Investment Review & Outlook: 1st Quarter Review
Economy
The credit crisis took a nasty turn in the first quarter, claiming its highest-profile casualty to date in Bear Stearns. A significant failure often marks the end of periods of severe financial stress (such as Long- Term Capital in 1998 or the savings & loan insolvencies in the late 1980s), and the Federal Reserve’s aggressive response in dealing with Bear Stearns may facilitate an eventual recovery from this particular slowdown as well. However, the unwinding of the housing bubble, the root cause of nearly everything that presently ails the economy, shows only hopeful signs of bottoming. Home prices as measured by the S&P/Case-Shiller Index have declined for thirteen straight months through January and stand 10.7% lower than year-ago levels. Building permits dropped to the lowest level in sixteen years in February as builders responded to a 30% reduction in new home sales over the past year. While the price declines and slowdown in residential construction are painful, they are necessary to help align supply with underlying demand, determined historically by the pace of household formation and trends in income. The process has further to run. Despite the supply of new homes for sale declining to the lowest level in nearly five years during February, the poor sales activity equates that figure to a 9.8 month supply, which is a twenty-six-year high. The devastating 60% jump in foreclosures over the past year has nudged the supply of existing homes higher as well.
However, sales for existing homes surprisingly improved in February, perhaps reflecting better affordability given recent price cuts. While certainly a positive, the spring selling season may bring an additional surge in property listings and further markdowns as clearing prices become more transparent. Therefore, we expect housing will remain a detractor to GDP growth into early 2009.
In addition to deteriorating housing metrics, the feared spillover into consumer and business spending now seems at hand. Consumer spending net of inflation posted no gain in February. Consumer sentiment, battered by housing’s travails, higher taxes, and surging gasoline prices, fell markedly during the quarter, resulting in a 0.6% drop in retail sales in February, the second negative showing in three months. Moreover, auto sales plummeted during the month of March, while durable goods orders fell in both January and February. Business investment, as measured by non-defense capital goods orders excluding aircraft, also decreased in February by 2.6%. The slowdown in home building and downsizing in the auto sector caused a contraction in manufacturing activity for the second straight month, although the 48.6 reading for the Institute of Supply Management’s manufacturing index remained well above readings typically associated with recessions.
The most worrisome development in the economy is the recent deterioration in hiring. The economy shed jobs every month in the first quarter, culminating with an 80,000 reduction in payrolls in March, the worst month for net hiring since March 2003. Source: Bloomberg, L.P.
Manufacturing and construction layoffs continue unabated, as 666,000 jobs have been lost in those two sectors alone over the past year, contributing to the rise in the unemployment rate to 5.1%. Weekly claims for unemployment insurance confirm the rapid deterioration in the labor market, jumping to 407,000 for the week ended March 28th. While recessions are typically associated with weekly claims readings in excess of 400,000, the four-week moving average remains below 375,000, albeit in a rising trend. In addition, payroll losses of 150,000 to 200,000 are normal in recessionary environments, versus a monthly average loss of 77,000 thus far in the first quarter. Therefore, while labor remains on the defensive, hiring trends by themselves do not point to a significant contraction in economic activity.
While the financial crisis remains a difficult obstacle to navigate, there are a few bright spots that should minimize the severity and duration of any slowdown. The slowdown in the growth rate of average hourly earnings allowed the Federal Reserve to be aggressive in stimulating the economy without worrying about creating a wage spiral associated with periods of stagflation. In addition, the Fed recognized that companies relying on short-term financing to fund growth opportunities have found it increasingly difficult to acquire capital in this environment of de-leveraging and counterparty concerns. The Bear Stearns collapse was the culmination of these worries, and spreads in corporate issuers widened accordingly. However, the Fed seems to have stabilized spreads somewhat through the creation of historic lending facilities aimed at unlocking the credit environment. In addition to the Term Auction Facility unveiled during the fourth quarter, the Fed created the Term Securities Lending Facility (TSLF) and the unprecedented Primary Dealer Credit Facility (PDCF). The former provides primary dealers the opportunity to swap up to $200 billion in AAA-rated mortgage-backed securities for Treasury securities. The facility allows dealers to unload assets trading at distressed prices for securities that are more liquid with the hope that firms will create loans with a less encumbered balance sheet. By setting the term at twenty-eight days, the facility provides time for market conditions to improve before the collateral is returned to the dealer.
