One year ago Fed Chairman Ben Bernanke said “the financial markets are better than regulators at allocating credit”. Little did he know we were headed for a major financial scare and they would step in. Clearly even the regulators were unaware of the magnitude of the problem. A year later Wall Street is in disarray and credit problems have spread beyond the US to Europe and other economies.
Last August home foreclosures began rising and fear and panic were building. Looking back we see a government bail out of a major brokerage firm, bank balance sheets decimated by massive write-offs of mortgage related assets and a stock market that is down 11.5%. During this year Iran and Israel threatened conflict and Russia invaded Georgia. All of this happened as oil prices climbed and fears of inflation and a global slow-down made headlines. Who feels like celebrating? It’s no wonder the stock market is down!
It is easy to get caught up in the day-to-day headlines and focus on the very real problems that plague our financial system. One year into this troubling financial crisis it is easy to lose sight of the fact that at some point stock prices will incorporate the bad news opening the door for a recovery. This will happen many months before the headlines turn positive.
The challenge is to keep the long-term in focus. It’s human nature to react to short –term news. The multi-year bull market ended and one year later we are looking at lower stock prices and higher expected returns than we were last August. The problems that plague our economy and financial markets will get worked out. Clues that the bear market is about to end are subtle and won’t be obvious until stock prices are higher than they are today.
Oil Prices, Commodities & Inflation
Oil prices have had a significant impact on investor and consumer sentiment rising to critical levels even after the 15% decline since the highs in July. A prolonged and material decline in energy prices would help solve a lot of our problems. Demand for oil is down and conservation efforts are underway but meaningful shifts that make a real difference take time. There is only so much we can do. Over 50% of the world’s oil demand is coming from emerging markets where economies and consumption are growing. Adding to this is the fact that oil is subsidized in many countries which is not an incentive to reduce demand. According to Morgan Stanley the subsidies have increased with the price of oil. They estimate that at $60 a barrel 10% of the world’s oil demand was subsidized and at $130 a barrel this figure rose to 22%. All of this, together with supply fears, adds upward pressure to the price.
Speculators have been attracted to the energy and commodity markets helping to drive oil prices even higher. It’s hard to say if it is speculation, fear of rising demand when supply is limited or the fear of increased political tension that influences the prices. There is definitely a link between the level of our currency and oil prices and a healthier US dollar is necessary for our pain at the pump to ease meaningfully. We feel the dollar is poised to go higher as other economies, such as Japan and Europe, weaken and then lower their interest rates. China and India import vast amounts of oil so if the surge in growth over the past few years moderates we could see a meaningful decline in demand. If this happens as the US economy recovers our dollar should rebound and everyone, consumers and investors, will feel better.
Our view is that energy prices will remain volatile but not decline much below the $80 to $100 a barrel level any time soon. We may have to live with higher oil prices as the rest of the world adopts our lifestyle and emerging middle classes consume vast amounts of goods. The world supply of energy is adequate at the moment but not growing – it’s shrinking and by 2010 we may be looking at forecasts for much higher prices. Supply concerns and shaky global politics won’t help. Efforts to find new energy sources take years and frankly should have been launched decades ago.
The Federal Reserve knows all this and is concerned about rising prices and higher inflation. The fear is that the increase in energy and raw material costs will be passed on to consumers in the end. This creates a “feedback loop” like we saw in the 1970’s. The Fed is between a rock and hard place – if they raise interest rates they will extend the economic decline. If they ease rates to spur the economy then risk of more inflation, especially wage inflation, rises. For now the “watch and wait” approach is expected.
Global growth should still approach 4% so there may be continued pressure on commodity and food prices. Headlines suggest the US is in an economic free fall when in fact the revised second quarter 2008 GDP growth was 3.3%, supported by strong exports. The lower dollar makes our goods more attractive which in the end supports profits for multi-national companies. A strengthening US dollar would reduce exports but hopefully will happen when other sectors of our economy show signs of strength.
The housing crisis is the number one topic as it relates to the US economy. Standard & Poor’s estimates that housing sales are down 16% since August 2007. Prices have declined 4.8% with three states, California, Nevada and Florida down more than 10%. This is the biggest drop in home prices since the indexes were developed in 2001. Sales of existing homes in July were the weakest since 1958. The lower the cost of the home the greater the decline in value! All markets are affected but negative equity is pronounced where buyers extended themselves with huge mortgages relative to the purchase price.
The most recent report in August offers a glimmer of hope. The housing slowdown is slowing down as the chart above shows. New home sales reported in mid-August were down less than expected and the inventory of unsold homes is lower than it has been. It’s conceivable that developers will consider production in 2009. Bargain hunters will also surface as soon as there are signs that things are not getting worse. The weak real estate market will persist but it may cease to have the devastating impact on confidence and spending.
High energy and commodity prices and a weak housing market are significant headwinds that have an effect on the capital markets and economy. The recent softening of commodity prices gives the Fed some breathing space and may make it easier to sit tight and not raise interest rates. This in turn will be positive for the capital markets. If housing prices begin to recover at the same time and the supply of homes on the market is reduced then we may be on the way to a more positive backdrop for the markets.
