Newsletters 2008 Newsletters Historical Precedent (12/08)
Monday, 15 December 2008 00:00
It’s finally official. The National Bureau of Economic Research (NBER) declared that the U.S. entered recession in December 2007, marking the end of the economic expansion that began in November 2001. The NBER defines recession as a “significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators”. To determine the actual beginning and end of a recession, the NBER looks at “when the economy reaches a peak of activity” and ”when the economy reaches its trough”.
While the stock market realed on the day of the official announcement, the removal of doubt as to the timing of this recession is actually quite positive based on historical precedent. First, it might be very surprising to learn that the date the NBER finally announces when a recession has started has actually occurred within one month of the same recession ending 75% of the time! Let’s take the last two recessions of 1990 and 2001 as examples. In April 1991, the NBER declared that the recession officially began in July 1990 – the NBER later declared that the recession ended in March 1991, a month before the official announcement of the recession’s start. Then in November 2001, the NBER declared the start of recession in March 2001 – two years later in July 2003 the NBER declared the same recession ended in November 2001, the same month that the recession was officially announced. You just can’t make this stuff up.
Since the NBER will eventually look to “when the economy reaches its trough”, we can’t help but prognosticate that the current quarter (complete with an unprecedented credit freeze, the failure of Lehman and WAMU, bailouts of Fannie, Freddie, AIG, Wachovia and Citibank, collapsing stock market, sharp rise in unemployment and sharp drop in consumer spending and business activity) will mark the trough for this recession. Even if GDP remains negative in the coming quarters, we doubt that it will be as negative as the current quarter. So, any uptick in GDP from the current quarter should be sufficient to mark this as the trough of the recession.
If that proves to be the case, historical precedent is very favorable for the stock market. The average length of recession since World War II lasted 10 months, with the recessions of 1973-74 and 1981-82 being the longest at 16 months each. This recession is already into its 13th month and so longer than the post World War II average. Should this recession last into April, it would surpass the 1973-74 and 1981-82 episodes as the longest recession since the Great Depression. Based on modern history, the current recession is already long in the tooth.
While the current economic environment rivals the severity of previous recessions in the 1970s and 1980s, this simply is no return of the Great Depression. During the Great Depression, GDP fell by 30%, unemployment rose to 25%, 40% of Americans faced foreclosure and industrial production fell by 50%. During this recession, 4th quarter GDP is expected to decline by 3% to 5%, unemployment is at 6.7% (with the most pessimistic forecast for unemployment to reach 10%), 5% of American homeowners risk foreclosure and industrial production increased by 1.3% in October, following September’s 3.7% decline. While the September drop in industrial production was the worst monthly decline since 1946, the month over month increase in October was the largest since October 1999. During the Great Depression, one-third of all banks failed. During this recession, only 22 banks have failed - that’s less than 0.25% of the approximate 9,500 U.S. banks with $100 million or more in assets. And today, unlike the Great Depression, we have a “social safety net” in the form of unemployment insurance and FDIC insured deposits.
Perhaps more importantly, the government response during the Great Depression is polar opposite to the intervention being undertaken today. During the Great Depression, the Federal Reserve allowed the money supply to decline and the Hoover Administration raised taxes and tariffs. Today, the Federal Reserve has lowered interest rates dramatically and injected massive liquidity into the financial system through an unparalleled expansion of its balance sheet. And the Bush Administration has engaged in a massive recapitalization of the financial system through the TARP program. Meanwhile, an estimated $500 to $700 billion stimulus package is already being considered by the new Obama Administration. Finally, unlike the Smoot-Hawley Tariff imposed protectionism that spread worldwide during the Great Depression, today’s crisis has been met with synchronized cooperation from all of the world’s leading economies.
During a speech on December 2nd, Fed Chairman Ben Bernanke tried to end the debate by stating that there’s “no comparison” and “an order-of-magnitude difference” between the current economic environment and the Great Depression. Be that as it may, the decline in the “blue-chip” Dow Jones Industrial Average from the peak in October 2007 to the lows of November 20th is already worse than all bear market declines of the 20th Century, with the exception of the stock market crash of 1929 to 1933 that kicked off the Great Depression.
Barron’s recently ran an article that ranked the current bear market decline with others throughout the last century. The worst decline occurred after the bubble of the “Roaring 20s” with an 83% drop in the Dow Jones Industrial Average over 34 months between 1929 and 1933. The second worse decline occurred in 1937 with a 50% drop in the Dow over 13 months. These two declines are commonly lumped together as the period of the Great Depression, a 10-year period between 1929 and 1938 where the average annualized total return for the Dow Jones Industrial Average was negative .9%. While we concur with Ben Bernanke that there is no comparison between today’s economic challenges and those of the Great Depression, we were flabbergasted to learn that the average annualized total return for the S&P 500 between 1999 and 2008 at negative 1% is already worse than the returns of the decade that marked the Great Depression.
How is it possible to have stock market returns during the immediate past decade worse than that of the Great Depression, without the economic realities consistent with the Great Depression? The answer may lie in the extreme euphoria and absurdly high valuation levels accompanied with the internet bubble of the late 1990s. In fact, the resemblance of the returns of the NASDAQ Composite from 1999-2008 compared to the Dow Jones Industrial Average during the 1929-1938 Great Depression period is uncanny. Just as the Dow dropped 83% over a 34 month period between 1929 and 1933, the decline of the NASDAQ Composite reached 78% over a 32 month period between 2000 and 2002. And just as the Dow fell 50% over a 13 month period between 1937-1938, the NASADQ Composite swooned by 55% over a 14 month period between 2007-2008. Interestingly enough, the recent “new” low set by the S&P 500 on November 20th closely approximates the market low set in 2002 after the burst of the internet bubble. A strong case can be made that the current bear market actually began in 2000 and is now in its final, blow-off phase. The market’s strong move higher from the 2002 lows suggests a successful re-test and confirmation of a base that has been built over a long, 10-year period.
