American Capital Management, Inc. |
The past year was most disappointing with sharp declines worldwide in commodities, stocks, real estate and various other asset classes. It was the third worst year in the 112 year history of the Dow Jones Industrial Average (1907 & 1931 were worse). We did not anticipate a correction this severe. These falling asset values and a severe credit crisis have taken a heavy toll on business and consumer confidence and precipitated a sharp slowing in global economic activity with much uncertainty. The damage, in terms of lost jobs, output and wealth, is extensive. A summary of index returns through December 31, 2008 is as follows:
| Dow Jones Industrials | -31.9% | Russell 2000 | -33.8% |
| MSCI EAFE | -39.9% | S&P 500 | -37.0% |
| NASDAQ Composite | -40.0% | Wilshire 5000 | -37.2% |
The nation faces a paradox in its “shift to thrift.” Consumers need to spend less and save more to pay for their past debts, but consumption needs to be stimulated for economic growth to resume, which will delay the deleveraging of debt. In the near term, the highest priority is to promote a global economic recovery by resolving the credit crisis and stimulating aggregate demand with policy initiatives. Fortunately, the early policy responses by the U.S., Europe and China have been significant in size and scope. But it will take time for the benefits to emerge.
The global economy is in recession with GDP expected to grow less than 1% in 2009. The geographic breadth and depth of the slowdown is unprecedented in recent times as all major economies are slowing simultaneously. For example, the world’s three largest economies (U.S., Japan and Europe) are all expected to experience negative economic growth in 2009. The emerging regions of the world will grow faster than the largest economies, but their pace of consumption and investment has been hindered by the global credit crunch and the difficult circumstances of their larger trading partners. The U.S. is experiencing the sharpest declines in GDP and employment in decades. This downturn will be marked by an unprecedented decline in consumer expenditures and debt, which have not contracted at the current rate since the Great Depression. Today, the government is the only significant support for the economy and its spending role will rise to multi-decade highs. With the help of fiscal and monetary stimulus, we expect the decline in U.S. economic activity to stabilize in 2009 followed by a resumption of growth in 2010. President Obama and the new Administration will take bold and decisive action to instill confidence and trust in the growth of our economy.
The worldwide commitment to stimulate economic growth with fiscal measures is aggressive and powerful. The U.S., European Union, Germany and China have all announced large fiscal stimulus packages. In the U.S. and several European countries, fiscal attention has shifted toward jump-starting the world’s economy with deficit spending rather than balanced budget measures. The American Recovery and Reinvestment Bill may approach $825 billion and focus on capital equipment incentives, expanded unemployment benefits, individual and corporate tax relief, infrastructure projects and state government assistance. This is in addition to the $700 billion of TARP commitments. As a consequence, this stimulus may equal 5% of GDP over the next two years while increasing our budget deficit to approximately 10% of GDP. The U.S. can afford some deficit spending since gross public debt as a percent of GDP is significantly lower than the post-WWII levels. The challenges are clear. Fiscal stimulus needs to create jobs by boosting domestic demand and be easily reversible thereafter to ensure long-term fiscal responsibility.
The Federal Reserve has opened the floodgates and moved aggressively to reduce interest rates and develop accommodative liquidity programs. Since September 2007, the Fed has reduced the fed funds rate by 500 basis points from 5.25% to .25%. This is an exceptionally rapid and unprecedented response, but warranted by the severe circumstances of the credit crisis. With the fed funds rate basically zero, the Fed has focused on other techniques of monetary policy to improve liquidity, drive down consumer-related interest rates and stimulate demand for credit. First, the Fed instituted a series of facilities to bolster liquidity at banks and brokers. Second, the Fed supported the corporate commercial paper market and money market mutual funds with ‘provider of last resort’ capabilities to eliminate the risk of illiquidity. Third, and most recently, the Fed is trying to lower mortgage interest rates by buying $100 billion in debt obligations and $500 billion in mortgage bonds backed or owned by the government-sponsored enterprises Fannie, Freddie and Ginnie. As a result, 30 year mortgage rates have declined from 6.61% to 5.32% – the lowest level since 1971 – and new mortgage applications and refinancings are surging. Additionally, the Fed will institute a new facility in February 2009 designed to lower interest rates on auto, credit card, student and Small Business Administration loans. As a result of the Fed’s actions, the severest part of the credit crisis has passed. Going forward, the demand response to lower interest rates will be an important factor impacting the speed of the recovery.