The PDCF, which was created to prevent runs on investment banks like Bear Stearns, allows broker/dealers to borrow directly from the Fed for the first time using investment grade securities as collateral. Given that the Fed risks running out of ammunition with overnight rates at low absolute levels, the Committee should be applauded for their creative, targeted approach to the crisis. Spreads and credit default swaps on financial companies have improved considerably since mid-March, and mortgage spreads have come in as well, indicating tentative signs of success.
In addition to easier monetary policy, Congress responded to the crisis by implementing an economic stimulus package via tax rebates in an attempt to revive the dormant consumer. Meanwhile, states such as Maryland, Illinois and Minnesota are drafting legislation to help stem the surge of foreclosures. Regulators for mortgage titans Fannie Mae and Freddie Mac agreed to ease surplus capital requirements, potentially freeing up $200 billion of capital to support the beleaguered market for mortgage-backed securities. An increase in the conforming loan limit in certain regional housing markets will further allow Fannie and Freddie to guarantee more mortgages and facilitate more lending. Furthermore, the weaker dollar has buoyed earnings for multinational companies, providing a cushion for the economy. While these positives are mitigating factors, we do not envision a resumption of above-trend GDP growth for the balance of 2008 and expect the best-case scenario for the first quarter to be a continuation of last quarter’s tepid 0.6% rate of growth.
Fixed Income
Fixed income returns again showed great disparity among sectors, as the credit crunch impacted each sector of the market to varying degrees. Continuing the trend evident in the fourth quarter, Treasury bonds remain the asset of choice for risk-averse investors, both domestically and abroad. Counterparty concerns among banks further supported the market, as dealers increasingly demanded Treasury collateral in repo transactions. The heightened demand for Treasuries resulted in a robust 4.43% return for the first quarter, and 8.86% over the past six months. The overall taxable bond market, as measured by the Lehman Brothers Aggregate Bond Index, fared relatively well, advancing a respectable 2.17% during the quarter and 5.23% since the end of September. In addition to Treasuries, agency bonds and prime mortgage-backed securities were accretive to the Aggregate Index’s return during the first quarter. However, within the index numerous sectors fared poorly, most notably asset-backed securities (-1.92% during the quarter), commercial mortgagebacked debt (-2.57%), and corporate bonds (-0.15%). The credit crisis inflicted severe damage on the municipal market, and returns for tax-free bonds were disappointing despite a strong March. The Lehman Brothers Municipal Bond Index dropped 0.61% in the first quarter, primarily due to a 4.58% loss in February, the worst month for the market in nearly five years.
The Federal Reserve responded aggressively to the financial crisis, lowering overnight rates by 200 basis points during the quarter to 2.25%. The first rate cut on January 22nd was an inter-meeting move of 75 basis points in response to a meltdown in the overseas markets the night prior. Sensing the credit crunch was deepening and labor markets were rolling over, the Fed followed with an additional 50 basis points at its regular meeting on January 30th, resulting in an unprecedented 125 basis points of easing in just over a week’s time. As the Committee managed the fallout from the Bear Stearns collapse, the Fed cut another 75 basis points at its March 18th meeting, noting that the credit crunch and real estate recession were “likely to weigh on economic growth over the next few quarters.” The March meeting marked the low in yields during the quarter, as two dissenting votes led market participants to scale back expectations for further rate cuts. In addition, the Fed’s creative and historic lending facilities aimed at providing liquidity to the dealer community eased counterparty concerns, reducing the odds that another run on an investment bank would take hold. With real interest rates moving into negative territory, we believe Treasuries hold little value at current levels and are increasingly looking at spread product as the credit environment improves.