The answer to the above question may also lie in how widely markets can deviate from the mean, especially as it corrects from periods of unusual excess. To understand just how overvalued the market was in 2000, consider that the total capitalization of the U.S. stock market was twice the size of the entire U.S. economy as measured by GDP, compared to the long-term average of stocks valued at 79% of GDP. Today, stocks are valued at 59% of GDP, requiring a rise of 35% to reach the long-term average. Stocks were stretched far above the mean in 2000 and now are stretched far below. The depressed state of the stock market today stands in stark contrast to the euphoric levels of 2000, with the irrational exuberance of the late 1990s a far-distant memory, having been corrected by the cruelest bear market in a century.
Just as it would have been a costly mistake near the peak of the market in 1999-2000 to extrapolate that we indeed had entered a “new era” and that stocks were one-way e-tickets to riches, it is a mistake today to extrapolate that future returns will resemble the poor returns of the past decade. While the “situational bias” is strong, we must remember that this decade of dismal stock market performance is in the rear view mirror. It is past. It is history. On the contrary, it is in part because market returns have been so far below historical averages that our optimism for future returns has increased. It is because of such widespread, consensus gloom that we believe better days lie ahead. The stock market returns of the last decade have been worse than that of the Great Depression, without the economic realities consistent with the Great Depression. The market is priced for depression. As investors and the collective market consciousness realize that we have a recession, bad as it is, and not a depression, stocks will be able to move their way to higher levels. Emblematic of this type of recovery, stocks will move higher even in the wake of awful news – we are beginning to see clear examples of this already.
The alternative thesis is that the economy will move into a new, worse Great Depression-like phase from here. This thesis is essentially a bet against the will of the Federal Reserve, U.S, Treasury and Congress to get our economy back on track. With the massive, almost unthinkable sums of monetary and fiscal stimulus being implemented and still being considered, we think this is a losing bet.
One potential catalyst for the economy in the coming year may be found in the housing market. The Fed’s recently announced $200 billion Term Asset-Backed Security Loan Facility and $600 billion program to buy debt and mortgage backed securities from Fannie Mae, Freddie Mac, Ginnie Mae and the Federal Home Loan Bank system influenced a sharp fifty basis point drop in mortgage rates, bringing conventional 30-year fixed rate mortgages to 5.47%, a three-year low. This drop in mortgage rates spurred a 112% increase in mortgage applications for the last week of November, double the previous record one-week surge. With the Treasury Department now considering a plan to help bring mortgage rates down to as low as 4.5% and Ben Bernanke calling for action to further stem the tide of foreclosures, stability in the housing market seems like an imminent probability. Matching historically low mortgage rates with increasingly attractive housing prices seems like a recipe for success.
And Fed Chairman Bernanke recently telegraphed that additional tools were available to the Fed, even if the Fed Funds Rate were to reach zero. Just the hint of the implications of “quantitative easing”, whereby the Fed further expands its balance sheet by buying long-term Treasuries to drive interest rates lower, seems to have had a material impact on interest rates. Indeed, the 10-year Treasury near 2.65% and the 30-year Treasury just above 3% are at 50-year lows. Think about that. The fact that investors are willing to accept a fixed 30-year return of 3%, before taxes and inflation, smacks of an emerging safety bubble. With the Fed on the cusp of a quantitative easing campaign, this is a bubble that may sustain itself for a considerable period as the Fed offers consumers and the economy ample time to mend. The fact that the dividend yield for the S&P 500 is now higher than the yield on 30-year Treasury bonds is remarkable, begging investors to climb the ladder of risk and buy stocks.
Meanwhile, not all of the economic news has been gloomy. In October, inflation fell more than expected and personal income rose more than expected. The price of oil has fallen below $50 per barrel and consumers are paying half of what they paid just a few months ago to fill their tanks. Business productivity beat expectations and rose by 1.3% in November. Productivity is now up 2.1% year over year and offers a clear sign that the underpinnings to our economy remain strong. In fact, we have gone eight quarters without productivity going negative, and this is the very first time the U.S. economy has been this far into a recession without at least one quarter of negative productivity. And both “Black Friday” retail sales and “Cyber Monday” sales over the internet came in better than expected. Sales on Black Friday were up 3% over last year to $10.6 billion with the average ticket up 7.2% from last year at $372.57. E-commerce sales on Cyber Monday jumped 15% to $846 million.
From the stock market low that occurred during previous recessions since World War II, the average gain in stocks is 16% three months out, 24% six months out, 32% nine months out and 32% one year out. And if we look at the average gain in stocks from the midpoint of time for these previous recessions (as opposed to the market low), the stock market has enjoyed an average gain of 21.2% twelve months from the midpoint. If we have not already suffered the worst of this recession (not depression), we believe that we are at least beyond its midpoint. As such, we believe that the NBER will eventually declare that the trough of this recession occurred between now and next April. While history never precisely repeats, it often rhymes. Given the historical precedent for stock market returns following recessions, we are confident that 2009 will prove to be a rewarding year for equity investors.
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