As Americans headed into the holidays, the National Bureau of Economic Research threw a wet blank on the season by acknowledging in early December that the United States was in a recession and had been since November 2007. Retail spending crumbled and the Conference Board’s Consumer Confidence Index declined to 38.6 in December, before falling to 37.7, an historic low, in January. Even worse, the nation’s unemployment rate rose to 7.6% from 6.8% in December (see “Unenjoyment”). Payrolls fell 598,000 and the number of unemployed increased to 11.6 million.
Leading economic indicators and the major equity indexes reflected the volatility and downward trajectory of the economy, entering a precipitous decline since peaking in October 2007, when the Dow was above 14,000 and the S&P 500 traded above 1400. In late January, both indexes were down more than 30% from a year ago.
“Momentum is still down in 2009,” says Jim O’ Sullivan, economist for UBS. “Chances are we are going to get a big drop in GDP for Q1 after a 3.8% drop in Q4. We do think that as the year progresses we will see stabilization and then the start of a weak recovery in the second part of the year.” He estimates first quarter gross domestic product will be -3%, Q2 will be zero; Q3 1.5% and Q4 2.0%.
“It’s pretty dismal in terms of sentiment, but from a trader’s perspective it’s been wonderful,” says Larry Young, senior trader at Infinity Futures. “We can make money whether the market goes up or down.” He says the equity index futures market has seen an influx of equity traders with downward bias; and that those traders have been selling into most rallies.
Dazed and confused
In a slowing economy with an uncertain jobs market, tighter credit and the negative wealth effects of the exceptionally weak housing market, frugality makes sense from an individual perspective. However, that could create a downward spiral that leads to businesses cutting prices, which leads to decreased profits and therefore fewer jobs — the paradox of thrift, as economists call it. In December, personal consumption expenditures fell for the sixth straight month and personal savings increased, according to the Bureau of Economic Analysis.
But the downward trend is even bigger than that, says Addison Wiggin, publisher of Agora Financial. With the end of the credit bubble, intensifying unemployment and a massive decline in consumer spending, the current environment is more like a 50-year cycle, which requires rebuilding the entire economy. After the 1929 market crash, Wiggin says unemployment didn’t immediately take off. “It was around 3% in 1931 and went to almost 25% by 1934. In an 18-month period, a quarter of the nation lost their jobs,” and he likens that to our current situation because the losses are widespread, ranging from retail consumer companies, like Circuit City and Linens ‘n Things, to major financial institutions and the auto industry.
“There are a lot of things going on in the real economy that are going to impact stock prices for a longer period of time than most people are prepared for,” he says.
Charles Rotblut, senior market analyst for Zacks.com, says consumer spending is not likely to rebound until 2010 because of the continuing pain in the housing market, and because unemployment will continue to rise, even as the economy comes out of recession, simply because businesses are going to be slow to hire. However, he does expect some economic recovery in the second half as business spending starts to improve along with profit forecasts.
“The one thing that is important is what we are seeing in earnings report revisions,” Rotblut says, adding earnings per share estimates for the S&P 500 were $93.73 in November, but expectations had been cut to $63.01 by early February. “It’s really difficult to peg what earnings are going to be like the rest of the year,” he says.
In evaluating stocks, Rotblut recommends looking for companies that create need-to-have rather than nice-to-have products; consequently, the consumer discretionary sector is one to be avoided. He favors agricultural companies such as Monsanto, which makes seeds that increase crop yields, and certain technology companies, such as OpenText. “They are very involved in social networking and blogs, but they are also very involved in letting companies electronically document their papers. And from a regulatory standpoint, that’s a mandatory thing. We are seeing companies like that doing well in this
Paul Larson, equity market strategist for MorningStar, likes Home Depot and Lowes, which are down significantly from where they were trading during the housing boom. “When your sump pump goes out, you are going to replace it. When your pipes burst you replace them. When your roof goes, you fix that. So, that maintenance part of the business is holding up just fine,” he says, adding that for current market prices to make sense, you would have to assume they never open a new store, that same-store sales never go positive, and that profit margins, which are down about a third from two years ago, never recover. “If you think there is even the slightest hope of a recovery in the next two or three years, these stocks are dirt cheap.”
The energy sector also continues to offer value for longer-term investors, Larson says. “There is still a limited amount of energy around in the world and this credit crisis and recession doesn’t solve the geological problems that we have in extracting all the barrels we need to consume once the economy gets back on track.” The most promising areas are alternative energy production, exploration and production, and pipelines. Refining is the least attractive because of the spread between crude oil and gasoline costs. “Because they don’t have control, and those two prices are incredibly volatile, you can have periods where you have negative gross margin.”
