American Capital Management, Inc. |
Market sentiment is improving with evidence that the downturn is stabilizing. During the first quarter, the S&P 500 index gyrated wildly with a sharp decline and a strong rally. For example, through March 6, the index declined –27% year to date and –58% from its October 2007 high, but ended the quarter with a decline of –11% for its sixth consecutive quarterly loss. The rebound in March continued in April and the market has increased +27% from its low. Popular investment pundits on Wall Street warn that this optimism is premature; however, we note that bull markets often begin with high levels of pessimism and grow on skepticism. Clearly, the economy remains fragile and the major indicators of GDP, corporate profits and unemployment are likely to moderate their deterioration in the quarters ahead. There is growing optimism that the worst of the downturn is passing. Technical observations suggest the market is amidst a process of consolidation and base-building – a positive development for intermediate and long-term appreciation. A summary of index returns through March 31, 2009 is as follows:
| Dow Jones Industrials | -12.4% | Russell 2000 | -15.4% |
| MSCI EAFE | -14.6% | S&P 500 | -11.0% |
| NASDAQ Composite | - 2.8% | Wilshire 5000 | -10.7% |
The global economy is experiencing some of the slowest growth in decades. The simultaneous downturn of every large economy has severely impaired normal trading patterns and hampered the ability of trading partners to offer economic assistance to their neighbors. Fortunately, massive fiscal and monetary programs are being implemented and the global economy may resume growth in late 2009 and strengthen in 2010. The U.S. may lead the world out of recession after leading the world into recession. After growing by +1.1% in 2008, the U.S. economy may decline by –3% in 2009 and increase modestly in 2010. Government stimulus programs are acting in a coordinated, effective manner to strengthen our financial system. Importantly, the worst of the sudden fall-off in most measures of demand appears to have been in the fourth quarter of 2008 and the first quarter of 2009. While these measures should begin to stabilize, employment will probably deteriorate further over the intermediate term. It appears that the severely damaging effect of the “negative feedback loop” has ended, the rate of deterioration is slowing and the economy is stabilizing
The downturn in employment is the worst since the 1930’s and needs to improve for the U.S. economy to recover strongly over the next few years. Payrolls have declined by 5.1 million jobs since December 2007 – a 3.7% decline from peak employment. This is the steepest drop in payrolls in the last 50 years and the speed of deterioration has been shocking. The unemployment rate is now 8.5% and may exceed 10% before it stabilizes. These job losses are the result of a steep drop in demand that has rippled from sector to sector and a lack of business confidence. Essentially, great uncertainty is prompting employers to cut aggressively to prepare for the worst. This self-fulfilling negative dynamic must be broken to augment a solid recovery. Employment growth is a vital underpinning for consumer spending and housing, but it is important to recognize that employment data is a lagging indicator. The unemployment rate usually peaks after a recession is technically over and the stock market has bottomed. In short, the strength of the recovery is dependent on job growth, but investors can become more confident in the stock market before the economy and job growth begin to recover.
After an epic collapse, many housing markets are showing early signs of stabilizing. The housing market will probably trough in late 2009/early 2010 and gradually improve as the employment situation stabilizes. Most national housing indicators, such as housing prices, sales and starts, have declined significantly from their peaks and are showing signs that the pace of decline is slowing. For example, housing starts have declined –75% from their peak in early 2006 to the lowest level of recorded data. Home sales are off –27% from their peak level in 2006 and inventories are near their highest level in decades. According to the S&P/Case-Shiller Home Price Indices, home prices have declined –17% over the last year and –30% from their July 2006 peak. This is the first time in history that national home prices have declined at this rate. Amidst these precipitous declines, there is evidence that the rate of decline in these indicators has slowed as home buyer interest is increasing with improvements in affordability, first-time home buyer tax incentives and plenty of attractive inventory. Home affordability has greatly improved through a combination of historically low mortgage rates and the decline in home prices. In response to low rates, mortgage applications are surging, but the surge is primarily for refinancings rather than purchases. Despite signs of stabilizing, the housing market remains unbalanced (i.e. too much supply and not enough demand) and a “tsunami of foreclosures” may temporarily worsen conditions as banks work their troubled loans more aggressively now that a moratorium on foreclosures has ended. First-time home buyers have a distinct opportunity to take advantage of this situation, whereas existing homeowners have to sell their homes in a difficult market before buying. Employment growth and stability of household income are critical determinants of the ultimate path of the housing recovery.
Confidence is improving for an economic and stock market recovery. Massive amounts of monetary and fiscal stimulus have been applied and the likelihood of the economy responding increases over time. The Fed has been aggressively buying Treasuries and mortgage backed securities causing mortgage rates to decline to historically low levels for well-qualified borrowers. In addition, the availability of credit is modestly improving, more so for businesses than consumers. Inflation is not a concern and was negative in the first quarter of 2009 for the first time since 1955. Also, cash on the sidelines is at record levels – while earning a small return. This represents substantial buying power over the intermediate term.
We remain confident that patiently waiting for fundamentals to improve is the right course of action. Equities are attractively priced at these levels for patient investors and will likely be worth significantly more in several years. The stock market environment remains volatile and vulnerable to sharp swings in sentiment and we are prepared to take advantage of these swings by remaining confident and opportunistic when others are fearful. Furthermore, we are focusing our research effort on those companies that are expected to benefit from the economic recovery and various stimulus programs. We are encouraged by the stock market’s recent strength. Technically, the market rally has been accompanied by rising volume and increasing breadth. Importantly, bank stocks – which led the market down – have recovered strongly from their lows on indications that the banking crisis is passing. There are risks, but we believe that the worst has past and expect confidence to build as the economy stabilizes and recovers.