Quarterly Chartbook June 30, 2009 What happened, where are we now, and what do we expect?
What happened? At the end of the day, the market events of the past twenty-four months can be attributed to poor assumptions about risk that led to the crisis and then the deleveraging of financial institutions once the crisis was underway. Major financial institutions were not alone in this mis-pricing of risk. But due to their ability to borrow massive amounts relative to their capital base, their errors are the most glaring. We ve cited examples in past Chartbooks of no income verification or 0% down loans, but those were only symptoms of a greater problem. These assets continued to accrue on financial firms balance sheets at the same time they were borrowing more and continuing to use those new funds to buy more lowquality assets. When the music stopped, there was simply not enough time to unwind the trades. That really didn t happen until the end of the 3 rd quarter in 2008.
VIX a guide to market volatility Notice the massive spike in volatility (to unprecedented levels) beginning last September. This is far more significant that the previous near-term highs associated with Bear Stearns in March of 2008.
S & P 500 From its peak to its trough, the S & P 500 lost over 56% - the most during any decline other than the Great Depression. But, consider that there were nine trading days where the market declined greater than 5% between October and November (compared to only one since the beginning of the year) an indication of the de-leveraging on financial institutions.
What happened? When the 3 rd quarter ended, banks, hedge funds and investment banks realized the need to un do much of the leverage they had accrued. The only way to do this was to SELL, and some sectors were hit harder than others. Value investors typically supply liquidity to the market, but many were unable to do so because of their disproportionate investment in banking stocks (typically, high dividend and low PE) and the fact that many had already deployed a good bit of cash as the market declined earlier in the year. So, lots of supply + little demand = price declines. This was repeated during October and November. The point of maximum pessimism in the economic indicators (not stock prices) was roughly during this period. As consumers watched their business indicator (the Dow) decline, they became nervous and restrained from spending. This impact was felt in corporate earnings in the first quarter of 2009, and the cycle became a self-fulfilling prophecy. That s when the bears really entered the picture during February and the first week of March, there was a bear run on the financial sector. Unrelenting sell pressure (both long and short) pushed our economy to the brink until regulators stepped in.
Where are we now? While the road may be bumpy ahead, it is our opinion that the crisis has been averted and the market lows of March will not be repeated. As we were in the midst of the turmoil, the most important thing was to not make policy errors. The individuals who led us through these events were the ideal team to have in place, both from an experience basis and from that of their academic histories. While many do not agree with all decisions made during this period, we can now move forward from a position of relative strength and begin to re-assess our needs as an economy. This is another way of saying that the Fed can begin to restructure its balance sheet and reduce money supply at the appropriate times. The market has increased about 38% from its lows and needs time to re-assess true valuation after these lofty gains, and this summer will likely provide more buying opportunities in the near-term as the market pulls back slightly.
TED spread After maximum pessimism in late October, the difference between US Treasuries and LIBOR rates has again entered a reasonable range. This was scary!
Credit spreads Credit spreads remain higher than their historic range, but they have contracted considerably in another sign of the abatement of risk aversion. Source: Merrill Lynch
Copper This chart is very useful it illustrates the absolute panic that set in when copper prices returned to the levels of late 2003 as well as the substantial rebound from that point (about 80%). To us, this (when viewed in context of other data) is an indicator that market participants believe the worst is over.
Housing prices Source: Dismal.com The rate of decline for housing prices has slowed over the past months the year over year trough coming in January and lagging other indicators trough values. While housing prices (especially in certain areas) are likely to be contained for quite some time due to the inventory build-up, the bottom has likely been reached.
What we expect We anticipate economic growth returning to the economy in late 2009 or early 2010. At that point, Gross Domestic Product will have declined from its peak by roughly 5 6%. However, the unwinding of the necessary actions to save our economy will take time and will have to be executed with precision. In addition, we are also undergoing a once-in-a-generation change in consumer behavior. At Cornerstone, we are calling it stratification and rationalization consumers are again being stratified according to disposable income and wealth (no more pretending) at the same time they are rationalizing their spending (do I really need that?). Some economists are calling this the new normal, and it will result in a drastic change to the way capital is deployed. What, then, is a fair value for the market?
The opportunity S&P 500 Market Cap/Nominal GDP 140.0% 120.0% 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% Sep-91 Aug-92 Jul-93 Jun-94 May-95 Apr-96 Mar-97 Feb-98 Jan-99 Dec-99 Nov-00 Oct-01 Sep-02 Aug-03 Jul-04 Jun-05 May-06 Apr-07 Mar-08 Feb-09 Historically, the market capitalization of a country s stock exchange trades roughly at parity with the nominal GDP for developed nations during periods where interest rates are not punitively high.
