Insights
Market Commentary - 2nd Quarter, 2008
During the early weeks of the second quarter, the stock market, as represented by the Dow Jones Industrial Average, continued its upward trend, but changed directions dramatically as the weeks progressed. For the quarter ended June 30th, the Dow reported a total return of -6.5%, while it’s year-to-date return (ending 6/30) was -13.4%.
Dow Jones Industrial Average
Source: Yahoofinance.com
Despite widespread discouragement during the past several months, a view of the Dow over the longer-term, might suggest a glimmer of hope. Given the technical view, a near-term support level may at least give the market pause on what some are now calling a bear market (the widely accepted definition of a bear market is a 20% drop from its highs). Based on history, according to a recent Business Week article, once the market declines by 20%, it has already suffered the greatest extent of its losses! Unfortunately, as the decline wears down investors' confidence levels, they tend to bail out at the bottom of the market - when things look their worst -- and the greatest opportunities present themselves!
According to a well respected investor group, the post-1940 “average” bear market (based on the Standard & Poor's 500 Index) produced a decline of 30.4% from its peak and took roughly 13 months to reach its trough. By the time the market was down 20%, the “average” bear market was 74% completed. Based on those averages, the current bear market would have roughly 4 more months to run its course. The shortest bear market occurred in 1987 and lasted only 101 days, with approximately 21% of the damage done on one day – October 19th. The longest, however, was the bear market decline of 1973-74, which lasted roughly a year and three quarters, and took a 48.2% bite out of the S&P 500 Index. As most individual investors evaluate the stock market based on the direction of the Dow Jones Industrial Average, the following chart offers a longer-term view of the Average.
Source: Yahoofinance.com
One must keep in mind, however, that the Dow Jones Industrial Average is a capitalization weighted, narrowly based indication of the equity market, reflecting the movement of only 30 stocks, some of which have performed quite poorly year-to-date. In the chart below, the components of the Dow are illustrated, providing a clear example of why averages can be deceiving. Had you owned the first 10 stocks listed below, performance results would have been dramatically different than owning those in the last two columns.
Looking at the broader based US equity benchmarks, the S&P 500 Index declined 2.2%, while the NASDAQ Composite rose 1.6% for the quarter. Year-to-date, while these benchmarks posted losses of 11.9% and 13.2% respectively, their performance was among the better performers from a global perspective. Canada reported positive results year-to-date, and when including Japan (the Nikkei 225), were the only two major markets that posted better results than the S&P 500 Index in the US! Reporting one of the worst performing global equity sectors was China - down roughly 45% year-to-date, reversing much of the gains achieved during the past several years.
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Contributing to the downtrend was the fact that financial stocks, overall, have been among the worst performers to date – down 18.3% and 29.7% for the year. Consumer Discretionary stocks were down 7.8%, while Industrial stocks dropped 10.1% for the quarter. Meanwhile, Energy stocks were the best performing sector (up 17.3%), followed by Utilities (up 8.0%). Large cap issues declined 2.7% for the quarter, while small cap stocks rose, albeit a meager 0.6%. In addition, value stocks underperformed growth stocks, in both the large and small cap sectors.
In the fixed income sector, interest rates began to move higher, signaling the end to lower rates. In the table below, you’ll note that most of the rate increase occurred in the short to medium maturities of the yield curve. However, keep in mind, that over the past year, rates have come down considerably, declining between 235 and 224 basis points in the short (3-month and 2 year) segments of the curve. As you can see, while there was only a difference of 104 basis points (4.08% vs 5.12%) in interest rates from 3-months to 30 years back in June of 2007 (a flat yield curve), today the curve is considerably steeper, with a slope of 279 basis points (1.73% vs 4.52%), which has traditionally signaled an economic turnaround may be ahead.
While yields alone don’t tell the whole story, one must look at a bond’s duration (which incorporates both the bond’s coupon rate and time left to maturity) to get a clear picture of the performance of the bond market. The table below illustrates the fact that most Treasury bonds with maturities under ten years have shown positive results year-to-date, despite the fact that bonds in all maturities (but particularly those over 7 years left to maturity) gave back some of their returns during the past quarter as interest rates rose. On a relative basis, however, while Treasuries declined 2.10% for the quarter, they’ve gained 2.23% since the beginning of the year. Interestingly, even though Treasuries are considered to be of the highest quality (and hence generally have the lowest yields), it was the bonds in the lower quality sectors that did better, as their higher yields helped offset the price declines which occurred when interest rates rose during the quarter (Generally, when interest rates rise, bond prices move lower, and vice versa). For the 6-months (year-to-date) period, the highest quality (Aaa) rated securities were by far the best performing market sector , up +1.65, versus the lower quality (Baa) rated sector which declined -0.94%. Conversely, the lower quality sector (+0.13%) clearly beat the higher quality sector (-1.09%) during the past three months (second quarter).
