The Process of Recovery 3-12-2009

Inside this edition of Signature Update

- Straight Talk From Industry Strategists
- Market Potpourri
- Inflection Points
- Yet Another Perfect Storm


Straight Talk From Industry Strategists

As one might imagine, during most weeks I have opportunities to participate in discussions with senior economists, chief investment officers, and market strategists across the country. This last week was no different, but the tone of some of these conversations represented an interesting shift in attitudes we haven’t seen for some time and I thought a few of their remarks might be meaningful here.

The first of these discussions was on conference call on Monday, March 2nd that included Linda Duessel, Federated Investors, Inc., Senior Vice President, Senior Portfolio Manager, and Equity Market Strategist. A week later, on Monday, March 9th, Bob Carey, Chief Investment Officer, First Trust Advisors, LP, presented at a luncheon in Salt Lake City. Though neither Duessel nor Carey are economists, they are each seasoned market strategists who have earned excellent reputations. Their firms manage tens of billions of dollars for some of the largest companies in the world and they have access to the best data and research available.

Neither Duessel nor Carey are noted optimists, but both were surprisingly upbeat. Duessel is one of the sharper minds in the investment management business and has a reputation for straight talk. Carey has guided First Trust’s investment operations for years and has helped the firm become the one of the top equity unit trust companies in the market. In the midst of a terrible week for the markets, both spoke optimistically about the direction of the markets over the coming year. When challenged, they each responded with facts and figures to support their conclusions, but deftly left room for the possibility that if certain events transpired in the coming months, then the markets would react contrary to their observations.

The bottom line for both Carey and Duessel is that we have been at or very near market bottoms and that there will be observable economic growth by the 4th quarter of 2009. They each expect the markets to begin sustainable rallies no less than three months in advance of increases in GDP and they see 2010 as a strong year for the markets. Carey notes that there is way too much information available in the markets today, but not nearly enough knowledge on the part of most decision makers. Like others in their field, each agree that it has been too late to sell for many months now, but perhaps not too late to reposition.

This week’s rally in the DOW certainly seems to support their positions.


Market Potpourri

Over the past several weeks, market sentiment had declined to -70, the lowest level in more than 20 years and lower than the negative benchmark -68 established in 1990 (on this scale zero suggests neither bullish nor bearish sentiment, less than zero is bearish and greater than zero is bullish). At the same time, the yield curve steepened (reflecting higher interest rates for long term borrowing and lower for short term) continuing a trend reversal of an inverted curve established in early 2008 (an inverted yield curve represents higher yields for shorter maturities and lower yields for longer maturities). Each of these indicators suggest a market rally in the coming months; the very earliest part of which may have been seen on Tuesday as the DOW climbed nearly 380 points. Other factors leading to Tuesday’s increase included unexpected earnings performance by Citigroup, supportive comments offered by Fed Chairman Ben Bernanke, and continued discussion over the ‘mark-to-market’ and ‘uptick rules’.

Thursday’s retail sales report also represented better-than-expected retail sales for February and an upward revision of January’s already positive results. This is yet more significant than many might suppose in that it not only bodes well for retailers, but signals a reversal in a troubling decrease in the velocity of money in our economy. Over the last several months the velocity of money, or the rate at which currency changes hands, had decreased to a rate of 5.5 versus a more typical rate of 7. When the rate at which money moves slows, it represents lower spending on the part of consumers and businesses, as well as decreased lending on the part of banks. In this case it also represented a shift from net-spending to net-savings in our society. The reversal of this trend is not only healthy for retailers, but suggests that consumers are prepared to lead the way out of the recession as they have done for nearly every sustained recession our economy has experienced in the last 100 years.

General Motors signaled that it is likely to file bankruptcy in the coming months, simply asserting to the public what had already been a foregone conclusion to the investment markets. Both GM and Ford have announced restructuring plans for their senior debt obligations and Ford has successfully renegotiated its labor contracts. These steps, taken without additional government intervention, are likely the most meaningful steps the US automakers have taken towards restoring fiscal health. Though we will likely see a very different GM emerge from bankruptcy, it is refreshing to see them taking such bold and necessary action on their own. What remains to be seen is whether they will file for a restructuring plan or an outright dissolution; either would be preferable to seeing them limp along under the weight of high interest debt and stifling labor contracts.