The Solution and Outlook
The solution to our problems can be summarized in one word – time! At some point housing prices will stabilize and slowly buyers will emerge to take advantage of real estate prices not seen in decades. Financial institutions will have written-off bad debt and have somewhat restored their balance sheets. At this point they will be willing to lend again – probably with much more conservative guidelines. Healthy banks will have acquired weaker finance companies and those that should never have existed will be gone. The banking and housing sectors will not be the major economic forces they were in the past few years but it is certain we will once again see activity in this area. Reputable buyers are beginning to emerge – to buy distressed mortgage related debt and other beaten down assets. Markets are efficient and at some point prices will be at a level where investors see opportunity rather than risk. This cycle repeats itself again and again. Financial institutions manage to get themselves in a mess every decade or so but they recover. This period is no exception. It will take time and at a point in 2009 confidence will be restored.
So….What About Stocks?
It’s a wonder with such widespread pessimism why anyone would have funds anywhere except under the mattress. It’s hard to believe that money can be made with the backdrop of higher commodity prices, an imploding housing market and frightened consumers. Unfortunately the media loves negative headlines and as the number of business channels on cable and satellite increase so does the fear factor. It’s very hard to take a long-term view of the situation and invest with confidence.
There are some surprisingly positive factors that could cause a recovery in stock prices sooner than we expect. In fact, all stocks are not down. Take a look at the big box, discount retailers like Wal-Mart, energy stocks, commodity companies, some household products companies and a number of healthcare companies. It’s hard to find a total portfolio that has risen substantially in the past year but many seasoned managers have done relatively well – avoiding the blow ups and problem sectors. Betting against airlines, department stores and owning less than a market weight in financial services has produced strong returns relative to the market.
Earnings drive stock prices. It’s the return to shareholders that matters. The more a company earns, the bigger the dividend checks and the more stock they can buy back. Many US companies have had strong earnings in the past year and if you’ve owned these you can celebrate. Exports have been strong as the weak dollar stimulated demand and most non-financial companies operating in China and other growing economies have benefitted. Second quarter 2008 earnings, without financials, rose almost 10% and growth stocks have outperformed value stocks by the widest margin in years – reflecting the focus on non-financial companies and strong earnings growth. There has been a wide gap between the best and worst performing sectors of the market.
Earnings guidance from companies may move stock prices more than the actual earnings. Companies have no reason to be too constructive and with a cloudy economic outlook they will guide investors to limited expectations. Stocks of those companies that beat expectations perform better than those who disappoint – they are punished severely. Expectations in general are still too high for 2009 so it follows that earnings expectations will come down through the end of this year. However, at some point in the not too distant future stock prices will reflect all the bad news and more.
The slow down in earnings this past year will mean that comparisons will get easier and companies will easily beat the lowered expectations and stocks will recover. The key to success is finding those high quality companies where expectations are unreasonably low. On the other hand it is important to avoid those beauty queens everyone owns and loves. If they disappoint high expectations then the stocks could get punished severely. Unfortunately, many investors love and buy what is working and fear what is out of favor. This results in buying at the peak and selling at the bottom. We have said before that subprime research leads to subprime results.
Going forward, the weak dollar theme may not have as much impact and some of the multinational companies with global revenues that have performed well will be sold to buy more domestic companies in the financial services and consumer sectors. A stronger US dollar means the currency benefit related to overseas activity will be reduced. Domestic companies may be favored where earnings comparisons will be relatively easy and business will pick up with the improvement in the economy.
It won’t be possible to time the bottom of the market. Three years from now today’s stock prices should look quite attractive. History has proven that stock prices recover in double digits after an economic slow-down or recession as the chart below shows. Stocks decline in anticipation of the economic slowdown and recover before the economy recovers. The market is now down about 20% from the peak last fall.
The market will react quickly to a shift in investor psychology and it is easy to miss the buying opportunity. It is better to buy a little early than not at all. Warren Buffet said “if a stock (I own) goes down 50% I’d look forward to it.” He wants to buy more of the quality stocks he owns at lower prices. The worst mistake individuals make is to sell stocks at the bottom.
International stocks have declined with US stocks this year. We feel the dollar will recover as some of the other economies weaken. Where a company is headquartered is not material – where they generate revenues is what matters. So, buy companies, not countries. The markets are truly global and commerce is not what it once was. Some dollar denominated US and International mutual funds own the same stocks or have similar characteristics. The diversification from international investing is not what it once was. This is evident as the decline in prices has been virtually universal and owning international stocks has not necessarily eased the pain of the downturn. The geographic lines between companies are blurred and opportunity depends on many factors, the least of which is where the home office is located. Selectivity and good research, across all countries and sectors, are keys to avoiding the problem areas as we navigate these uncertain times.
Not So Happy Anniversary
August 9, 2007 was the official kick-off date of the energy crisis. This has been a rough year no matter how you look at it! We have lower stock values, gas at $4.00 a gallon, food prices higher, unemployment at a rate not seen since 2004 and home values down significantly. At times it feels like we’re walking up a down escalator. History has proven that when sentiment is this low and pessimism prevails it is an opportunity to buy. Billions of dollars are on the sidelines and even the most skilled investors could miss the opportunity waiting for the absolute bottom. It is time to begin nibbling at stocks and if there is another downdraft in the market, which is possible in the fall months, increase equity exposure in earnest. The bear market could end tomorrow or a year from now but either way long term, strategic investors will buy today when fear prevails and benefit tomorrow.