Newsletters 2008 Newsletters Recession Already Priced In (2/08)
Friday, 15 February 2008 00:00
With the S&P 500 having reached a low of 1310 on January 22, approximately 5% below the expected 1375 bottom of our forecasted intermediate-term range, we are compelled to revisit our investment thesis and assess what has changed. Let’s examine the economic fundamentals and determine the extent to which any change in outlook is warranted.
GDP: Fourth quarter GDP remained positive but came in surprisingly low at just 0.6%, well below the consensus 1.2% estimate. Despite accounting for only 4.2% of real GDP, the obviously weak residential housing market declined at the worst rate in over a quarter century and reduced GDP by 1.2%. The big surprise for the quarter was the rare drop in business inventories, largely due to autos, which cut 1.3% off GDP. The silver lining is that the big drop in inventories may signal an imminent rise in production, especially since final sales for the quarter (GDP less inventories) rose 1.9% and indicate that real demand remains solid.
The consensus calls for 1st quarter GDP growth of 1%, hardly blazing but positive nevertheless. And the International Monetary Fund (IMF) still expects worldwide GDP growth of 4.1% for 2008, albeit below the 4.9% registered in 2007 and the 4.8% forecasted for 2008 only recently. The lowered IMF forecast directly relates to the slowing U.S. economy and its impact on the rest of the world. The IMF predicts that U.S. GDP will decline to 1.5% in 2008, down from the 2.2% registered in 2007.
Secular growth overseas and the favorable impact of a weaker dollar should keep the export economy humming. Meanwhile, consumption rose 2% in the fourth quarter despite plunging home values, tightening credit conditions and rising energy prices. Exports and the consumer kept GDP positive in the fourth quarter and we see little reason why this should not remain the case going forward, especially with the Federal Reserve having slashed interest rates so aggressively and the price of oil having declined by 10% from its peak in recent weeks.
Monetary Stimulus: The Fed surprised the markets with a 75 basis point inter-meeting cut on January 22 and then cut rates again by 50 basis points to 3% at its regularly scheduled FOMC meeting on January 30. This 1.25% combined cut within such a short period is rather extraordinary and marks the most significant and positive change since we issued our forecast for the year - the Fed has newfound resolve to get ahead of the economic curve. The Fed recognizes that “downside risk to growth remains” and so has turned to an accommodative position on a dime. Further, the Fed stands ready to “act in a timely manner as needed to address those (downside) risks”, leaving the door open for further cuts ahead. Indeed, the Fed Fund futures now reflect a near 100% chance for another 50 basis point cut to 2.5% by the Fed’s next formal meeting on March 18.
Fiscal Stimulus: Congress has approved a $168 billion stimulus plan that will put $600 per individual and $1,200 per couple in the hands of tax paying Americans. The plan also extends higher expensing limits and accelerated depreciation benefits for capital equipment purchased in 2008. Further, and perhaps most important, the plan increases the loan limit for the FHA and government sponsored enterprises Fannie Mae and Freddie Mac, allowing millions of additional homeowners to benefit from today’s historically low interest rates. The soundness of the rebates has been widely debated but the net impact will be beneficial to consumers and businesses alike and offer a much-needed boost to the economy.
Employment: The Labor Department reported that January nonfarm employment fell for the first time in four years by 17,000 jobs. This news is critically important since the relatively strong job market and low level of unemployment has been an anchor for the economy, especially since a strong labor market is seen as an antidote to the collapsing housing market and helping keep the consumer afloat. Yet as bad as the January nonfarm payroll report is, December was revised to 82,000 jobs created, up from the original 18,000 estimate. And the unemployment rate actually declined to 4.9% from last month’s 5%. Further, the culprits for job losses remained in obvious areas, residential-construction, manufacturing and financial services. Employment still rose in education, health services, hospitality and even retail.
As witnessed in the revision to December’s employment report, the labor market is difficult to precisely forecast. There is no doubt that employment is slowing, but it would be a mistake to extrapolate outright declines month after month. It’s too early to tell whether January’s decline portends a longer-term trend. As such, we should expect market volatility to remain heightened around the proximity of forthcoming employment reports.
Other Data: Other incoming economic data released over the past month has been a mixed bag. The ISM manufacturing index rose 2.3% to 50.7 in January, while the ISM service index plunged to 41.9, offering conflicting views since an ISM read above 50 indicates expansion and below 50 indicates contraction. The University of Michigan consumer sentiment report strengthened in January to 78.4 from December’s 75.5. Meanwhile, durable goods orders increased by 5.2% in December, indicating that business capital investment remains strong. And industrial production increased by 1.5% over year ago levels. On the whole, the evidence confirms a real slowdown, but it remains premature to determine whether or not we are in a recession.
Regardless of whether we are in recession or not, it sure feels like one given the recent slide in the stock market. In fact, the stock market has already taken the liberty of pricing in what Merrill Lynch, UBS, Northern Trust, Morgan Stanley and Global Insight have already predicted - a recession is here. With recession now the consensus among Wall Street economists and with most major indices off 20% from their peak, fear and prognostication of recession was enough to cause a precipitous decline. With so much fear already priced into the market, we remain confident that the worst is behind us and that the market will rebound soon enough. Tops and bottoms are impossible to precisely forecast, but we are convinced that we are closer to the end of this corrective phase than the beginning of something more dire.
The probability for recession is now known and being priced in by the market. Any positive economic surprise to the contrary that leaves even a wisp of doubt to this now-consensus view would bring a lot of sidelined cash back into this market in short order. Further, given the low level of equity valuations and interest rates, even bad news may be greeted as an opportunity to “buy the news”. We expect increased volatility over the coming months as the market digests incoming economic data, and we will remain focused on taking advantage of that volatility.
While consensus earnings estimates are still likely to come down, the impact of the massive monetary and fiscal stimulus has yet to take hold. Since it typically takes 9 months for rate cuts to show any material impact, the economy is on the precipice of realizing the Fed’s bold actions, which the stock market should soon anticipate. The stock market trades at a forward PE less than 14 and the dividend yield for the S&P 500 is now greater than the 3-month Treasury bill yield for the first time since 2002. With the 10-year Treasury bond yielding 3.55%, stocks are cheap. Now is the time to overcome one’s fear and realize that bear markets provide rare opportunities to invest in the world’s greatest companies at bargain prices. We are making no changes to our year-end forecast at the current time.
Please remember to contact us with any questions and to inform us of any changes that might impact management of your portfolio.| < Prev | Next > |
|---|