovery from inflation during the 1980s and 1990s. My guess is “yes,” i.e. a similar tailwind will pop up in the next few years, which could include one or more of the following life-changing technologies: 1) A dramatic jump in cheap energy supplies, driven by the commercialization of cheap alternative energy technologies, such as solar power and cellulosic ethanol. Already, there is some contention that we may have achieved “grid parity” at a Nevada solar plant installed by First Solar. Even if that isn't the case, grid parity is inevitable, with current projections calling for grid parity to be reached sometime in the 2010 to 2012 timeframe in parts of California, Nevada, Hawaii and Texas. The adoption of plug-in hybrids will allow us to benefit to the utmost from the inevitable goal of "grid parity" - at least in parts of California, Nevada, Hawaii, and Texas. Combined with the commercialization of natural gas production in the Marcellus Shale and the Haynesville Shale (which collectively is estimated to hold more than 12 years of U.S. natural gas consumption in recoverable reserves), there is a good possibility that crude oil imports will start to embark on a downtrend sometime in the next few years; 2) A new era in personalized medicine that could lead to "cures" for various kinds of cancer and other diseases, including Alzheimer's. This will dramatically lower the "burden" to modern society and allow baby boomers to become ever more productive in their latter years; 3) A breakthrough in materials sciences - resulting in the commercialization of carbon nanotubes as basic building blocks for our transportation and our housing infrastructures.
None of this will allow the global economy to grow at a rate above our 20-year historical average for a sustained period of time, but they will definitely allow the global economy to sustain a 3% to 5% growth rate at least for the next decade, or two. As we have mentioned over the last six months, achieving such Schumpeterian growth will be very beneficial to the US economy on an absolute and relative basis, as Americans have nearly always been at the forefront of each Schumpeterian growth wave. But what that means is that we will need to be very selective in terms of picking stocks, industries, and even countries. Russia will continue to be in decline, and the Middle East may again turn into a basket case if oil stays at $50 or below for the next decade.
For subscribers who do not have the time or the inclination to dig deeper into individual industries or companies, I highly recommend having an overweight in the SPY in your taxable accounts – an ETF for the S&P 500 that is highly tax-efficient – and accumulating SPY in your portfolio over the next few months during market corrections. As I have mentioned before, the SPY is now trading at a very decent valuation. At a 3.12% dividend yield, it is now trading at a 0.98% yield premium to 10-year Treasuries – the greatest positive spread since June 1958. Similarly, the S&P 500 dividend yield to Moody's Baa bond yield ratio stood at 0.39 as of December 24, 2008. The last time it had been at such a high level was at the end of September 1990 (which preceded a 10-year bull market in the S&P 500) – when this ratio hit 0.38. Given that the Federal Reserve is now directly targeting fixed income yields in the riskier areas of the market, such as auto loans and credit card asset-backed securities market and GSE mortgage-backed securities, my sense is that the Moody's Baa yield will continue to come down over the next few weeks, even as corporate defaults continue to rise. This will increase the S&P 500 yield to Moody's Baa bond yield ratio yet further – and should indirectly induce investors to flock back to the U.S. high yield and equity markets. With money market funds now yielding anywhere from just a little over zero to only as “high” as 2.4% (the Vanguard Prime Money Market Fund currently has a yield of 2.36%), there is a good chance we could see some reallocation by money market investors back into riskier corporate debt or equities. Moreover, with approximately $3.5 trillion in money market assets, it would not take many of these investors to cause a tremendous rally in the S&P 500, as the amount of cash in money market funds could now buy 45% of the total market capitalization of the S&P 500, or over one-third of the entire U.S. market capitalization. I also expect the Feds to continue to accumulate GSE mortgage-backed securities – with the intent of taking the 30-year conforming fixed mortgage rate to 4.5% or below. That's right: Aside from directly targeting the riskier areas of the fixed income market, the Feds have also made clear that they are now directly targeting the housing market. For now, we will wait – and continue to accumulate the SPY on any dips and weakness.