The Fed’s policy moves have been of marginal help to the municipal market, which is working through a perfect storm of dislocations unique to that market. The deteriorating credit quality of the monoline insurance companies and subsequent credit downgrades generated a wave of margin calls and forced selling among hedge funds. As tax-free yields adjusted higher in response to the unrelenting quantity of bid lists, levered arbitrage accounts betting on municipals outperforming Treasuries got squeezed, creating additional selling pressure. Concurrently, the $330 billion auction-market seized up for the first time in its twenty-five year history, as the dealer community refused to commit capital to support the auction process. With bank balance sheets shrinking following $230 billion of write-downs, liquidity for the secondary market dried up, and municipal yields as a percentage of Treasuries routinely topped 120% in February. Data showing slowing sales and property tax revenues at the local government level and talk of municipal bankruptcies in Vallejo, California and Jefferson County, Alabama fed the environment of risk aversion. Eventually, municipal bond mutual funds flush with client inflows selectively bought into the market in late February, providing a floor under the market. As the yield curve steepened, individual investors, frustrated with paltry yields on money-market funds, looked to municipals as taxable-equivalent yields comfortably topped 8% for longer maturity bonds. In time, we believe the current market environment will be considered an excellent buying opportunity. Yields are unsustainable on a relative basis and attractive in absolute terms compared to historical risk-adjusted returns of other asset classes. Therefore, we have been accumulating positions in long-maturity municipals for appropriate portfolios.
The easy monetary policy engineered by the Fed fostered concerns that inflationary pressures seen early in the quarter would become somewhat entrenched. The March FOMC statement acknowledges this risk, characterizing inflation as “elevated” while noting that “some indicators of inflation expectations have risen”. With oil prices comfortably above $100/barrel and food prices surging, headline inflation numbers are uncomfortably high. For example, the annual increase in wholesale prices nearly tripled over the past year after exceeding 6% for five straight months. Likewise, annual increases in consumer prices have topped 4% for the past four months. In addition, import prices increased at a 14.8% pace through March, primarily due to higher fuel costs. Excluding fuel, import prices still rose a sturdy 5.0% during the period, raising concerns that the weakening dollar is nurturing inflationary pressures. Moreover, elevated inflation data in Europe and China and rising labor costs within these countries threaten the “global surplus of labor” thesis, raising the odds that the secular trend of global deflation may be winding down. While persistently strong headline inflation will eventually filter into core measures, we suspect sufficient slack will arise in the domestic economy to prevent a meaningful pass-through. The housing bubble is clearly a deflationary shock, and mounting layoffs should restrain wage growth in the near-term. Therefore, we expect core CPI and PPI to remain in the mid-2% range that has persisted of late, with moderate improvement possible later in the year.
Equity
Volatility continued in earnest for equities during the first quarter of 2008. Concerns over the health of the economy, the deteriorating housing market, and credit market crises accelerated as the New Year unfolded. January presented a very difficult and fragile market environment, as the unwinding of trades by one rogue trader at a foreign bank was enough to rattle confidence in global equity markets and prompt an emergency inter-meeting rate cut by the Federal Reserve. Stocks bounced back from the lows placed in January but ultimately fell victim to similar anxieties in March. This time, predicaments surrounding liquidity and counterparty risk at financial institutions culminated in the near failure of Bear Stearns, one of the country’s oldest and most storied investment banks. There was virtually no place to hide in what was the worst quarter for stocks in more than five years. While the major equity indexes were able to “climb a wall of worry” last year, so far 2008 has been especially difficult across all markets and styles, with no indices posting positive results for the first quarter and not one sector within the S&P 500 able to deliver positive results. For the quarter, the major indices posted the following results: S&P 500 -9.4%, NASDAQ -14.1%, and DJIA –7.0%. International equities did not fare much better, as the MSCI EAFE was -8.8% for the quarter.
Due to the magnitude of the market’s sell-off from October to January and the ensuing negativity into March, it is an opportune time to discuss what a stock market “bottom” looks like. Market corrections, generally defined as declines of 10% to 20% in value over a relatively short period of time, are normal. History tells us that they occur, on average, every couple of years. Indeed, based on a study performed by Dorsey Wright & Associates, we know that since 1965, the S&P 500 has experienced corrections of 15% or more on no fewer than twenty-two different occasions. Analyzing the historical data, we can draw some conclusions as to market behavior during these times. For instance, when the S&P 500 declines 15%, it routinely will decline further and eventually “bottom” on average, down 20%. The time in between these subsequent declines takes, on average, thirty-four days. Examining similar episodes in the past reveals that in periods following market declines of 15%, the average return to the ensuing “peak” was +44.4%. From our perspective, there are two key takeaways from this data. One, while painful to endure, corrections are common and perhaps necessary occurrences. It is healthy for markets to periodically purge accumulated excesses while providing a not-so-subtle reminder of the risks inherent in owning equities. And, two, corrections of this magnitude usually present very good buying opportunities for those with reasonable investment time horizons.
