Over the last month or two, there have been several questions about the economy, the markets, and my outlook that have come up in multiple conversations with clients, and I thought these might be worth addressing at large. I hope you find it worth reading.
Since what’s going on has a credit bubble at its root, what’s the status of the credit markets?
As of February 19th, 2008, the 10-year Treasury yield is at 2.83%, well above the record low of 2.07% set on Dec 18th. The three month LIBOR, the rates banks charge each other overnight in London, has decreased to 1.25% from its high of 4.82% on Oct. 10. The TED spread, another important credit market indicator is now at 0.95. It had been stuck above 2.0 for some time after peaking at 4.63 on Oct 10th. Being below 1.0 is a big improvement, although a normal spread is around 0.5. Finally, the 90-day A2P2 (high quality/low quality) credit spread is at 2.27 and has seen a huge decline in 2009 from its high of 5.86 after Thanksgiving [1]. That’s good but again still too high. The bottom line on all of this is big improvement, with hope ahead that the Treasury’s bank rescue plan will further (and hopefully dramatically) improve the willingness of institutions to extend credit over the next several months.
What are the equity markets doing?
Based on 12/31/2008 index performance data from Morningstar, emerging market holdings and international small cap stocks [2], which have been the best performers over last five years, have been hardest hit over last few months, and the US markets, despite being the origin of the credit crisis, have held up a bit better. Despite their recent poor performance, however, over the last five years, most international indexes have still managed to outperform the US markets.
On November 20th, we reached, what until today, was the low so far yet seen during this difficult market stretch – Dow 7392 on an intra-day low. As I write this, the Dow has dipped a bit below that and now stands at 7336. Since November, the US market has traded in a range of low-to-mid 7000’s and 9000. The net effect for a more globally diversified portfolio since November 20th has been no improvement, but no further deterioration either. However, if you look at your month-end statements from October through January you might think otherwise since the markets have finished each month at somewhat lower month-end values than the month before, but in general, including international markets, we’re still somewhat above the overall lows we saw the 20th of November.
One other bright spot in equity markets has been the dramatic decrease in market volatility as measured by the Chicago Board of Options Exchange VIX index. The VIX, which peaked at over 80 in November, closed yesterday at about 47. That’s still too high (normal is under 20), but it’s a vast improvement over what we were seeing in October and November.
Are there other historical precedents for market declines this big?
Yes. Four in the US markets since 1900. The Bank Panic Crisis of 1907, the Great Depression (market declined from late 1929 to mid-1932), the oil shock recession of 1973-74, and the bear market of 2000 – 2002. In all cases the US markets declined by between 45% and 53% (as of February 19th, US markets, as measured by the S&P 500 index, are down 50%), and in all cases except the 1929-32 period, recovered either fully or substantially within three to five years. That doesn’t mean that will be the case this time, but at the bottom of those prior markets, very few people had any reason for optimism either (and thus the market was down by almost 50%) and yet, the markets inevitably recovered.
How bad is the recession we’re in compared to others?
Both the recessions of 1973-74 and 1981-82 were worse than what we’re seeing right now by most measures. Unemployment today stands at 7.6%; in the 73-74 recession, it peaked at 9.0%, and peaked at 10.8% in the 81-82 recession. Additionally, a year into the recession, we’ve seen the Gross Domestic Product (GDP) fall by 1.1% so far (vs. 3.1% and 2.7% in the 73 and 81 recessions. (By comparison, the Great Depression saw sustained unemployment of 25% and GDP fell by over 25%.) [3] We’re a far cry from anything like those numbers.
Any reasons for optimism?
I’m encouraged that despite the continuing spate of bad economic news that the markets have hovered near the lows we saw in October and November. That may mean that much of the bad news we’ve seen (and hopefully the bad news yet to come) has been already “priced into” the market.
There was a positive surprise (+6.3%) in the December pending home sale data, which was published in the last week or two. [4] Additionally, the Baltic Dry Index, a measure of global shipping cost and demand is up 210% from its December low [5], although still well below its high in May of 2008. The trend, however, is at least a little encouraging. Finally, the Shanghai stock market index (SSE) [6] is also up about 22% since the first of the year.
To what extent was what we’re seeing predictable?
Mark Hulbert is the founder of Hulbert Financial Digest and has been tracking the advice of more than 200 financial newsletters since 1980. He noted in a recent NY Times article that of the 10 best- and 10 worst-performing market timing newsletters over the previous 15 years – seemingly long enough to separate out those with superior ability – that the historically best-performing newsletters were more bullish (optimistic) on stocks at the start of the fourth quarter than were the 10 worst performing newsletters. That is to say that the newsletters with the best 15 year track record were, on average, more wrong than the newsletters with the worst 15 year track record. So, to have had good odds of avoiding the fourth quarter’s losses, an investor would have had to choose his fortune teller on some basis other than past performance.
Here’s a relevant quote:
“My great regret is that I and so many of us who have been involved in this industry for so long did not recognize the serious possibility of the extreme circumstances that the financial system faces today.”
Robert Rubin, former co-CEO of Goldman Sachs, former U.S. Treasury Secretary, and a man on whose watch Citigroup, the largest financial institution in the world when he joined it, lost most of its capital.
