Never argue with a man who buys ink by the barrel
March 31, 2009
Market Summary – 1st Quarter, 2009
It is important for investors to understand the unprecedented magnitude of the Federal Reserve intervention in the US economic system. Faced with potential financial collapse, the Federal Reserve Chairman, Ben S. Bernanke, has led the Fed Open Market Committee through a series of innovative moves. Under his leadership, the Fed has deployed trillions of dollars to contain the worst economic contraction since the 1930s. Rather than allowing the recovery to occur by chance or the traditional corrections of capitalism, we now have a government directing and providing massive stimulation to the economy. Those who do not recognize these forces will be left behind.
Bernanke is the right man at the right time, and this headline is another way of saying “don’t fight the Fed.” He is wielding extraordinary powers far beyond anything imagined by his predecessors. As an authority on the Great Depression, Bernanke is well aware of the mistakes made by central bankers, private bankers and government leaders during that time. It is Bernanke’s belief that the greatest threat to the economy is to do too little, even if some actions that might be taken today may cause problems in the future.
The financial marketplace meltdown in September and October of 2008 put tremendous stress on the system. In a matter of weeks, a cascade of events, beginning with the collapse of Lehman Brothers took a toll on a “Who’s Who” in the industry. Merrill Lynch, Fannie Mae, Freddie Mac, Washington Mutual and AIG all needed a rescue. This unparalleled collapse of the most significant financial powerhouses created an unprecedented threat to the economy.
Bernanke is the key player in this period of extraordinary government intervention. Along with keeping the entire ship afloat in late 2008, he engineered Fed involvement and helped convince Congress of the need for the Troubled Assets Relief Program (TARP) to help banks stay afloat. Once the situation was stabilized, Bernanke aggressively shifted his focus to getting the economy back on the right course.
We said in our 4th quarter, 2008 newsletter we believed the market would act favorably in 2009 despite poor economic numbers. This was due, in part, to our belief that Bernanke had drawn a line in the sand, indicating he would do what it takes to save the system and get the economy back on track. In the first months of 2009, that figurative line looks more like a gorge.
According to calculations from Bloomberg News, the government and Federal Reserve have spent, lent or committed $12.8 trillion to keep the wheels of the economy turning. This includes:
• $7.8 trillion from the Fed – including credit to AIG and bailout dollars for Citigroup, purchases of mortgage-backed securities (to help keep rates low) and of Treasury securities, and support for asset-backed segments of the market including automobile and student loans. On one day alone, March 18, Bernanke and the Fed committed more than $1 trillion, easily surpassing the value of the massive stimulus package passed by Congress in January.
• $2.7 trillion from the U.S. Treasury – including stimulus packages in 2008 and 2009 and the $700 billion TARP rescue package.
• $2.0 trillion from the FDIC – much of it to fund the new Public Private Investment program to try to rid banks of toxic assets.
That is a massive amount of liquidity put to work in our economy. The $12.8 trillion total is just shy of last year’s Gross Domestic Product for the U.S. While it is hard to imagine that anything more could be done, don’t discount the determination of Bernanke and the administration. As Goldman Sachs CEO Lloyd Blankfein stated recently, they “will do what it takes. If it is enough, that will be great. If it is not enough, they will have to do more.”
If there is anybody who is in a position to do more, it is Bernanke. Is it wise to bet against Bernanke and the Fed?
We have reached a period where many people question what a free market economy means. The sad but unavoidable fact of capitalism is that situations like this happen from time-to-time. The storylines typically start with periods of amazing, free-market driven growth that blossom into boom times, which then leads to excessive behavior and ultimately results in economic correction. While our faith in longtime American institutions may be shaken, it should be noted that our nation has survived previous setbacks. Often the darkest times have been the prelude to generational opportunities…capitalism continues to prevail.
The gilded age of the 1920s ended in the economic contraction of the 1930s. The savings-and-loan crisis of the late 1980s and early 1990s shook our confidence in Main Street bankers. The Long Term Capital Management hedge fund collapse in the 1990s showed us that even Nobel Prize-winning economists could not outsmart market forces. At various points in our history, the government has been forced to step in when capitalists over-reach. It isn’t pretty, but it is an ingrained part of human behavior.
Those who understand cycles seem to have a certain calm about them regarding the current situation. President Obama’s recent comments at the G-20 summit in London reflect the mindset:
“I think what we’ve learned here, but if anybody has been studying history they would have understood earlier, is that the market is the most effective mechanism for creating wealth and distributing resources to produce goods and services that history has ever known but that it goes off the rail sometimes.”
The President went on to say that “we just have to put in some common-sense rules of the road, without throwing out the enormous benefits that globalization have brought in terms of improving living standards, reducing the cost of goods, and bringing the world closer together.”