Equity market bottoms usually possess similar characteristics. One such trait is heightened volatility. Most investors are keenly aware that the markets have been extremely volatile of late. But can this be quantified? Based on our observation of twenty years of market data from FactSet, the first quarter of 2008 was the third most volatile on record. Volatility, in this case, is measured by the frequency of days with a price move in excess of 1%. Of the fiftynine trading days in the first quarter, 51% of them produced a 1% move, either up or down, the highest percentage since the 69% reading in the third quarter of 2002. The recent spike in the CBOE Volatility Index confirms the results of our analysis. As can be seen in the accompanying chart, this index, which represents a market estimate of future volatility, has recently ascended to heights not seen since early 2003.
Extreme negative sentiment, or rampant pessimism, is another factor often prevalent at market bottoms. Today we find that consumer sentiment towards the markets and the economy is extremely low. The April 14, 2008 issue of Fortune magazine has a picture of a broken Wall Street sign on the cover with a caption that reads “How To Fix Wall Street.” Needless to say, this is the type of magazine cover typically seen near market bottoms, not tops. Turn on the television and there is talk of record house foreclosures and the possibility of recession. The American Association for Individual Investors (AAII) has conducted a weekly poll of investor sentiment towards the stock market since 1987. Two of the most bearish readings in the history of the study were recorded during the first quarter of 2008 (January 24th and March 13th). The widely cited Reuters/University of Michigan consumer sentiment survey recently recorded its lowest reading since 1982. And, according to a story from Bloomberg News on April 2nd, “investors are so scared of stocks and bonds that they have stashed a record $3.51 trillion in U.S. money market mutual funds” despite the fact that yields have fallen to extremely low levels. When sentiment is this low, it is safe to assume that a lot of bad news has already been priced in to equities. Financial crises are also historically linked with market bottoms. The Bear Stearns bailout could very well qualify as the incident that characterizes the current situation. Time will tell.
Earnings reporting season is once again underway. Argus Research recently reported that final earnings results for the fourth quarter 2007 showed a decline of 23% relative to fourth quarter of 2006 results. However, excluding the Financials sector, S&P 500 operating earnings increased by 16%. According to an analysis prepared by Credit Suisse, consensus S&P 500 earnings estimates for first quarter 2008 continue to be revised downward and are currently expected to be 12% lower relative to last year. It is also worth noting that analyst estimates are quite disparate and that expectations outside of the Financials sector remain positive and robust. The market will certainly be listening carefully to management commentary. At this point, it is probably irrelevant for equities whether or not the economy is experiencing a slowdown or a recession. But, with the direction of the economy in question, anecdotal evidence from corporate chieftains can offer very insightful evidence as to the health of the economy under the surface of the headline numbers. We are focusing on what impact higher input costs, higher borrowing costs, a weaker consumer, and generally softer economic activity will have on earnings results for the quarter and guidance for future periods.
In stock portfolios, we are becoming more constructive toward investment prospects within the consumer discretionary and financial sectors. As noted in previous commentaries, these areas have been severe underperformers, and both expectations and valuations have been dramatically reduced. With a prudent approach, we are investigating these “early cyclical” areas of the economy for potential opportunities. We still favor investments in sectors related to energy, industrials and basic materials. Demand driven growth, in addition to elevated raw materials prices, continues to support profits in these areas of the economy. As always, we remain focused on managing risk in portfolios. To that end, we are cognizant of placing too much emphasis in areas where we have had past success and are determined not to become complacent. If the market is indeed in the process of forming a bottom, new leadership may very well emerge on its way out. Our analysis should lead us to these areas of the market, focusing on secular shifts and enabling us to identify investment opportunities in high quality companies able to deliver improving earnings despite the uncertain economic environment.
Massive and unprecedented stimulus efforts by the Fed should help to curtail the duration and magnitude of the current economic slowdown. These, coupled with increased financial market stability and a continuation of resilient global economic activity, should help to restore investor confidence and facilitate a move higher for equities in the months and quarters ahead. Equities have historically performed very well following troughs in economic activity. Examining the last five economic trough periods, as defined by the National Bureau of Economic Research, we find that equities were higher by 13.8%, on average, six months later. As Mark Twain once said, “history doesn’t repeat itself but it does rhyme.” Based on the data of previous market cycles and a thoughtful examination of our current situation, we take comfort in the belief that the worst for equities is behind us and that the framework has been set for positive returns ahead.