Also worth noting is the performance of both the Harvard and Yale endowments, both widely considered to be among the best managed money on the planet, which have reported losses or anticipated losses for the third and fourth quarters alone between 25% and 35%.[7]
There is no doubt that there were those who predicted, in some fashion, the housing and resulting market crisis that we’ve been mired in for the last several months. However, there were also intelligent arguments against such a dire outcome. As Mark Hulbert points out, if you had based your decision on getting in or out of the market prior to October, it would likely have had to have been based on something other than that pundit’s past performance, but I’m not sure what that something else would have been.
Do I have a market outlook?
I’ll start by saying that I don’t place much credence in market prognostications – mine or anyone else’s. Fortune telling is always iffy, at best. That said, if I had to fathom a guess, I’d suspect the economy is going to continue to deteriorate for several more months, if not into early 2010, with unemployment rising throughout. I also wouldn’t be surprised to see markets bounce around in a range from the 7000’s into the low-9000s similar to what we’ve seen over the last three months. Finally, if history is any guide, I’d expect the markets to eventually start their recovery – whenever that may be – prior to the economy improving and prior to there being much good news to celebrate, economically speaking.
Of course, this is just my speculation. There are of course some very smart people who are much more pessimistic, and some who are much more optimistic, and it’s entirely possible we see deterioration in the equity markets before we see a recovery.
If the economy is going to deteriorate, why would markets not deteriorate too? And why do you think they might recover before the economy bottoms out?
Historically, markets have led the economy down, meaning they go down before the economy does, and they have usually recovered prior to the beginning of an economic recovery. This was true in many of the past recessions we’ve seen, including even the Great Depression. Additionally, markets tend to price-in the anticipation of bad news, often before that economic reality is realized, and in some cases, they price-in a reality that is worse than what eventually materializes. Therefore, it’s quite possible that the lows we saw in October – November (and are seeing again) may have properly anticipated the economic reality we’re seeing right now.
Should we be making changes at this point?
Of course, that’s a question that must be answered individually for each client, but generally, selling out in the thick of a liquidity crisis and after equity markets have already realized substantial losses (40% to 60% across the globe) is probably not great timing. Volatility has historically been the price one pays for the longer-term returns equities have produced on average. It seems to me that, unless you believe we’re heading for another Great Depression, we’ve paid most, if not all, of the price (in terms of volatility) for owning stocks and so, it might be worth being patient and waiting for the eventual recovery, whenever that materializes.
How about portfolio rebalancing?
For anyone who has equities as part of their portfolio, they are most likely underweighted in equities at this point as equities declined sharply in September through November. Our normal course would be to rebalance per our schedule unless you’d like us to do sooner. The benefit of rebalancing during a down period is to increase your equity (stock) exposure by reducing your fixed income (cash and bond) exposure at a time when equity prices are low. Of course, if equities were continue a downward trend, this wouldn’t be helpful, but historically speaking, rebalancing after a downturn like the one we’ve seen has been a profitable move more often than not.
What’s the risk of getting out and then getting back in?
The benefit of getting out at the moment would be defense against the possibility of a further substantial and sustained decline in worldwide equities.
In my experience, people’s tendency is to get out at some point (usually at or near a bottom in the market) with the hope of getting back in at a lower point or at about the same point that they got out, and in the process miss any further anticipated losses. However, in every case I can think of where I have seen people attempt to do this, the result has been getting back in after a substantial market recovery has occurred and often when the market is 20% to 40% higher than the point at which they jumped out. It’s usually just too hard for people to get back in at a bottom, because at the very bottom, the sense of abject pessimism is usually overwhelming – even more so than it was when they got out. So, the result usually is that of leaving a substantial amount of money on the table and often hinders the eventual recovery of the portfolio back to pre-downturn levels.
That said, let’s assume for a hypothetical investor we were to increase bond exposure and thus decrease equity exposure — perhaps as a temporary stopgap against further potential downturns. Further assume that the market declines from its present level of 7300 down to 6500. How likely is it that that investor will be willing to get back in at that point? (In my experience, the answer for most people is “not very likely at all”. On the other hand, let’s assume while that investor is sitting on the sidelines, the market increases by 30% to 9500. In my experience, that’s the point the typical investor will want to get back in, meanwhile kicking himself for not being in for the first 30% of the ride. (You see the problem, I’m sure, and it’s by-and-large an emotional one.)
As always, please let me know if you have any questions or would like to review your specific concerns or situation in more detail.
Footnotes
1. Source of data: 10-year Treasury yield – Wall Street Journal; LIBOR rates – www.BankRate.com; the TED spread – www.Bloomberg.com; and the 90-day A2P2 spread — www.FederalReserve.gov
2. While international investing may provide growth opportunities and diversification, it does involve special risks such as currency fluctuation and political instability and may not be suitable for all investors.
3. Dimensional Fund Advisors, Institutional Quarterly Review, 4th Quarter 2008
4. National Association of Realtors, February 3rd, 2009
5. Bloomberg: www.Bloomberg.com
6. Bloomberg: www.Bloomberg.com; While international investing may provide growth opportunities and diversification, it does involve special risks such as currency fluctuation and political instability and may not be suitable for all investors.
7. New York Times, December 16, 2008, “Yale Endowment Drops . . .”