Today, we've seen significant improvement in most of the indicators and we are enjoying the commodity strength, tech sector rally, and are especially pleased with how our muddle through investments in high yield bonds and preferred stocks have performed. Though the majority of our indicators demonstrate that our situation is vastly improved over where we were six months ago, we still see reason for caution, rather than optimism, and the unique nature of our current portfolio reflects this view.
The high yield bond rally came and is providing some much needed liquidity, at least to some firms. Many financial companies, including banks, insurance companies, and real estate companies, have been able to issue common stock to de-leverage companies and reduce default risk in the junk bond sector. Other companies have been able to roll over existing debt, and even issue new high yield bonds at high, but still reasonable interest rates, in order to forestall a cash crunch later in the year or in 2010.
True, the auto bailout trampled bondholder rights for holders of GM and Chrysler debt, but in general the existence of an option to raise money in the high yield bond market has saved many companies, and is probably one of the key reasons we are breathing much easier now than we were last Christmas. Santa really did come – in the shape of the bond underwriting units of Goldman Sachs and J.P. Morgan.
A rally in oil prices also signals strength in the global economy. Oil prices below $40, to us, signaled a global depression. That oil prices have stabilized suggests that the sub-$40 prices were more a result of hedge funds dumping futures and energy stocks, rather than an indication of a disastrous economy going forward. On the other hand, higher oil prices also hurt the consumer, so it is a mixed blessing that we’ve seen prices rally.
The rising prices may also signal a weaker dollar in the months and years ahead. Gold has also rallied. If worldwide economic activity increases, energy demand would likely increase and the energy rally would probably continue. However, if the dollar plunges, energy prices might remain firm even if a global recession ensues. Oil is priced in dollars. If the value of the dollar declines, the global energy community will need to raise the price of the commodity, all other things being equal.
In other words, we’re glad oil prices rallied, but we don’t think that it is a sure sign of future economic strength.
In December, we were hoping that the government’s new TARP program would enable banks to start lending again. That hasn’t happened.
The bank panic led to the wheels locking up on what some have called the “shadow banking” sector. There were many non-bank lenders who were funding all types of speculative, and some even not so speculative ventures. These shadow bankers, be they hedge funds, independent loan companies, independent mortgage companies, car finance companies and credit card companies, no longer make sub-prime loans (assuming they are still in business at all).
Traditional banks have not filled the lending void. The big bank TARP recipients are mostly sitting on capital, rather than trying to meet the demand for credit. In many cases, they have no choice. Bank regulators have clamped down hard on real estate lending. Most banks find themselves already over the limit of what the Fed would like to see. Also, given the recession, it's hard to argue against the need that banks feel to be especially prudent with depositor funds.
A recent company presentation by a local mining company proves that, thus far, even a well researched enterprise with reasonable proven resources and a profitable manufacturing process – even at today’s depressed cobalt prices – is not a fit enterprise to receive $250 million in financing. Yet, anyway. The company is limping forward, improving its reserve study but trying not to spend too much of its cash, waiting for the banking system to normalize so it can raise capital to proceed.
With capital, it is a very viable company. Unfortunately, it continues to struggle, today.
In a typical economic recovery, it is the price of money (i.e. the level of interest rates) which determines whether or not companies can borrow money to move forward. For my entire investing career (now a quarter of a century in the making), all the Fed had to do to get the economy moving again was lower interest rates. By re-pricing money, lower, borrowing increased, consumers refinanced high rate mortgages, and the economy rebounded.
This time it’s different. I know, I know – those are the four most dangerous words in investing. But, literally, this cycle is different. It’s different because over the past 25 years, rates fell so low that it was almost impossible to go much lower. It’s also different because even at low interest rates, the fear in the banking system is so great that while there is demand for money from the business sector, the bank vaults are still locked tight.