In the meantime, I expect the U.S. unemployment rate to peak in the 8% to 9% range sometime in the next 6 to 15 months. The damage has now been done. The deleveraging phase is still in motion. This will continue to hit the industries/sectors that have excess capacity or that have misallocated capital in the last few years – including many companies in the retail, lodging, and restaurants industries. The deleveraging trend should also spread to the commercial real estate sector in 2009. Without the aid of government infrastructure spending, domestic construction should fall off a cliff in 2009. Even should oil prices rebound to over $50 a barrel (which is what the futures curve is currently predicting) early next year, we should start to see projects being “mothballed” and layoffs in the energy and the materials sectors. With retail, lodging, and restaurants shedding their excess capacity, and with commercial real estate struggling and the energy and materials sectors beginning their own round of layoffs starting next year, unemployment could rapidly rise above the 8% level by early next summer. The graduation of the 2009 MBA and undergraduate class in the summer would increase the unemployment rate still further – as the number of unemployed and “yet looking” will no doubt increase at that time. There is a bright side to this, though, as many bright students in the natural sciences and engineering fields will instead choose to get their PhDs and stay in their fields, instead of heading to Wall Street.
While Obama's planned fiscal stimulus (now estimated to be in the range of $675 to $775 billion) should no doubt put a cushion under the economy in 2009, my sense is that this will do little in the short-term to stem the rise in the unemployment rate, as 1) any immediate tax rebates would most likely go towards rebuilding savings, and 2) the major goal of the fiscal stimulus is to invest in long-term U.S. economic growth, such as investments in alternative energy technologies, the sciences (such as an increase in NIH funding), education, and infrastructure (which will create little jobs as much of the costs in building infrastructure are materials costs, and not labor costs). Make no mistake: Obama's fiscal stimulus plan will not benefit the uneducated retail work or mortgage broker who have recently been or are in danger of being laid off.
The Other Shoe to Drop?
As I have mentioned before, the European Central Bank's lack of urgency (and blunder earlier in July, as it raised its policy rate by 25 basis points even as the entire global financial system was collapsing) is disappointing, as: 1) With the exception of Germany, the majority of the Euro Zone's countries had experienced a housing bubble larger than the US housing bubble, 2) The Euro Zone cannot export their way out of their economic problems, given the still-high Euro and a potential global recession, 3) Aside from Germany and France, no other countries in the Euro Zone can credibly implement a fiscal stimulus to spur economic growth, given the region's high debt-to-GDP ratios and budget deficits. Including the planned fiscal stimulus by the UK and other economies within the European Commission (but outside of the Euro Zone), the total stimulus package is estimated to be just 200 billion Euros, or just 1.5% of the European Commission's GDP. Compared with Obama's $675 to $775 billion (4.8% to 5.5% of U.S. GDP), this is just a mere drop in the bucket. More ominously, the Euro Zone's biggest customers and biggest borrowers (i.e. Central and Eastern Europe) are now plunging into recessions of their own and have huge negative cash flow problems (e.g. Greece is highly leveraged to the depressed shipping industry and is running a current account deficit equivalent to 10% of its GDP). Banks in the Euro Zone, in particular, have lent close to 4 trillion Euros to Central and Eastern Europe. Before this is over in Europe, I expect many more IMF bailouts and a potential global bailout for some European commercial banks. This is definitely the “other shoe to drop” aside from the ongoing deleveraging phase in the U.S. commercial real estate market (in particular within the hotel and retail sectors).
My personal belief is that any potential systemic problems from the Euro Zone, and Central and Eastern Europe could emerge as soon as January next year – putting the European Central Bank, the IMF, and the World Bank in “crisis mode.” While Europe could still avert a potential systemic collapse by dramatically cutting interest rates early next year, I am not optimistic on such an outcome, as the European Central Bank has indicated in recent days that it may pause at its next meeting. Other measures that could avert a potential systemic collapse in Europe could include: A larger-than-expected fiscal stimulus, accompanied by income tax cuts, in Germany; more decisive action by the IMF in Central and Eastern Europe, with fewer strings attached; and concerted action by the Bank of Japan and other central banks to bring the Yen down, as many countries in Central and Eastern Europe have borrowed in Yen (as well as in the Euro, the USD, and the Swiss Franc). Given the slack response by the European Central Bank, the Bank of Japan, and the German government during this crisis so far, I am not optimistic at all that Europe could emerge from this unscathed. For now, we will continue to monitor the deteriorating situation in Europe and not hold our breath, but for those who still have assets in Central and Eastern Europe (including Russia), I highly suggest shifting those assets into U.S. Dollars as soon as feasible.
In my next “ad hoc” commentary, I will devote some space to the Chinese economy and individual industries. Until then – we wish you a great and happy New Year's and a prosperous 2009!
Henry To, CFA