2006 Economic Forecast Update

In our October 2006 Economic Update luncheon for clients, we expressed fears of a 30% market sell-off, comprised of a 20% decline in earnings and a reduction in the Price/Earnings ratio from 16X earnings to 14X earnings. From the 2007 peak, this 30% sell-off would have taken the market down to 1085. If you start from where the market was in October 2006 (1350), the 30% sell-off would take the market down to 945 on the S&P 500 Index.

Today the market hit (bottomed out at?) 1008 and closed at 1056, above the October 2006 projection but below the October 2007 peak-to-trough forecast.

Furthermore, the sell-off resulted from the real estate problems that we highlighted in October 2006. The trepidation we felt in 2006 is now widely shared. The recession is no longer an intellectual construct, but rather a day-to-day (if not hour-by-hour) headline.

Today’s liquidity crisis is worse than we’d anticipated. In any case, it feels worse than we were prepared to feel. However, if psychology can pinpoint a market low, then it can’t get much worse than this. If I were going on psychology, alone, this would clearly be a buying opportunity.

• So what have we done about it?

All we’ve done, recently, is put new money to work. Accounts that brought in new cash in the past month may have had more money sitting on the sidelines (thankfully) than most, and those reserves have now been invested.

Most portfolios, however, still have money on the sidelines waiting for the market to turn around. In fact, at this point the trades are loaded and we’re just waiting for the right opportunity to invest.

I’ve been looking for a big sell-off (1,000 points down on the Dow) with a spike in the volatility index for a couple of weeks, now. We haven’t seen that magical combination, though the Dow sank 777 points last Monday, and was down over 800 points at one point today. Also, we’re down well over 1,000 points since I first started looking for that sell-off.

Stocks are very cheap, as compared with bond yields. Some market bloggers are speculating about the “mother of all snapbacks” when this sell-off ends. It could be that my volatility spike will come on the upside, rather than the downside. Woudn’t that be nice!

• What might make us buy?

In addition to this painful exercise of “how low can it go,” I’m looking at a couple of specific indicators for a signal that the tide is ready to turn. Signs that the liquidity crisis is lessening, or that the markets have completely priced in a global recession, would signal a reasonable re-entry point. The market is now off more than 30% from its high. Financials stock prices have been cut in half. The commodity sector has experienced its worst sell-off in 50 years (since 1956). Clearly, now is a better time to buy stocks than it was a year ago (when most investors were far more willing to do so).

The liquidity crisis will gradually resolve itself. The Fed and the U.S. Treasury are creating new and innovative ways to pump money into the system. After the 1987 crash, the Fed was on the phone with member banks, asking if any customers needed money (and indicating that the Fed was willing to make certain that they got it). I have little doubt that those same promises are being attempted today.

The Fed is paying interest on banking reserves that never used to receive interest. The bailout bill brings a new buyer into the market for hard-to-value (and liquidate) Level 3 assets. Last week’s bill also makes it possible for the S.E.C. to suspend mark-to-market accounting, and hopefully the S.E.C. will announce measures to that effect sooner rather than later, reducing the pressure on banks to dump assets. Raising FDIC insurance limits will hopefully bring in new deposits to the banks, increasing their balance sheet and hopefully the banks will be able to re-enter the corporate bond market on the buy side, since we haven’t seen many buyers, lately, even in that reasonably safe asset class.

Signs that the liquidity mess is beginning to improve might soon include lower corporate bond rates, higher junk bond prices, and lower spreads between Europe’s LIBOR rates and the U.S. Fed Funds rate, which signals the unwillingness of banks on the continent to lend money to its upstart brethren here in the New World.

I’m also looking for signs that the global recession has been fully priced into the global equity markets. In the last 3 months, Latin American stocks are down almost 35%, the Europe ETF has fallen about 20%. Japan is off nearly as much, and Asia stocks (ex-Japan) are down about 23%.

In my mind, the U.S. banking crisis bottomed out on July 15, and we’ve been trying to put a bottom in the liquidity crisis ever since then.

What’s caused the most pain recently, however, has been the gradual recognition over the past 3 months that the U.S. has exported its problems overseas. The world is now anticipating a global recession, and the commodity and international equity markets are adjusting rapidly to this new reality. The good news is that Central Banks around the globe are now preparing plans to add stimulus to offset the global credit crunch.

When we see the impact of these stimulus measures reflected in a stabilization of global energy prices, that will likely be an important turnaround point. At the end of the trading day, today, energy prices appeared to remain weak, even though the stock market rallied about 450 points off its low. Had energy prices been leading the way, I might have bought into the market. As it is, I thought it best to take another look at things tomorrow.

Though energy prices have certainly fallen recently, oil prices are still up 17% over where they were a year ago, and natural gas prices remain 7% higher. Stock prices in the energy sector are down closer to 20% over the same time frame. It feels like we’ve gone from a two standard deviation overvaluation in June to a two standard deviation sell-off event in September/October. In spite of this, the multitude of steps that the Fed is taking to get money into the financial system seems bound to put downward pressure on the dollar during the months to come, which generally puts inflationary pressure on the price of commodities.

Though we’ve bemoaned the high and rising energy prices in months past, I would really like to see energy prices stabilize just north of $100 per barrel. My guesstimate for “fair value” is actually around $115. If energy prices were to stabilize, I’d say that the global equity markets are starting to find equilibrium again and now reflect the unpleasant reality, which we first talked about late in 2006, that a recession is in the cards.

At times like this, it is sometimes hard to remember that what follows a “recession” is typically a recovery. Helicopter Ben (Bernanke), so-named because of a paper he wrote about preventing another depression hypothesized that ultimately the government could simply drop dollars out of a helicopter in order to get things moving again, is dead set on providing liquidity any way he can.

Whether or not today marked the bottom, I don’t know. In the long-term scheme of “Buy low, sell high,” however, I think we’ll find in retrospect that we’ve reached a buy point.

I decided to wait another day, for signs that the liquidity situation is improving, or that energy prices are ready to stabilize. We’ll see if “wait and see” proves to be a costly decision. Up until today, it hasn’t.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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