The opportunity (part II) 9.00% S&P 500 Market Cap/Nominal GDP Interest Rate Adjusted 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Mar-77 Feb-78 Jan-79 Dec-79 Nov-80 Oct-81 Sep-82 Aug-83 Jul-84 Jun-85 May-86 Apr-87 Mar-88 Feb-89 Jan-90 Dec-90 Nov-91 Oct-92 Sep-93 Aug-94 Jul-95 Jun-96 May-97 Apr-98 Mar-99 Feb-00 Jan-01 Dec-01 Nov-02 Oct-03 Sep-04 Aug-05 Jul-06 Jun-07 May-08 When adjusted for interest rates, the symmetry of the recent downside and the run-up prior to the tech-wreck is very interesting.
Inflation 16% Price Pressure Index -- Longer Term View Price Pressure Index Consumer Level Inflation 16% 14% 14% 12% 12% 10% 8% 10% 8% 6% 6% 4% 2% 0% Apr-53 Apr-55 Apr-57 Apr-59 Apr-61 Apr-63 Apr-65 Apr-67 Apr-69 Apr-71 Apr-73 Apr-75 Apr-77 Apr-79 Apr-81 Apr-83 While there are a number of prognosticators concerned about money printing, we believe that is an issue for another day. In the meantime, there is tremendous excess capacity in the system from homes, to factories to employees. Apr-85 Apr-87 Apr-89 Apr-91 Apr-93 Apr-95 Apr-97 Apr-99 Apr-01 Apr-03 Apr-05 Apr-07 Apr-09 4% 2% 0% -2%
Personal savings rate Personal Savings Rate 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 - Jul-89 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Personal savings has rapidly moved from less than 1% to almost 7%. This is dramatic and indicates just how much consumer behavior is changing.
Retail sales Retail Sales as a % of Personal Income 40.00% 39.00% 38.00% 37.00% 36.00% 35.00% 34.00% 33.00% Dec-92 Jun-93 Dec-93 Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Retail spending has collapsed concurrent with this savings. While this is painful in the near-term, this is a healthy structural change in how we spend our money.
Retail spending something interesting to consider This is somewhat of a side-track, but an interesting one nonetheless It is our opinion that the outrageous salaries that professional athletes have commanded in recent years will begin to curtail, both in terms of duration of contracts and compensation. The reason for this is simple, and it all comes back to the consumer there are just a few sources of income for professional sports, and they are all consumer-related in one way or another. Let s look at them -Ticket sales -Stadium naming rights / subsidies -Merchandising apparel -Advertising for television As there is less household discretionary income, reduced marginal consumption will affect most of these, while others have been affected by different forces.
The yield curve and bank re-liquification While we will not argue that banks are in a position of strength (we think a number are very weak indeed), an upwardly sloping yield curve implies opportunity for the banks to move towards stronger balance sheets. Specifically, as banks lend at higher long-term rates and borrow at lower short-term rates, they retain the spread. At the same time, hard-to-value assets are ceasing to decline as the market sorts through the rubble.
Leading indicators Economic Momentum 60.00% 13 Week 52 Week 3 Year 40.00% 20.00% 0.00% 1/22/1999 5/22/1999 9/22/1999 1/22/2000 5/22/2000 9/22/2000 1/22/2001 5/22/2001 9/22/2001 1/22/2002 5/22/2002 9/22/2002 1/22/2003 5/22/2003 9/22/2003 1/22/2004 5/22/2004 9/22/2004 1/22/2005 5/22/2005 9/22/2005 1/22/2006 5/22/2006 9/22/2006 1/22/2007 5/22/2007 9/22/2007 1/22/2008 5/22/2008 9/22/2008 1/22/2009 5/22/2009-20.00% -40.00% -60.00% After sinking as low as ever recorded, the weekly leading indicators have surged forward signaling opportunities ahead.
Our Outlook There are a number of significant challenges that remain, some are today s problems and some are to be considered over the coming two- to threeyears. Unemployment is a lagging indicator and will likely reach double digits before it begins to improve. Negative sentiment associated with this may weight on market returns in the near-term. Change in consumer behavior makes sector selection very important. This is one of the reasons the commercial real estate market may have issues (but, these are already likely factored in to stock prices). Inflation is not the concern, yet. Central bankers will eventually have to be prudent, careful and timely as they reduce money supply. As markets (both securities and transactional) return to normal, the gap between market valuation and GDP will close that is our opportunity in the coming years!