Newsletters 2009 Newsletters Markets on the Mend (2/09)
Friday, 13 February 2009 02:44
Despite a one-week bounce to start the New Year, the stock market drifted lower for the month with the S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite down by –8.57%, -8.84% and –6.38% respectively through January. As expected, the stock market has been stuck in a trading range and seems destined to test the recent lows set in November of last year. While the market is in the process of digesting a slew of awful economic and corporate earnings reports, it is important to remember that these reports represent the backward looking 4th quarter peak of the credit crisis. As bad as the 4th quarter was and the current recession is, the markets are priced for an outright depression. Ample evidence is mounting that the worst of the crisis has passed. Soon enough, the markets will begin to recalibrate to the fact that we are in a (nasty) recession, not a depression, and eventually will begin to sniff out the “mustard seeds” that point to recovery.
Instead of focusing on the rear view mirror reports that confirm how bad the 4th quarter was, consider the following forward looking data points that point to markets on the mend:
Economy
As bad as the economic news has been, there are early signs of slight improvement that support the notion of a fourth quarter ’08, early 1st quarter ’09 trough. For instance, the Conference Board’s Leading Economic Indicator Index rose by .3% in December, as four of the ten components of the Index improved from November. It was the first increase in the LEI Index in six months. The ISM manufacturing index ticked up slightly in January to 35.6 from 32.9 in December. The ISM service index rose to 42.9 in January from 40.1 in December. The University of Michigan sentiment index was 61.2 in January, up from the 60.1 reported in December. Productivity rose by 3.2% in the fourth quarter. And the advanced report of 4th quarter GDP was –3.8% versus consensus expectations for –5.5%. All of these economic reports came in better than expected. Meanwhile, the loss of 598,000 jobs in January was not as bad as many had feared and is only slightly worse than the revised report that 577,000 jobs were lost in December. It is important to remember that as large as the absolute number of job losses has been, the workforce is also much larger than in previous recessions, so the percentage of jobs lost so far is actually comparable to the recession of ’90-’91, not the much worse episodes of ’73-’74 or ’81-’82 and certainly not the Great Depression. And, despite the continued hemorrhaging of jobs, hourly earnings continued to rise in January by .3% and are now up 3.9% year over year.
Housing
The housing market is stabilizing and seems to be bottoming. The combination of sharply lower housing prices and historically attractive mortgage rates is spurring sales activity. The National Association of Realtors reported that sales of previously occupied single-family homes rose by 6.5% in December after plunging by 9.4% in November. It was the largest rise in sales since January 2002, a period that marked the early phase of the housing boom. The National Association of Realtors also reported that pending sales of previously owned homes rose a better than expected 6.3% in December. And with residential construction of new homes still plummeting, residential construction is now only 3.1% of GDP, its lowest level of total economic output in modern history.
Banking
Due to the waning of interest rates from crisis levels, massive government intervention and a still-healthy yield curve, the banking sector is showing signs of improvement. Three month LIBOR has decreased from 4.8% to approximately 1.2%, so the spread between LIBOR and T-Bills (the TED spread) is below 90 basis points for the first time since last June. An indicator of liquidity and credit risk, a narrowing TED spread is seen as confirmation of successful efforts to inject liquidity into the lending markets. And 2-year swap spreads are down from 165 basis points to 50 basis points, almost back to their normal level of 30 to 40 basis points. Since swap spreads are seen as a barometer of counterparty risk and reflect the premium investors must pay to protect against credit risk, a declining spread indicates a growing appetite for risk. Despite claims to the contrary, Federal Reserve data shows that total bank credit rose at a 12% pace during the fourth quarter.
Interest Rates
Interest rates are finally beginning to rise from unprecedented low levels. Since the peak of the credit crisis, the yield on 30-year Treasury bonds has jumped from 2.5% to just over 3.7%; the yield on 10-year Treasury notes has climbed over 85 basis points from just over 2% to now over 2.9%; the yield on 5-year Treasury notes has risen from 1.1% to 1.9%; and the yield on Treasury bills has rallied from literally zero to .35%. The peak of the credit crisis was marked by a flight to safety as investors flooded into all securities backed by the U.S. Treasury. This exodus into safety and quality was so profound that investors were willing to accept 0% in T-Bills just for the government guarantee of principal return. The fact that yields are rising implies a willingness of investors to gradually assume additional risk, with at least some portion of the outflows from low yielding CDs and Treasuries finding its way back to the stock market.
Volatility
As reported in our October 2008 newsletter titled “The Fear Bubble”, the Chicago Board of Trade Options Exchange Volatility Index (VIX) spiked in October to just over 80 and formed a technical “double-top” in November that coincided with the November 20th stock market lows. The VIX offers a clear sign of investor sentiment with high recent readings suggesting extreme levels of fear. High levels of fear and extraordinary spikes in the VIX have always coincided with major market bottoms. Since November 20, the VIX has moved steadily lower and now sits at just over 40. Even though the VIX remains at historically elevated levels, the sharp drop since November suggests that the stock market is functioning at more normal levels with much less expected volatility than what we endured last Fall.
Much has been said recently about the rise in personal savings at the expense of consumer spending. Since 70% of the U.S. economy is based on consumption, it will be very difficult for GDP to experience a sharp recovery without an increase in consumer spending. Indeed, personal savings as a percentage of disposable personal income rose to 3.6% in December, up from 2.8% in November and only .8% in August. This represents an amazing 450% increase in the level of savings in only 6 months! Most economists now expect the savings rate to increase further, perhaps to as much as 5% by year-end.
While the current surge in personal savings is having a negative short-term impact on economic conditions, it is a significant long-term positive as consumers are in the process of getting their finances in order so they can again spend once conditions improve. The recent surge in refinancing activity coupled with the rise in personal savings suggests that consumers are doing just that.
And the rise in personal savings also bodes well for other-than-cash investments to receive their fair share of the savings pie. At the recent FOMC meeting, the Federal Reserve telegraphed its intention to maintain a low level of interest rates for a considerable period of time, even signaling the Fed’s willingness to buy U.S. Treasuries in order to keep rates low. The Fed is forcing investors to consider climbing up the ladder of risk, and the recent rise in Treasury yields suggests that investors are starting to heed the Fed’s beckoning.
Perhaps the rise in Treasury yields is also signaling that the maximum period of deflationary risk is passing. After all, the Fed’s easy monetary policy and massive government intervention are specifically designed to do just that, quell deflation. Since the market seems to have lost track of the possibility that the Fed’s policies might actually work, any hint that inflation risk has returned (or that the risk of deflation has abated) would lead to a substantial reallocation of investments in favor of “risky” assets such as equities to the detriment of “safe” assets such as Treasury bonds. With the yield on the S&P 500 now higher than the yield on the 10-year Treasury for the first time in 50 years, we believe there is far less risk in owing stocks than the market currently perceives.| < Prev | Next > |
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