Recession and the Bottoming Process (11/08)

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Saturday, 15 November 2008 00:00 Written by James Van de Voorde

With third quarter GDP falling .3% and fourth quarter GDP expected to decline between 2% and 4% (the sharpest fall in GDP since the recession of the early 1980s), it is abundantly clear that the U.S. economy is in recession. As bad as the economic news is and shall remain for at least the next few months, it is important to remember that the stock market always bottoms well before the actual economy does. As Warren Buffet stated in his recent op-ed piece in the New York Times: "The market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over." Consider the following evidence supporting an eventual recovery and other coincident, contrarian indicators that suggest the bottoming process for the stock market is at an advanced stage:

  • The $700 billion TARP program, the FDIC’s Temporary Liquidity Guarantee Program, the $540 billion Federal Reserve money market guarantee and the Fed’s unlimited commercial paper backstop program have all kicked in and are having the desired effect of thawing out the credit markets.
  • The VIX Volatility Index, the most widely used measure of market fear, spiked in October to 90, up from 20 at the beginning of September, a 350% move higher in less 2 months. This is the highest reading in the VIX’s history and is associated with climactic selling. Previous bear markets have always ended with major spikes in the VIX.
  • At current prices, the stock market trades at a PE of 11 times normalized earnings. Even if we take the most pessimistic earnings forecasts for 2009, the market currently trades at a trough, forward PE of 14. Stocks have not been this cheap since the beginning of the great bull market that began in the midst of the 1981-1982 recession.
  • The dividend yield of the S&P 500 at 3% is higher than the 5-year Treasury yield at 2.51% and just below the 10-year Treasury yield at 3.7%.
  • The price of oil has tumbled from $150 to $60, a 60% decline in 4 short months. If oil remains near these lower levels, this "energy dividend" for consumers will be between $200 and $300 billion per year. If even a fraction of this savings is spent, it will have a very positive impact on GDP.
  • With oil and all commodities having plummeted, inflation is expected to be negative in the coming months, allowing the Fed to cut rates by 50 basis points at last week’s FOMC meeting. Additionally, companies throughout many industries will benefit from lower commodity costs.
  • In addition to the Fed’s most recent cut, the ECB, Bank of England, Swiss National Bank and central banks throughout Asia have joined together in a massive coordinated effort to cut interest rates globally. And China just announced a $586 billion stimulus plan to bolster its economy, an incredible sum equal to nearly 20% of China’s 2007 GDP that will focus on infrastructure spending and used by the end of 2010.
  • A new record for outflows from equity mutual funds was set in September with $56.6 billion yanked from the market, topping the $53.2 billion pulled from funds in July 2002 at the bottom of the last bear market. This new record set in September was topped in only the first two weeks of October with $75 billion having been pulled out. The record for mutual fund inflows was set in March 2000 at the peak of the last great bull market.
  • While retail investors sell, insiders are buying in record sums.
  • A new economic stimulus package has been blessed by Ben Bernanke and may be in the pipeline. While President-elect Obama says a new stimulus package will be his first order of business, it appears that Nancy Pelosi is attempting to push through an immediate "lame duck" stimulus package.
  • The plunge in housing prices has finally resulted in a surge of home sales. In the six-county region of Southern California, home sales shot up by an unprecedented 65% in September year over year. With new housing starts having diminished to levels that previously signaled a housing bottom and with foreclosed homes selling rapidly (50% of September Southland sales were foreclosures), the housing market appears to have stabilized.
  • Massive loan modification programs are being introduced as a potential salve to the housing market. J.P. Morgan will modify terms on $70 billion in mortgage debt that will cover as many as 400,000 homeowners. Bank of America has two modification programs in place, one targeting 265,000 borrowers and the other designed to help 400,000 borrowers from it’s Countrywide Financial division. And Wachovia initiated a loan modification program for approximately $120 billion of option ARMs before being acquired by Well s Fargo.
  • Despite the current crisis, the dollar has remained strong and is now up 20% from it’s all-time low six months ago. A strong dollar gives Americans more buying power and further pressures the price of oil.
  • The $3.5 trillion of cash in retail and institutional money market funds could buy an amazing 44% of the entire S&P 500 at current levels.
  • There is a record number of new 52-week lows and down volume has steadily dwarfed up volume by 9 to 1 this past month.
  • Non-financial companies within the S&P 500 have approximately $1 trillion of cash on their balance sheet. This cash could buy 15% of the S&P 500, ex-financials.
  • The current record short interest on the NYSE represents approximately $1 trillion of additional buying power.
  • There remains north of $4 trillion in sovereign wealth funds.
  • Revised tax laws and the TARP’s capital injections will lead to an enormous wave of bank consolidation.
  • Volume on the "pink sheets", the over-the-counter market widely known for speculative trading of "penny stocks", has declined to .07% of total NASDAQ dollar volume, the first time it has dipped below .1% of NASDAQ volume since this data was initially collected in 1995. Pink sheet trading volume correlates with speculation and reached a record 3.5% of NASDAQ volume in February of 2000, just before the internet bubble burst. The previous record low was 32% higher than the curent low and set near the bottom of the last bear market in July of 2002.
  • Jim Cramer says "sell". Warren Buffet says "buy".

    Despite the recent gloom, productivity expanded at a better-than-expected 1.1% last quarter, bringing the average annualized rate down to 2.4% in the first three quarters of the year. Meanwhile, the weekly figure for jobless claims hit a high of 499,000 jobs on September 26 and has remained essentially flat to down slightly for the past six weeks, an indication that jobless claims may have stabilized. While credit standards have tightened markedly over the recent months, lending by all commercial banks is at an all-time high and is up 9.2% in the last 12 months. Swap and credit spreads are falling rapidly – 10-year swap spreads are now approaching low levels last seen in 2003 just before the Bush tax cuts went into effect and the economy turned the corner. The Prime Rate is at 4% (down from high of 7.5%), Libor is at 2.29% (down from high of 5.15%), and 30-year fixed mortgages are at 6.14% (down from high of 6.61%).

    Forced redemptions by mutual funds, massive hedge fund liquidation, tax-loss selling and continued bad news on the economic front are sure to influence continued stock market volatility over the coming months. The bottoming process is both messy and scary, but we are convinced that time and hindsight will prove this to be among the best buying opportunities of a generation.

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