Insights
Market Commentary - 1st Quarter, 2008
By the end of the first quarter 2008, it was apparent that the Federal Reserve’s unprecedented efforts in mid-March to restore confidence and provide stability to the markets was working…at least for now. After the near failure of investment bank Bear Stearns, the Fed’s actions had a positive effect among investors by stemming the downward motion of the dizzying rollercoaster experience which began during 2007.
Dow Jones Industrial Average
Source: Yahoofinance.com
Year-to-date, the stock market, as represented by the Dow Jones Industrial Average, declined 7.32%, while virtually all other equity markets, including the broader indicators and the foreign equity markets, declined notably more. On the other hand, most of the higher quality investments in the fixed income markets posted positive returns, as interest rates, particularly in the shorter term maturities continued to move lower.
Source: ING Investment Management
As the fixed income sectors, and in particular, mortgage securities related to housing markets, were at the center stage of the current financial debacle, it is interesting to note that home equity loans had the worst performance, by far, relative to US Treasuries which, as noted above, returned +4.81%.
Fixed Income Market Sectors |
Excess Return % vs 1st quarter 2008 |
Home Equity Loans (HELs) |
-16.82 |
Long Maturity Corporate Bonds |
-8.08 |
Commercial Mortgage Backed Securities (CMBS) |
-7.70 |
Non-Investment Grade Credits |
-7.69 |
Asset Backed Securities (ABS) |
-5.94 |
Corporate Credits – Financial Sector |
-5.30 |
Investment Grade Corporate Credits |
-4.87 |
Emerging Market Credits |
-4.64 |
Residential Mortgage Backed Securities (RMBS) |
-0.81 |
Agency Adjustable Rate Mortgages (ARMS) |
-0.38 |
Source: ING Investment Management
By mid-March, the Federal Reserve had cut the Federal Funds rate an additional 0.75% to 2.25%, bringing the total reduction to 300 basis points (3.0%) since it began easing monetary policy in 2007.
US Treasury Yields (%) |
3-mo |
2-yr |
5-yr |
10-yr |
30-yr |
March 31, 2007 |
5.03 |
4.57 |
4.53 |
4.64 |
4.84 |
June 30, 2007 |
4.80 |
4.86 |
4.92 |
5.02 |
5.12 |
September 30, 2007 |
3.46 |
3.99 |
4.25 |
4.59 |
4.87 |
December 31, 2007 |
3.24 |
3.05 |
3.44 |
4.02 |
4.45 |
March 31, 2008 |
1.32 |
1.61 |
2.46 |
3.42 |
4.29 |
Chg in Yield (1st Qtr 2008) |
-1.92 |
-1.44 |
-0.98 |
-0.60 |
-0.16 |
Chg in Yield (yr over yr) |
-3.71 |
-2.96 |
-2.07 |
-1.22 |
-0.55 |
Source: Bloomberg, FIS
Note the dramatic decrease in the 3-month T-Bill rate from a year ago and the transformation of the yield curve from a flat-inverted shape to a more normal, positively shaped term structure. Classically, an inverted yield curve tends to forecast a coming recession. This shouldn’t surprise us, as most individuals feel that current economic conditions are recession-like.
Source: Dwight Asset Management
Most economists, however, would argue that the US economy overall is not in a recession, but rather experiencing a slow-down, given that the traditional measures which signal an official recession (defined as two consecutive quarters of negative real growth in gross domestic product) have not occurred during the current business cycle. The following chart indicates those states that are presently in recession mode. Note that while much of Massachusetts is still officially showing positive growth, conditions vary by metropolitan area. In fact, the areas of the country that are seemingly less affected by current conditions are those in the mid section of the country that didn’t experience dramatic growth during the boom phase, and where agriculture represents a high percentage of gross state product (North and South Dakota, Idaho, Nebraska, etc.).
Consider, also, the rise in commodity prices, including gold, which has been dramatic. Soybean prices on the Chicago Board of Trade have jumped from around $7.50 a bushel in late 2006 to close to $15 today. Wheat prices have doubled to nearly $10 a bushel, while Corn prices have also doubled to roughly $6 a bushel. States such as Washington, Vermont, Texas, Louisiana, Kentucky, Michigan and Oregon are also prospering, as more than 10% of their gross state product is represented by exports. The continuing weakness in the Dollar has helped to further boost economic activity in those states.
While the recent decline in the US Dollar has been dramatic, it began its clear downtrend in early 2002 before stabilizing during much of the period from 2004 to early 2007. The graph below illustrates the trade-weighted currency index for the US, Japan and the Euro zone for the last 5 years.
Source: Goldman Sachs, Federal Reserve
Consensus thinking suggests that further deterioration in the value of the dollar is in store. The impact of a lower dollar could translate into both higher commodity, food and fuel costs here in the US, particularly given the use of corn and other products for production of ethanol. These increases will ultimately work their way through to the consumer, with the ramifications still to be felt in the future. Tourism in the US, on the other hand, is a clear beneficiary of the declining dollar, as states report a conspicuous increase from foreign visitors!