Reviewing the overall fixed income market sector, note that the Home Equity sector of the Asset Backed Market performed terribly year-to-date (-18.51), while Mortgage-Backeds (includes GNMA, FNMA and FHLMC), and most of the higher quality sectors (Treasuries, Agencies, Supranationals, Foreign Agencies) showed positive results. In the past three months, however, the lower quality CMBS issues posted slight gains, while most corporate bonds fared comparatively better versus the higher quality and Treasury issues.
Finally, a note about the foreign markets. So far this year only US and Canadian Treasury yields (10 year maturities) remain below the levels from late 2007, though the trend for interest rates world-wide has clearly been to higher levels. These yield levels provide further evidence that until US interest rates become more competitive (move higher) that the US dollar will remain under pressure. The Federal Reserve, however, may be walking a fine line between its focus on interest rates, the dollar and ultimately inflation! In the current environment it will be difficult for the Fed not to play the inflation card, as core inflation continues above the Fed’s implied comfort zone. While long term inflationary expectations have remained relatively steady, the largest single increase was in food and energy prices (which comprise only about 25% of the consumer price index). Still, this rapid increase in food and gasoline prices have clearly raised short term inflationary fears to where it’s likely that the Fed will look to keep inflation under control at the expense of economic growth. Of interest is the fact that there are many who believe that inflation is actually much higher than reported. While the chart below illustrates inflation estimates based on pre-1983 criteria vs current official calculations, it’s not surprising that perception and reality appear to be so different.
Many investors, however, have begun to look back to the 1970’s when the economy was slowing and inflation was rising at roughly 8-10% (during which the term Stagflation was coined). This does not appear to be the case in today’s environment. Still, despite widespread inflation concerns on Wall Street, the US inflation rate is comparatively lower than most of the other countries in the world. The US rate has been reported at 4.2%, year-over-year, dramatically lower than the 31.4% and 31.1%, reported respectively, for Venezuela and the Ukraine, though slightly higher than most of the European countries.
Source: BIGroup
Continued upward momentum characterized the commodity markets, with corn, metals and crude oil reaching new highs. One of the largest contributing factors in the inflation scenario has been the price of oil, which has run up so dramatically this year, surging from $100/barrel in early March to more than $140/barrel at the end of June. It has been suggested that this dramatic rise has been the result of speculators who have driven the price to such high levels. If so, there is a good probability that the price may edge lower in the coming months, as “fundamentals” were not the cause of the increase. Still, US consumers have clearly changed their consumption of gasoline – with the $4 price per gallon being the proverbial “straw that broke the camel’s back”. Interestingly, the Department of Energy estimates that a 1% decline in personal income results in a 0.5% drop in gasoline demand.
Interestingly, while US car makers are sitting on huge inventories of gas guzzling SUVs, the Chinese have been buying them up like hotcakes! In the first four months of the year, SUV sales in China rose by 40% - twice the growth rate for their passenger cars. Fueling this frenzy is the fact that the cost of gasoline and diesel in China are roughly 40% cheaper than in the US, and approximately 80% less than in the UK! Another very interesting statistic is that according to the Bureau of Economic Analysis, the cost of energy in the US (gas, fuel and other energy) as of % of discretionary income, has not yet reached the levels seen in the late 1970’s and early 1980’s.
Furthermore, while recent volatility in crude oil prices appears to have been dramatic, the chart below suggests that the volatility is not unusual based on its 20 year history!
Source: Bespoke Investment Group
Anecdotally, realtors locally have noted that individuals have been requesting copies of previous years heating bills, as dramatically higher heating oil costs has become another determining factor for individuals when considering a new home purchase! As for the continuing discomfort in the housing market overall, home prices remain in a major slump. Since June of 2007, foreclosures have risen by an amazing 53% year-over-year, though activity in June actually decreased 3% from the month before! Here too, realtors have suggested that the housing market does in fact have a better tone, despite the huge inventory overhang. On the other hand, one in every 501 US households nationally, has either lost a home to foreclosure, received a default notice or was warned of a pending auction. Nevada, California and Arizona topped the list with the highest number of foreclosures, while California, Florida and Ohio reported the highest rate of foreclosures.