Quite frankly, it is difficult to assemble a room of optimists. Major economic indicators are likely to worsen before improving and the uncertainty of future growth is high. Stock and corporate bond markets reflect the negatives and the question remains as to how much “bad news” is already priced into the marketplace. Given the level of pessimism and history of human behavior during stock market corrections, we believe equities are attractively priced at these levels for patient investors and will likely be worth significantly more in several years. But new lows may be made before we go higher.
The financial markets appear to be in the early stages of recovery. Most recently, the clearest evidence of recovery is in certain bond markets where interest rate spreads have begun to improve with better liquidity, less refinancing risk and greater confidence. It is typical for bond markets to heal before equity markets. Admittedly, equity fundamentals are weak, but stock prices typically bottom several quarters before the inflection point in earnings. Valuing earnings during a recession is imprecise because earnings are volatile and cyclically depressed. Studies show virtually no relationship between annual changes in earnings and stock prices – only long term trends correlate. But assuming S&P 500 operating earnings are $60 in 2009, the market is fairly valued at 14x earnings. This assessment is complicated by two factors. First, the 2009 earnings estimate may be cyclically low and normalized earnings may be substantially higher, suggesting a more attractively valued market. Second, the 2.3% yield on the 10 year Treasury implies (via the Fed model) a higher valuation might be warranted, but the low yield signifies the possible threat of deflation and sluggish earnings growth. In a related matter, it is worth noting the dividend yield on the S&P 500 (3.2%) exceeds the yield on the 10 year Treasury (2.3%) for the first time since 1957, while money market fund yields are at an all time low.
Technical and historical observations suggest the market is amidst a process of consolidation and base-building prior to recovery. Bear in mind, the first interest rate cut in this monetary easing cycle was 16 months ago, the current recession started 13 months ago and the market fell -52% over the 13 months from the October 2007 highs to the November 2008 lows. Historical market patterns suggest the possibility of a bottoming process after such passages of time. For example, since 1950 there have been nine recessions (not including the current one) with an average duration of 10 months. On average, the S&P 500 fell -26% from peak to trough over the course of 14 months. The 1973-74 correction was the worst with a recession lasting 16 months and the S&P 500 declining -48% over 21 months. Importantly, the gain in the market 12 months after the October 1974 low was +38%. Presently, the 10 year annualized total return for the S&P 500 is negative, an infrequent occurrence over the last 80 years. However, the subsequent 10 year returns after such instances have historically been strong. This illustrates that periods of sub-par returns in the stock market are inevitably followed by periods of strong returns.
Positively, cash on the sidelines is at a record high. For example, total money fund assets equal 39% of the Wilshire 5000 market value representing substantial buying power. The supply of new issuance from non-financial companies has been low as the capital markets have been closed. For example, the market for IPO’s last year was the worst in 20 years with only 43 deals underwritten versus 272 in 2007. Furthermore, large companies such as Johnson & Johnson and Abbott Labs have continued to acquire smaller companies. Negatively, corporate buybacks have slowed considerably as companies conserve cash and financial companies, particularly the banks, have issued large amounts of equity to the government and other investors.
The stock market environment remains risky and vulnerable to adverse events such as bankruptcies, deflation, earnings disappointments, large layoffs, protectionism, and corporate malfeasance. Remedies are being applied to ameliorate these risks. The timing of an eventual recovery is uncertain, but we believe the risks have been mostly discounted. We expect significant rallies on “bad news” to be among the first confirming signs that the market has appropriately discounted the difficult times. We will get to this point, but we are not sure when. Investors know that reward is commensurate with risk and periods of great uncertainty are usually followed by periods of great opportunity. In addition, 2009 is the Chinese “Year of the Earth Ox” whose signs imply dependability, durability and stability. It also favors long term investments and proceeding in a cautious determined manner. These signs have positive investment implications.
| Yearend 2007 |
Yearend
2008 |
Difference/ Change | |
| Fed Funds Rate (%) | 4.25 | .25 | -400 BPS |
| 10 Yr. Treasury Yield (%) | 4.05 | 2.25 | -180 bps |
| Inflation (CPI y/y % ch.) | 4.10 | .10 | -400 bps |
| Gold ($/oz). | 835 | 883 | +6% |
| Oil ($/barrel) | 96 | 45 | -53% |
| Dollar per Euro | 1.46 | 1.34 | -8% |