Signs of life
For the equity markets to recover, credit markets will need to ease substantially (see “No quarter”), which the government is encouraging through an unprecedented amount of intervention. Success would be evident in an increased number of debt deals, a pick up in corporate bonds and merger and acquisition activity.
“What the Fed is doing is targeting various markets through various Fed purchase and lending operations,” O’Sullivan says. “They set up the Commercial Paper [CP] Funding Facility to help the CP market. They are directly buying mortgages. They are about to start up this Term Asset Backed Lending Facility to support the asset backed securities market. They have increased their lending through the [Term Auction Facility] TAFT and that was to help the banking system in particular. The things to look at are credit spreads and mortgage rates, which are starting to come down. For banks, the LIBOR has become more of an indicator than the TED spread, and certainly we have seen some success there.”
But Larson says that despite declines in the TED spread, it will take time for credit markets to loosen. “Governments around the world have increased confidence in the banking system and managed to avert collapse,” which was a real threat in October, he says. Another positive sign is the actual volumes going through the credit market are starting to pick up. “There was a report that showed the actual volume of bonds being sold was the highest since April. That’s a very good thing, because in October it was a wasteland; nothing happening at all.”
The Institute for Supply Management surveys (ISM) and the Fed’s Beige Book also will offer insights into the timing of a recovery, Rotblut says, and the ISM manufacturing index improved slightly to 35.6% in January, up from 32.9% in December. Readings below 50% indicate contraction.
For the time being, inflation also is a distant threat. “Long term, CPI [consumer price index] and PPI [producer price index] are going to regain their importance in the market. But headline numbers have been so affected by energy that we are going to continue to see declines in those numbers on a year-over-year basis,” Rotblut says.
In preparing his outlook, Wiggin found that the Dow was trading near 6,400 when former Federal Reserve Bank Chairman Alan Greenspan first used the phrase “irrational exuberance” 12 years ago. “If this were truly a bull/bear cycle, we might find ourselves back at that level, or even below,” he says, pointing out that the Japanese indexes have traded to 27-year lows. “We are headed much lower than most people are prepared for. If our bear market is as steep, prolonged and difficult as those Japan has gone through.... That would blow everyone away.”
In the short-term, he says that optimism from Obama’s election will allow the Dow to hover near 8,000; but when the president is challenged, as he surely will be, the bubble will burst. “That’s where you get your first serious sell off; April or May. Until then, he gets a ‘free’ card.” He anticipates the Dow will trade down to 6,000 this year, and that small cap stocks will lead the market out of its downtrend. “They will be the most nimble and the most able to react to positive things in the economy. They won’t carry as much debt, they’ll be stronger innovators and be able to seize upon any trends with consumers faster than large caps or medium caps dealing with the credit crisis.”
Rotblut says it wouldn’t surprise him to see the Dow trade down to 6,000, which would bring valuations to the single digits on the profit-to-earnings ratios. “It could be a very volatile year and people need to be prepared for that,” he says.
Much of the stock market’s recovery will depend on the emotional responses of retail traders to market volatility, says Julie Murphy Casserly, president of JMC Wealth Management CFP. “About a year and a half ago, Goldman Sachs added behavioral psychologists to their investment management portfolios and every one was like, ‘Ugh! That’s crazy, why would you do that?’”
Now, considering ubiquitous access to online trading accounts, relatively unsophisticated retail traders are affecting markets with their emotional responses to the markets’ swings. “You really only had sophisticated investors in the market 20 to 25 years ago. They were pension funds; they were run by companies, not by individual employees. That’s a big difference. We have got to get our arms around that.” She expects 2009 to be extremely volatile, but ultimately flat, explaining that in every recession market since 1949, there’s been only one downturn year when the market didn’t recover 27% to 58% within 12 months. That was in 2001 and it took until 2003 to achieve a 33% return. “With us being in the third worst downturn, 2001 was the fourth, it’s going to take more than 12 months to come out of this.”
With equities trading at such enormous discounts, opportunities abound not only to snatch up bargains, but also to profit from the negative sentiment.
There are many opportunities for investors, Larson says. “If you have the cash, the patience and the willingness to sustain some volatility, there are a large number of bargains.” But he adds this caution: “Stocks are inherently volatile and we are in an exceptionally volatile period.”
Young suggests that traders leave their biases outside and trade off the data. “On the equity side, people are not comfortable selling. They are comfortable buying low and selling high, but some of the biggest money is made by sellers,” he says, suggesting put options to hedge current holdings and profit from the downtrend. “We are going to look back five years from now and see people who were able to seize this moment instead of just being victimized until things got better.”