Monday, January 19, 2009
Markets declined precipitously last week as the kick off of 4th quarter earnings season validated expectations that there would be no corporate earnings, and the banking system received its first cash infusion from the second half of the TARP authorized only yesterday. The ink wasn’t even dry in the Senate! Nonetheless, Bank of America (a regulated bank) had to seek $10 billion in bailout funds, and another $10 billion in guarantees, to shore up its capital base thanks to escalating losses within the recently ingested Merrill Lynch (an unregulated bank). Citigroup mentioned that it lost $8.29 billion in the 4th quarter ($19 billion for the year) and that it would spin off its Smith Barney division to a joint venture with Morgan Stanley and split the remaining bank into two operating units, Citicorp (the good assets) and Citi Holdings (the bad assets). Shares of Bank of America and Citigroup fell almost 50% last week. Preliminary 4th quarter GDP estimates will be released on January 30th, and will reveal an economy deeply in recession, requiring a massive dose of fiscal stimulus. Can we afford all these bailouts?
We can’t afford not to afford them
Economists widely agree that with private demand falling sharply, the economy needs a heavy dose of public demand, i.e. government spending. So the plan to deal with tanking mortgages is to mortgage taxpayers! The Congressional Budget office recently announced that the US fiscal deficit will reach $1.2 trillion, up from $455 billion for 2008. Oh, and this doesn’t include the pending fiscal stimulus package estimated at nearly $800 billion over the next two years. So throwing that in will take our 2009 deficit to nearly $1.6 trillion, or over 11% of GDP, while government spending will account for 27% of our economy. For comparison, our deficit reached a post WWII high of 6% of GDP in 1982, so we will double that. The good news is that by 1998 we returned to a surplus, so we have some recent history of economic resiliency (unlike Argentina for instance). This point is important since financing this deficit will require record Treasury bond issuance of nearly $2 trillion for 2009, double 2008, which was double 2007. On a positive note, with the entire Treasury curve now below the long term inflation rate, the government’s inflation adjusted interest payments will act more like receipts. At these rate levels, inflating away this debt will be a breeze! Why would anyone buy these bonds? In many cases they have to (i.e. pension fund requirements, etc.), and the current risk aversion globally makes the Treasury market the globe’s mattress. So the primary benefit of being the world’s reserve currency is our seemingly unlimited credit line. The Wall Street Journal publishes the results of every Treasury auction and for the $16 billion of 10-year bonds issued yesterday, dealers had $41 billion in applications. Demand therefore outpaced supply by a factor of 2.5x. Which looks promising, but I still check every auction just in case. What would happen if supply started outpacing demand? I don’t have to walk you through those economics.
Don’t Fear Returns
We have often referred to the most common measure of stock market volatility, the VIX index. Think of the VIX index as the cost to insure your stock portfolio. When perceived risks are low, the insurance costs fall, when perceived risks are high, the insurance costs rise. For reference, when complacency peaked near the end of 2006, the VIX bottomed out at 9.39. At the height of the panic in 2008, the VIX peaked over 80. The VIX acts like an emotional barometer. Want to know what mood I’m in? Check the VIX. Santa Claus brought relief to the markets as the VIX level steadily declined by half between November 10th and January 2nd. This provided all of us the mental space to focus on more important things. Within the last week, however, the VIX has once again commanded our attention, rising 30% to 55. Last year’s volatility was historic by every measure. While the real economy will struggle considerably, given the government’s demonstrated resolve, I think we have moved beyond the panic moment. If so, what can we learn from previous peaks in the VIX?
S&P 500 Returns
VIX High Peak 1 Yr Later 2 Yrs Later 3 Yrs Later
8/23/1990 36.47 +28% +34% +48%
10/08/1998 45.74 +39% +46% +11%
8/05/2002 45.08 +16% +29% +47%
11/20/2008 80.86 +14% (thru 1/16/09) ?? ??
While this may be a small sample space to draw conclusions from, it certainly stands to reason that fear isn’t infinite and that any reduction will support a recovery in investor sentiment. Add to that the historic levels of cash on the sidelines, and you have fuel for an advance. According to work done by the Leuthold Group, the $8.85 trillion of cash held currently in cash, bank deposits, and money market funds equals 74% of the market value of US companies, the highest since 1990. What was happening then? The savings and loan industry collapsed, Drexel Burnham Lambert went bankrupt, and the US fell into recession. Sound familiar? The S&P rallied nearly 30% over the next twelve months.
We will officially inaugurate our 44th President, Barack Obama, on Tuesday. I personally will not be standing in the cold for six hours to catch a glimpse of the motorcade, but I do look toward his arrival with optimism. The sooner we can match our monetary efforts with fiscal efforts, the sooner our economic recovery. Pray that Congress behaves for this discussion. They misbehaved for the TARP discussion and the market fell 34% in 15 days. Pavlov?
David S. Waddell
Senior Investment Strategist
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**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.