Newsletters 2008 Newsletters Contrary Indicators Abound (3/08)
Saturday, 15 March 2008 00:00
The stock market continued to slide last month with the Dow Jones Industrial Average, S&P 500 Composite and NASDAQ Composite now down 7.53%, 9.38% and 14.36% respectively through February. The composite of all Osher equities under management are comparably down just 6.76% through February, even after having outperformed on the upside by such a wide margin last year. As discussed in our January newsletter, the stock market is currently in the process of discounting or pricing in the growing probability for recession. Eventually, perhaps soon, the stock market will look beyond today’s flood of bad news and begin to discount the imminent, positive impact of the massive fiscal and monetary stimulus now in the pipeline.
The offsetting factors that led to anemic .6% GDP growth in the final quarter of 2007 remain in place today. On the negative side of the ledger, a collapsing housing market, tightened credit, a softening labor market, high energy prices and falling consumer confidence leave the economy exposed to heightened downside risk. Helping to abate these considerable negatives, strong exports, low interest rates, inventories in balance and steady if not spectacular growth in consumer and government spending should minimize the magnitude of recession. Fiscal and monetary stimulus ought to minimize the duration of recession.
It is important to realize that whether or not we currently meet the technical “two consecutive quarters of negative GDP growth” definition of recession, the stock market has already discounted the probability. With PE ratios having contracted to such historically attractive levels and interest rates so low, we again emphasize that we are much more likely to be closer to the end of this corrective phase than the beginning of something more dire.
Contrary indicators abound. Not only has the AAII Survey on Investor Sentiment recently registered the most lopsided reading of market pessimism in 25 years, the weekly ABC News consumer confidence index now sits at 14-year lows. As investors grow more pessimistic, cash in money market funds has ballooned to over $3.4 trillion as of February 27, compared to $2.4 trillion in money markets last February. This cash provides an enormous potential catalyst for the stock market. With the Fed cutting short-term interest rates, the yield investors receive on cash is steadily declining while stock valuations and dividend yields have become more attractive. With so much pessimism and so much cash on the sidelines, the ingredients are in place for a potentially sharp stock market recovery.
The growing level of short interest in the stock market magnifies the potential impact of this sidelined cash returning to stocks. Many investors sell stocks “short” hoping to profit on a continued decline in prices. Short-sellers borrow shares and then sell them, hoping for the stock to fall so they can buy the shares back at a lower price and pocket the difference. Short interest on the New York Stock Exchange rose to a record high of 14.4 billion shares in February, equal to 3.8% of the total shares outstanding on the NYSE. To put this in perspective, current short interest represents an astounding $700 billion of the total $18.5 trillion market capitalization of the NYSE. When the market begins to recover, many shorts will be forced to cover their bets since shorts have unlimited potential for losses in a rising market. Short-sellers represent another enormous source of funds to eventually drive stock prices higher.
Meanwhile, the Wall Street Journal reports that corporate insiders are buying their own company’s shares at a pace 35% higher than last February and 49% higher than two years ago. It was reported that nearly half of the insider buying is occurring at large-cap companies. Corporate America is awash in cash and continues to buy back stock with approximately $2 trillion of cash on the balance sheets of companies in the S&P 500. In fact, balance sheets have never been stronger and Corporate America has enough cash on hand to pay off all U.S. corporate debt outstanding! We gain confidence when company’s buy back stock and insiders buy shares in the open market, particularly when valuations are as attractive as they are now.
Fed Chair Bernanke’s recent testimony virtually guarantees additional rate cuts ahead, stating that the Federal Reserve “will act in a timely manner as needed” to keep the economy on track. The Fed had already downgraded its expectation for 2008 GDP growth to a range of 1.3% to 2%, down .5% from their most recent forecast. Bernanke’s cautionary statements that consumer spending “appears to have slowed significantly” and the financial markets remain under “considerable stress” point to a Fed more concerned about growth and much less concerned about rising inflation than in the recent past. Despite the current headwinds, the Fed remains upbeat that today’s troubles are transitory. Bernanke offered the Fed’s forecast for 2009 GDP growth at a range of 2.1% to 2.7% and for a range of 2.5% to 3% in 2010.
The Fed Fund futures confirm what Bernanke has telegraphed with futures pricing in a 75% probability for a 75 basis point cut and nearly 100% chance for at least a 50 basis point cut at the March 18th meeting of the Federal Open Market Committee. Futures markets expect a full 100 basis point of easing by the end of the year.
The market has been especially volatile recently as news regarding the potential bailout and re-capitalization of bond insurers Ambac and MBIA has surfaced. Preserving the AAA credit status for these monoline insurers is critical since it averts a meltdown scenario where monoline insolvency affects the otherwise safe municipal bond market. As the monoline conundrum approaches resolution, speculation has grown for other forms of remedy and even outright government intervention. Bernanke’s recent testimony offered the suggestion that banks should allow borrowers to write down principal balances to help “restore some equity for the homeowner”. And the New York Times reports that the Bush administration and Federal Reserve are working towards a government rescue whereby the Fed or perhaps the FHA would buy distressed mortgage debt from troubled banks and homeowners. While these reports remain pure speculation, this type of news is precisely the kind of unknown positive that would spark a significant rally from the return of sidelined cash and short covering.
Bucking the negative trend in the stock market, commodities have surged to all-time highs and are now commonly considered a “safe haven”. The price of crude oil is now just below its inflation-adjusted high of $104.24 set in April of 1980. According to Merrill Lynch economist David Rosenberg, global oil demand has risen by 1.7% while production has risen at a 1.5% annual rate over the last five years. Despite production having risen at nearly the same pace as demand, the price of oil has surged 400% from $20 per barrel to over $100 per barrel during this period. Clearly, there is something more than supply and demand at work. Meanwhile, gold has spiked to a record high of just under $1,000 an ounce. Perceived as a hedge against the weak U.S. dollar, investors seem to be speculating that the rate of decline in the U.S. dollar will continue unabated. We are now taking a contrary position and have reduced our exposure to materials and commodities. The commodities-as-safe-haven “trade” seems to be an increasingly crowded one.
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