Credit market spreads widened further over the last week (the difference between treasury yields and those of lower rated corporate bonds of similar maturities), suggesting an expected increase in junk bond default rates. The increase in potential reward has been sufficient for many investors to step up and accept higher risk of increased potential default rates in return for the higher yields offered for BB and BBB rated bonds.

“Beware of the crowd at extremes” is an old investment adage implying that, when enough investors believe something is going to happen with regard to a particular investment, it is usually a good time to look in the other direction. Some recent examples might include:

· 1999 – “I’m moving all my money into technology stocks. Can’t you see technology is the wave of the future?”

· 2006 – “I’m putting all my money in real estate. You know, real estate investments have never gone down.”

· 2008 – “Oil stocks and oil futures are the only sure way to make money. We’ll never see oil below $75 per barrel again.”

2009 – “I’m going to invest all my portfolio in gold and cash. Can’t you see gold is going to $3,000 an ounce and stocks are going to zero?”



Inflection Points

We can look back to two pivotal weekends in September 2008 as inflection points for the market downturns we’ve experienced as market volatility reached all time highs and multi-hundred point movements became a daily occurrence. As Paulson, Bernanke, Bush and others were revealing their fears over the credit market crises, other elected officials and populist commentators repeated the rhetoric and consumers and business owners began to react by curtailing spending plans, designing layoffs, and reducing production. We may never be able to tell the ‘chicken’ from the ‘egg’ in this scenario, but one thing is certain: the bloody picture displayed before us of dire economic consequences served to make those consequences radically and swiftly worse than they may otherwise have become.

Afterwards the market began to climb back towards more realistic levels and eventually topped 9,000 on the DOW, but has since retreated by another 15-20%, in reaction to the current administration’s taxing and spending plans. While the Bush administration and Alan Greenspan may have been responsible for much of the DOW’s decline from its 14,000+ high, the Obama administration has certainly contributed to some 2,500 points of the recent drop in values.

We’re now looking towards another inflection point, the point at which the market will make its next significant turn. Just as we can look back to September 2008 as a turning point, we’ll also be able to look towards a point in the 3rd or 4th Quarters of 2009. When markets sour as rapidly as they did over the last year, we know that recoveries can be just as violent on the upside. Investors who have followed the market’s downward slope may find the ride up to be just as exaggerated. The palpable fears of the last six months may well give way to exuberance, only this time it will likely be more rational than it was when Greenspan made note of it some years ago. While we’re not suggesting that we’ll see a climb back to the 14,000 level in a similar time frame to that which we went from 14,000 to 6,500, this may take years, we do expect that the rally signaling the end of the bear market will be swift and steep.


Yet Another Perfect Storm

In the last 12 years we saw a ‘perfect storm’ develop in terms of economic policy errors. The Congress’s repeal of the Glass-Steagall act (the legislation that kept banks and investment firms separate), the SEC’s elimination of the ‘up-tick’ rule and virtually ignoring naked short selling violations, the Treasury’s implementation of ‘mark-to-market’ accounting, the Federal Reserve’s easing of monetary policy, deregulation efforts that ultimately allowed for the CDO, CDS (collateralized debt obligation and credit default swaps), and rampant speculation in the oil markets all culminated in the disasters we’ve seen in the last 18 months.

It took years for the storm to build and will take a few more for it to completely subside, but our economy will heal and rebuild just as do our cities and towns in the wake of other, more natural disasters. Some good first steps have been taken to this end, but the next step is likely to be an important change in ‘mark-to-market’ accounting.

While this process has clearly helped make the value of certain types of assets to be more transparent, it has also devastated the financial markets and capital ratios of lending institutions. Rather than simply eliminating these rules, we’d like to see them changed to retain the transparency of the value of assets on corporate balance sheets, thus effecting stock prices, but not force the regulatory agencies to restrict lending practices based on hard-to-value assets. This provides the proper incentive for financial institutions to make prudent investment banking decisions without crippling the rest of the economy by freezing the credit markets.

Over the next two weeks the SEC and the Treasury are likely to make changes in the ‘up-tick’ rule and ‘mark-to-market’ accounting standards. As they do so, the financial sector (banks, investment banking and brokerages) may experience significant increases in valuation and which may be followed by more realistic lending practices. Additionally, the economic recovery, or stimulus packages recently passed through the House and Senate may be given a substantial boost. All of this points to a strong 2nd half of 2009 and even stronger 2010 for the economy as a whole.