Though weakness in the housing sector is likely to persist for the remainder of 2008 and into 2009 (some even say into 2010), there are some very highly respected economists that are suggesting that the worst might be over, as home sales are finally staring to show some stability. Until recently, though strong employment and income growth had helped offset weakness from the housing market, the results hampered GDP (Gross Domestic Product) growth. That said, the second quarter posted yet another period of positive economic growth. Surprisingly, though Retail Sales held up well, most individuals are acting, feeling and conserving as though they were in a recessionary environment. Validating this observation is the fact that consumer sentiment levels have fallen to a 16 year low.
Though individuals in all but the highest income brackets claim to be feeling they’re in recession, it is of interest to know that the US is officially not in recession. Traditionally, a recession has been characterized as 2 consecutive quarters of GDP contraction. Of even greater interest is the recent debate and clarification by the NEBR which is responsible for the recession dating procedures and definitions. According to the NBER’s Recession Dating Procedure, they define it as the “peak to trough decrease in business activity”. A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy. Most recessions are brief and they have been rare in recent decades.”
So what’s the bottom line, and what can we expect for the future? To start with, despite high levels of uncertainty and fear among many investors and individuals in general, a recent Bloomberg survey of Wall Street Analysts suggests that rather than doom and gloom, they are quite positive! Fifty percent consider themselves “Bullish (43%) or Very Bullish (7%); 12% consider themselves “Bearish (12%) or Very Bearish (0%), while 38% are “Neutral”. In the chart below, note that more than half view the market as undervalued, with the vast majority expecting that the key to the direction of the stock market in the upcoming 12 months is overwhelmingly what happens with credit conditions!!
While we tend to be wary of consensus thinking, we too are becoming more open minded with regard to putting some cash back into the market. Though we still see the potential for further downside over the near term, we expect that additional opportunities to buy stocks at lower prices may exist between now and year-end. Oil prices are another key factor in the equation, particularly in the face of the upcoming winter months, whereby further upside pricing pressures are likely to affect inflation, and in turn, would lend itself to the Federal Reserve’s raising interest rates as an offset. This, however, would likely stall any potential for economic growth. Currently, we anticipate that the next two years will be a period of sub-par growth, particularly as housing remains subdued. We believe that the national statistics are skewed by data from some of the more hard hit demographic areas (Florida, California, Arizona, etc.) and that housing conditions locally, while bad, are not devastating.
Interestingly, we don’t believe that the upcoming political election will have any major impact on the markets, as the first year of a presidential election is usually a positive one (that will be the subject of our next monthly commentary). All in all, we’re becoming increasingly more optimistic and while we expect there to be additional downside and a continuation of volatility through the remainder of the year, we think there are opportunities to be had. We will slowly begin to re-deploy cash and cash equivalents into more permanent longer term assets.
We also continue to feel that high dividend yielding securities which generate cash earnings and pay out dividends (6-7%), will help to keep pace with inflation and may be able to offset any principal losses that may occur. Over the long-term, these investments tend to be an outstanding way to diversify your portfolio, as they tend to have less correlation with the core positions in one’s portfolio. The same would hold true for various alternative investments, such as low volatility hedge funds, where short selling, protective puts and arbitrage between different securities have proven to be quite defensive in the current environment. Some of these investment could be suitable replacements for small cap or aggressive growth stocks, or even some fixed income securities, though one must carefully evaluate one’s investment objective and risk tolerances to be sure that these investments are appropriate.
We might add, that given the passage of time in what has been a very volatile and fast changing decade, it might be wise to consider a full “financial physical” in order to re-evaluate your financial health in the current environment. Have your objectives changed? Have your investment allocations changed accordingly?? Have you saved enough for retirement? Given a realistic set of assumptions, will those funds last throughout your probable lifetime…your spouses…your children… your grandchildren?? On the other hand, are you being ultra cautious, when in fact your financial health is fine and you may be able to live more comfortably and at ease just for having thoroughly analyzed the details and found solutions where and if needed? We’re here to assist you in these matters and all others relating to your financial affairs. As always, feel free to contact us. We appreciate your business and would love to hear your comments or answer any questions you may have.
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