Monday, Noevember 17th 2008
The beatings will continue until morale improves
I know you are tired. The S&P 500 continues to act like my two-year-old daughter saturated with Halloween candy. Statistically, the market has had daily moves of at least 5% every 11 days this year. On Thursday, one of the sharpest intra-day rallies arrived unannounced, and Friday, markets erased nearly all of the advance.
The erratic movements in the market can only be eclipsed by the erratic moves in Washington. Between now and January 20th, Obama needs to appoint 7,800 presidential appointees and 1,177 require Senate approval. Saturday, President Bush presided over a gathering of state heads that oversee 95% of global economic activity. Although he has titular authority, he has no real authority, as I don’t believe he will be an Obama appointee. Hedge fund managers faced Congress’s firing line Thursday and appear to be the newest scapegoats for our blameless legislators. Secretary Paulson scrapped the original TARP playbook in favor of injecting more capital into banks, ensuring that consumers still have access to credit for household purchases. Of his first installment of $350 billion, all but $60 billion has already been spent on bank re-capitalizations and AIG’s capital call.
The rules for the next $250 billion will likely be revised, as Congress seems unsatisfied with the deployment to date. Paulson will be happily resting in his retirement villa soon enough, leaving the role of super banker to the yet-to-be-named (Summers) Obama appointee. The automakers have tin cups in hand on Capitol Hill after reporting that they have less than 12 months worth of cash remaining. Should we invest? The quarterly reports of our most recently nationalized franchises, Fannie Mae, Freddie Mac and AIG, indicated losses of $29 billion, $25.3 billion and $24.4 billion respectively. Our nationalized portfolio therefore lost $78 billion last quarter. Maybe the automakers will turn profitable with government officials in the management suite.
I miss the days of researching and analyzing corporate earnings. Trying to predict and monetize the decisions of legislators makes spreadsheet construction next to impossible. With the political world in turbulence, how can we expect anything different from the markets? Due to the political transition, the uncertainties surrounding fiscal stimulus, tax policy, regulatory policy, trade policy, and leverage standards, many participants don’t know the rules of the game any more. For this reason you have market participants selling because they are scared, selling because they are margined, or selling to meet redemptions. Traders offer little help as they dart in and out of positions. Program trading accounted for at least 25% of volume last week, meaning algorithms were calling the shots. The patient money remains steadfastly committed, having negligible influence. Therefore, the cash rich bargain hunters must lean against the selling with enough force to tip the balance. It happens, as it did on Thursday. When the flywheel starts rotating the other way, more hunters emerge, adding to the momentum. The pre-cursor for a market recovery is therefore a crescendo of pessimistic selling that moves the bargain hunters to action. For the last month and change, that line in the sand has been 8000 on the Dow. Recent political and market volatility may be exhausting, but we drew the line on October 10th, so in an absolute sense, nothing has happened since then.
Where to look now
Many of the elements necessary for economic recovery have fallen into place. Energy costs have fallen, employment costs have fallen and benchmark interest rates have fallen. In a functional world, these declines would increase business operating leverage and foreshadow dramatic profit recovery. Where our process fails currently is that credit extension has ceased.
There are some encouraging signs. The actions by the government have corrected most of the distortions in the short-term loan markets. Central Bank rates are down, inter-bank lending rates are down, commercial paper liquidity is up and money market assets are up. The resurrection of these markets offers proof that well thought out government action can generate results. Yea Fed! Translating this, the government has access to cheap money through oversubscribed Treasury auctions. That money has been injected into our banking system and inter-bank lending markets, giving banks access to cheap capital.
But, corporations and consumers have not received relief. Corporate bond spreads reached a record 6.18% over treasuries on October 29th. While those spreads have narrowed slightly, the ability for corporations to borrow longer commitments of capital remains elusive, if not usurious, at best. For lower quality borrowers, nothing is moving. With wages stagnating and job losses increasing, no one wants consumer debt. This has virtually shut down the securitization market for credit card pools, enough so that Secretary Paulson has shifted the direction of the TARP facility to bolster consumer borrowing. So the next fronts in the financial crisis will be corporate and consumer borrowing. We will be watching movements in corporate credit spreads and anticipating a temporary facility to add liquidity to the consumer debt market, just as the Fed did with the inter-bank markets.
What to do
Last week, I was asked how we are reconciling the portfolio strategy with the torrent of new political and financial developments. The truth is, the market may give you information by the second, but investment judgments must be made over time.
Questions you may be asking:
1) Do we think that markets will recover?
Yes. Many markets, like the inter-bank markets, already have.
2) When will they recover?
It’s a fool’s errand to try to time the recovery. Research indicates that monetary stimulus acts with a six-month lag. Rapid expansion in the money supply currently should translate into economic growth in the latter half of 2009. Smart fiscal stimulus (like payroll tax cuts) can create a more immediate response, which could lessen the damage done by non-existent corporate and consumer credit. Markets lead the economy by 6 months as well, so a second half of ’09 recovery could be matched with a first half market rally.
3) What could returns look like?
We advanced 20% from October 28th through November 4th. That indicates how powerful a posttraumatic rally might be. Using history as a guide from the lows of May 1932 and July 1982 (really bad markets/economies), markets rallied 367% and 267% respectively over the subsequent 5 years.
4) How will we address them?
Our “recovery” position will weight our sector allocations to financials, energy and materials. We will emphasize mid-sized companies and Asian markets. Our portfolio will be diversified and participatory; we will continue to explore emerging opportunities and will make changes in our special situations allocation if so compelled.
Fortunately, our outperformance coming into this cycle has reduced the impact of this downturn for our longer-term clients. To further mitigate the downturn, our offense must be equally effective as markets recover. I am confident that our portfolio has the ability to be just that.
Patience may not feel active enough to qualify as an investment strategy during such turbulent times. However, when you are going over the rapids, as we are, turning back is not an option, jumping out is not an option. Making marginal adjustments and awaiting the calm waters ahead provides the only payoff.
Enjoy the weekend.
David S. Waddell
Senior Investment Strategist
Click here for more information on Waddell and Associates.
**This blog represents the opinion of W&A and is for informational purposes only. It is not intended to be construed as tax or legal advice by the recipient. Past returns of investment are no guarantee of future results.
***Any data reported in this blog has been compiled from the Wall Street Journal, Morningstar, Investors Business Daily, or various other informational internet sites.