Ramblings of a Portfolio Manager

'08 or '82?

U.S. stocks plunged last week, giving the Dow first seven-day loss since 2008. The culprits: reports of slower-than-estimated growth in jobs and factory orders and concern that China’s economy has slowed. The Dow, S&P 500 and Russell 2000 are now respectively 14%, 16% and 19% off their April 23rd highs. Another day like Friday and the Russell will be in Bear Market territory for 2010. So far this year, bond returns have exceeded stock gains by the widest margin in nine years. Not exactly how strategists had hoped the first half of the year would unfold.

At the end of last week pessimism in the equity markets was almost as high as it was when Lehman went down in 2008. In fact, the one through 10-year Treasuries ended the week yielding less than they did in mid-late September of 2008, when Lehman failed and AIG required a minimum of $85 billion in government support to stave off a collapse of the entire financial system. Memories of those times are fresh, however, and as investors wonder what will be the next shoe to drop they are dumping equities wholesale and running to the “safety” of US Treasuries, ignoring the perils of that strategy. As one portfolio manager said, “It’s like running under a tree during a thunderstorm.”

Let us say categorically that this is NOT 2008 by any stretch of the imagination although right now the equity markets are acting like it. Back then we had a true credit seizure—banks weren’t lending to other banks, one-month LIBOR rates, currently at 0.35%, exceeded 4% and even GE couldn't roll its commercial paper. We hate to use the phrase but, yes, this time is different…very different. What we have now is a softening in the labor market after a rebound off the bottom which was due in part to Fiscal stimulus. The market, always forward-looking, is ratcheting down its growth expectations—but the expectations are for growth nonetheless. In late 2008 we were staring over a precipice, wondering whether banks would open the next day, let alone how low S&P 500 earnings were going to fall. As of the end of April, S&P earnings expectations were for $100 for 2011, an all time high. Even a drastic cut of 20% would bring them back to late 2005/early 2006 levels when the equity markets were much higher than they are now. The trouble is the uncertainty factor and that is currently depressing multiples on what are declining earnings estimates—a double whammy to stock prices. Unfortunately, the uncertainty comes from our own government. The President and Congress, rather than showing concern for a U6 unemployment number hovering near 17%, are busy punishing Goldman Sachs with 2000 pages of worthless regulation. The only part of the Government that investors trust right now is Bernanke and the Federal Reserve and they are somewhat handcuffed right now given what the fools in Congress are doing. That will change, of course, and the winds are already blowing that way. But no one wants to wait until November to see how many of them get kicked out.

In our opinion, this market looks a lot more like it did in 1982 than 2008. Back in ’82, the Economy was emerging from a deep recession and growth was rapid. The Federal Reserve, seeing the 8%+ growth in GDP and having just come through a terrible period of inflation, started hiking rates too quickly. That move—too much too soon-- sent the Economy right back into recession. The markets followed in lock step and we had two back-to-back bear markets. We don’t expect that to happen this time. We have a Federal Reserve Chairman who is a student of history and not about to repeat the mistakes of the past. One mantra often heard is that the Fed is out of bullets---rubbish! The Fed can still re-instate Quantitative Easing and most likely they will, given that there is no inflation in sight. At current rates homes will sell again and there is a good chance that the home buyers tax credit will come back. Republicans will gain votes in Congress in November and the benefits from European debt-cutting measures will become clear as the year progresses. All this says to us that the markets may be setting up for a strong rally through the end of the year.

Basically we have hit the reset button after a nice run from last year and now have the same opportunities to make money as we did last spring. Investors just need to be patient, wait for the bottom and get back in—psychologically difficult we recognize, but this is where and how fortunes are made. It isn’t often that the markets hand you a second opportunity to make big money but, we believe, they are fast doing so again. No-one knows where and when the bottom will come—any day we could get news that China has taken its foot off the brakes, that the US or Europe is doing Quantitative Easing or some other positive news. Given the state of pessimism, it won’t take much. Frankly, earnings season has such low expectations, even that could initiate the turn. Just a little factoid: the S&P and Dow are now just 10% or less above where they were at the height of the AIG and Lehman crisis yet the situation is clearer, the uncertainty less and we have a strong domestic policy for growth and recovery already in place. Earnings estimates are 50% higher too. The uncertainty is much less yet the markets have barely moved. We like the way things are setting up and even though picking the precise bottom is tricky, we suggest investors begin averaging into the market now, while prices are depressed.