That said, the expectation for energy prices to continue to rise during the next few months will likely have a considerable impact on summer travel for US citizens, be it via automobile, the airlines, etc. Having stabilized somewhat from the mid-80’s to the mid-90’s, as illustrated in the chart below, oil prices roughly quadrupled since the beginning of 2000, as the result of increasing demand from the US, Europe and Asia. Today, however, strong and notably increasing consumption from China, India and the Middle East is raising the global demand even higher and clearly outstripping the worldwide supply of oil. Is it not surprising that the price of oil is so high and heading higher????
Source: The New York Times
How all this will affect the economy and the financial markets is yet to be seen. Looking ahead, we believe that the economy will continue to remain under pressure during the 2nd quarter, before improving slightly during the second half of the year. However, until the financial market surprises cease and the housing market begins to show signs of stabilization, the general economy may have difficulty sustaining an extended period of growth, despite the fact that no clear evidence of a US recession has even yet to emerge. The Fed’s stimulative efforts should begin to have a notable impact as the year progresses, though inflation pressures could become the next area of real concern. Political pressures and the prospect of a new president have taken a back seat to the pressing issues of the credit crisis, though as the election nears, investors will begin to incorporate probable outcomes into the market expectations.
Most encouraging, however, is the growing expectation that the worst of the housing and sub-prime problems may be over, based on the following chart which shows a dramatic drop-off in resets for sub-prime mortgages by the end of 2008. This, in conjunction with the Fed’s dramatic decrease in interest rates, is being viewed in a very positive light.
A recent quote by market guru Laszlo Birinyi seemed to sum up the outlook after the first quarter ended with the following statement that….”trying to predict today’s market is like trying to bottle fog”…. This may be true…but for those who are looking to their current investment portfolio, evidence suggests that the worst may well be over, though diligence and patience may still be the order of the day. Keep in mind that investing in the current environment, which is still filled with uncertainty and volatility, may be like taking a walk down a well lit path in a dangerous neighborhood, where one is likely to experience periods of considerable anxiety during different stages of the journey.
An article in Barron’s Magazine noted that volatility in the stock market has increased significantly, suggesting that the recent volatility surge (in the US markets) is a bullish sign and that while “huge volatility isn't unique to today's market, it often occurs just ahead of a substantial rally”. Note below, that while the S&P 500’s volatility is considered high from an absolute basis, on a relative basis, other markets outside of the US are even more volatile. Note also the price declines that have occurred in these foreign markets, some of which had appreciated to what appeared to have been unsustainable levels during the past year or two. Hence, the need for continued caution and diligence when investing abroad.
Other sources note that the US stock market has risen more in recessions than in periods of slow growth. Nonetheless, according to Vanguard and IC&R research, the average monthly return on the S&P 500 during expansionary periods was modestly higher at 1.05% versus 0.76% during recessions. Also, in three of the past four recessions, the stock market began to rise several months before the recessions ended. This is not surprising since the official identification of recessions has typically been announced well after a recession has begun. Note the charts below, which illustrate the historical trend of the stock market in both the past nine recession (averaging 11 months) and post recession periods in the US since 1953, identified by the National Bureau of Economic Research.
Source: Vanguard
S&P 500 Index shown on a logarithmic scale for clarity
Source: National Bureau of Economic Research.
Clearly, history isn't a guarantee of future performance, and past recessions can't predict future stock returns. Furthermore, anyone trying to time the markets (getting out and in again) is facing a difficult, if not impossible task. As famed investor Jesse Livermore once said, "Throughout all my years of investing, I've found that the big money was never made in the buying or the selling. The big money was made in the waiting!” That said, long-term investors who were tolerant and well diversified during periods of market risk and economic uncertainty were ultimately rewarded for their patience. Depending upon one’s risk tolerance and investment objectives, we believe that a well-constructed, long-term core strategy should include large, mid and small cap growth and value stocks, from both the domestic and international arenas. In addition, we feel that one’s portfolio should also include positions in alternative investments.
While several of the alternative markets have either increased dramatically or have come under significant downside pressures during the past year, we think it is important that cash, hedge funds, financials, REITs, precious metals and commodities, including energy, be included to round out your portfolio and add a notably greater level of diversification. These alternative markets generally have low and often negative correlations to the investments in ones core portfolio and can have a major impact in stabilizing ones portfolio while adding value over the long-term. As the financial markets become increasingly more global and market dynamics continue to change, investors need to be proactive and reposition their portfolios accordingly to remain current with the changing times. For example, even CALPERS, the California Public Employees’ Retirement System, the largest United States pension fund, is looking to begin adding a sizeable long term allocation to commodities, such as gold, silver, oil and wheat.
If you’d like to discuss any of these alternative investments in more detail, or have comments and questions regarding your portfolio or current/prospective market conditions, please don’t hesitate to contact your financial advisor at WB Smith Companies. We’d also like to speak with you regarding tax planning strategies for 2008, given the current market conditions, as well as 401(k) rollover strategies and Roth conversions from traditional IRAs before eligibility rules change in 2010. Also, please let us know if there are areas of interest that you’d like us to research and report on in our upcoming commentaries.
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