We’ve followed the level of “excess reserves” sitting over at the Fed, which represents dollars that the banks could be lending, but don’t. It is the banks’ vault, and that is where the money sits. It needs to be out in the economy, but we’re still waiting. Hopefully, when a gazillion stimulus dollars (please, don’t even get me started on that topic) hits the economy, the bankers will stand willing to finance the projects. Until then, we’re still waiting for this key indicator to improve.
Outside our borders, in a few places, efforts to provide liquidity are working. The mining company officials are focused on seeking development partners in China, which seems to be one of the few parts of the world which has money. It may take awhile for some of that global liquidity to slosh back onto our shores.
A much better sign is that bond markets are working again. High quality companies can still issue bonds. The prices aren’t ultra-cheap, but these companies do have the ability to raise money. Some forecasters are favoring large companies over small companies, simply because the big (high quality) companies can borrow money and move forward, while smaller companies are dependent on the banking system, which doesn’t seem to be open for business. I’d rather see all companies have access to capital, when appropriate, but at least we’re much better off as compared to December, when no company, anywhere, was in a position to borrow money to fund job creation.
In December, we also hoped to see market volatility decline, and it has. We’re not quite back to normal, but we can see normal from here, and it’s a darn sight prettier than the scene looking back. “Lack of volatility” is sort of like good health. You don’t really notice it, until it goes away. Then, it becomes the only thing that matters.
This leaves the final indicator: economic fundamentals. How are things going? This week, the leading economic indicators were up, but don’t let those numbers fool you. The strongest indicators were “market based” indicators. The stock market has rallied a lot since March. Interest rates, especially in the corporate and high yield markets, have declined. These market based indicators are positive. However, they are bouncing up off of extremely low levels in March, back when foolish talking heads from both the Left Coast and the Washington D.C. Beltway were talking about nationalizing our banking system. Just because we’ve discarded a stupid idea, and the markets have rallied, does not mean that we’re ready for the real economic fundamentals to rebound.
As we’ve written before, money matters. Interest rates matter. If they go up, as the U.S. struggles to finance its huge deficits, that is going to cut into consumer spending and postpone a housing sector rebound, because mortgage rates will go up as well. Higher rates will threaten a rebound in business investment, too. Right now, the best hope we have for a rebound is that business inventory levels are pretty low. If businesses re-stock, and sales and job growth increase as a result, we might be able to lift ourselves up out of the mire. If rates skyrocket, however, the cost of holding inventory will go up, companies won’t be able to afford to re-stock, and there goes our business rebound.
In addition to reasonably priced money lending rates, businesses need to be able to earn profits in order to justify expansion and job growth. I believe that the markets are forecasting an earnings rebound based on the very tenuous assumption that a rebound always follows a recession, and this recession is already longer than typical.
A muddle through economic rebound, based solely on cyclicality, probably lies ahead. A substantial rebound in profits, however, is much more a matter of faith. In the May 18 issue of Barron’s, Alan Abelson observes that first-quarter earnings on the S&P 500 Index came in “a tad over $10.” The current earnings scenario has earnings for the entire year coming in at around $40, down nearly 60% from peak levels. Typically, earnings fall about 10% in a recession, and rise 11% in the rebound. The 2000 recession was very severe for companies, resulting in a 20% decline in profits, and a similar rebound (fueled by an irrational and very generous banking system).
How realistic is an earnings rebound, of 150%, back to previous levels?
I wonder if the next economic rebound will result in a more “typical” rebound in corporate profits – perhaps a 10% to 20% increase to around $50 for the Index. If so, with the S&P 500 closing at 921.23 today, that gives the market a current Price/Earnings multiple of almost 18.5X earnings. If that’s what happens, the market rally is probably already over. A sustained increase from here might be hard to imagine.
A muddle through recovery is a pretty good scenario, from an economic point of view. It is not as encouraging, if you’re primarily concerned with where the stock market goes from here.
The answer, we believe, is to move away from a “typical” stock market portfolio. We are using more alternatives (gold, an inverse bond fund, commodities) and more high current income securities (junk bonds and preferred stocks) than ever before. If, in fact, “this time is different,” then that observation should apply to your portfolio as well.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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