Anxieties around the banking sector have once again paralyzed the markets. With Citigroup and Bank of America trading like lottery tickets and negative surprises emanating from State Street and others, we seem to be right back into the fall of 2008. The governmental solution at the time was the TARP plan, which morphed from a toxic asset purchase plan into a capital injection plan and now may be morphing back into a toxic asset purchase plan. Truth is, the conversation must be an “and” conversation and not an “or” conversation at this point. The size of the government intervention likely needs to grow as well from the $700 billion to a number far greater.
At one point the off balance sheet soup of credit derivatives equaled $2.2 trillion (so says Treasury Secretary to be Timothy Geithner); if we mark these assets down to .50 cents on the dollar we systematically need to write off $1.1 trillion, a bit more than $700 billion. If the government decides to purchase these assets, it needs to arrive at a price. A price too low would cause system-wide markdowns, which could threaten the solvency of even more banks; a number too high will enrich the banks at the further burden of the US taxpayer… Catch 22. While I believe that a purchase arrangement should and will likely occur, the pricing decisions will determine both the outcome and unintended consequences of the facility. Uncertainty surrounding this issue translates into lower equity prices. Just how far have the banks fallen? In 2007 the KBW Banking index, made up of 24 of our nation’s largest banks, fell by 22%; it fell 47% in 2008, and has fallen 38% so far year to date. The combined market values for Citigroup and Bank of America equal $46 billion. This amounts to half of what they have received in emergency funding from the government to date. Until we can inoculate the banks, any steps forward in the market or the economy will be questionable.
Looking past the banks
While the investing environment year to date may resemble that of last fall, there are some notable differences. First, we haven’t seen the late day selling climaxes that we experienced then. In fact, none of the days so far in 2009 have closed at the lowest point in the range. Of the 7 negative trading days so far this year, stocks on average have rallied .72% off the daily lows. Furthermore, daily average volume has fallen over 20% since October. This demonstrates that the blunt selling we experienced in the fall has become more selective. For example, technology names have held up well year to date, which is a theme we access through our position in the Calamos Growth Fund. While still lower on the year, this tech heavy allocation has outperformed the S&P 500 by nearly 4 percentage points. Relative strength in technology may signal the potential for new market leadership. Even with low debt ratios and global revenue diversification, many technology names are trading at valuation levels they have never seen before. It is far too early to anoint technology as the groundhog, but the consideration and debate is in itself a positive sign. In fact, using Morningstar’s classifications, the stock types that have performed the best so far in 2009 are those classified as “speculative growth.” Welcome back speculators.
Hold the line
I recently tripped over an interesting piece from Ned Davis Research that looked at the patterns of waterfall declines in the stock market. There have been 10 quick, high volume declines of more than 20% since 1929. Following the nadir, in this case November 20th, markets tend to enter a range-bound basing period for about three months where the lows may be retested (where we are right now). From that phase, markets tend to advance into the end of the recession, plateau into the date of lowest earnings and move higher from there. This process historically takes about a year. Using it as our map, our basing phase should continue into March. The sign of health during this period is therefore not a sustained advance but a successful re-testing of the lows. For those playing at home, the low point on the Dow was 7400. We breached 8000 last week four different times, attracting buyers each time, a healthy sign. So in light of an abysmal week of financial earnings, we escaped without breaking lower. Industrial and energy earnings will be up for scrutiny this week and will provide insight into the condition of the real economy outside of financials. The big news comes Friday with the advanced 4th Quarter GDP release. The market expects the economy to have contracted by more than 5% in the 4th quarter providing plenty for investors to digest.
What we are talking about
With all of the liquidity being pumped into the system, any increase in velocity will likely stoke inflation. In an inflationary environment, materials, commodities and gold tend to perform well. We have exposure to these themes in our portfolio but have options at the ready to expand that exposure, if deflationary fears shift to inflationary fears. For example, among our largest underlying stock holdings are Newmont Mining, Anglogold, and Barrick Gold. Another theme we have been researching revolves around the expected infrastructure-spending spree. Worldwide government spending makes a case for global construction and engineering names, but caution is warranted. These stocks have advanced considerably off the November lows and may need to retreat a bit for us to be more interested. Another conversation involves Asia, which may be in the best position to weather this global downturn, as they have built up huge savings surpluses. This enables both the Asian governments and consumers to spend in an economically stimulative fashion without borrowing. We have identified opportunities to re-enter Asia after leaving in Q1 2008 and will be watching consumer trends closely to see if Asia can stimulate domestic demand to offset export demand. So far this is inconclusive, but we’re monitoring it closely. Our conversations evolve daily but these are the themes receiving the most current attention.
David S. Waddell
Senior Investment Strategist
**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.