As the pendulum swings
Bad news has dominated the headlines over the past year. The market under-priced risk and now the pendulum has swung to over-state risk and under-price assets. This mis-pricing gives an incorrect vision that the economy will continue to deteriorate. We are seeing early signs of a turnaround in the economy. None of these may yet be sufficient to claim that a trend has begun, but they could be signs that at least the bottom has been discovered or is close at hand. These subtle signs include:
#1 Housing bounceback
Housing starts jumped 22% in February, ending the longest string of declines in 18 years. Other housing data released last month included modest increases in building permits, sales of existing home and new home sales. Conventional 30-year mortgage rates are below 5%, the lowest level in 40 years and refinancing activity has skyrocketed.
#2 Consumer recovery
The job market is poor and shoppers are cautious, but consumer spending rose in both January and February. Even though the gains were modest, it provides encouragement that the retrenchment in spending may have reached a nadir. For example, Best Buy had an incorrect vision of their inventory needs and stores recently reported running out of selected TVs, and digital cameras after being caught by a surprise rush of demand in early 2009.
#3 Coming consolidations
The recent drop in energy prices resulted in the creation of a new energy giant in Canada, as Suncor Energy purchased Petro-Canada for approximately $15 billion. We saw a similar trend in the 1990s with the consolidations of Exxon-Mobil, BP-Amoco, Conoco-Phillips and TotalFinaElf. This trend is likely to continue since it is cheaper to buy oil in the marketplace than to drill for it. Consolidations benefit shareholders.
#4 Cash remains in play
According to Credit Suisse, a record $14 trillion in cash is sitting on the sidelines – in money market funds, bank savings accounts and Treasury debt. At the same time, U.S. equity market capitalization is valued at less than $10 trillion. Given that real (after-inflation) interest rates on many cash instruments are 0% or lower, it is only a matter of time…
Jeremy Grantham, a British money manager and noted pessimist has shifted his view. While holding cash looks to be the strategy du jour, Grantham warns that those with too much money out of the market will miss a very large chunk of the recovery. He points out that in a six-month span from June 1933 to January 1934, the market gained 105%.
#5 Fewer stocks hitting rock bottom
Professional short-seller Doug Kass, who has been a longtime bear, points to some encouraging signs. One is that fewer stocks participated in the market’s decline in 2009 than was the case late last year. When the Dow dropped to 8,451 in October last year, 2,900 stocks reached new lows. The March 9th low for stocks, when the Dow dropped to 6,547, saw just 855 stocks hitting new lows (TheStreet.com, March 24, 2009). That tells us that most stocks have stabilized ahead of the market.
#6 Dividend yields are higher than interest rates
For the first time in 50 years, the dividend yield on the S&P 500 topped that of the 10-year Treasure note. In other words, even with NO capital appreciation, that equity index is generating a greater return than bonds in today’s environment. Investors should eventually recognize the obvious opportunity. It is helpful to have your investments in place before the market turns.
All the foregoing signs now give reason to be optimistic.
Reverting to the mean
Professor Jeremy Siegel (featured guest at our inaugural MPMG Speaker Series event in 2006) in the March 9, 2009 issue of Barron’s said that the law of averages may be about to catch up to the markets – to the benefit of investors. Siegel has tracked market returns on an inflation-adjusted basis back to 1802. Stocks, in that time, averaged about a 7% return per year. That represents the mean return. But of course, actual performance varies each year. According to Peter Brimelow on MarketWatch.com, the market plunged more than 40% below Siegel’s trendline earlier this year. This has happened on other occasions. Siegel says the record gap between the long-term trendline and actual market performance was in 1932, when the market was 43.1% below trend. The following year, stocks gained 58%.
Siegel says on average, the seven largest gaps where actual performance lagged the trendline since 1872, the market has averaged:
• a 24% rally the following year;
• a 21.4% average annual return over the first three years; and
• an 18.4% annual return after five years.
Siegel’s point is simple – things look a lot more promising for the long run when you are down 50% from your previous high than when the market is peaking.
A vision for investors
We continue to experience stressful times – the economy in recession, markets down dramatically and both the job security and financial security of millions of Americans is fragile. As investors, we believe these problems can create opportunity for those well-positioned.
Our belief, as the economy and markets reach a crossroads, is that it is difficult to bet against Ben Bernanke when valuations of many companies are at 50-year lows. The combination of aggressive stimulus efforts and a growing universe of attractively priced securities offers potential for significant wealth creation.
Past economic recessions were met with relatively minimal government involvement. This contraction differs sharply from previous declines as the Federal Reserve is providing intense monetary intervention. Consequently, when the economy turns, we expect the cost of goods and services to over-heat. Therefore, we believe hard assets play an integral role in any portfolio.
At this point however, potential future inflation is not the principal focus of the Fed. The central bank seems to have confidence it can deal with that issue later if necessary. The greatest risk on the table now is to be too timid in trying to turn the economy around. It comes down to getting money moving in the economic system. Ben Bernanke has the biggest printing press in town and a seemingly unlimited supply of ink.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.