Market Update — After worst week ever, Dow rises more than 11%

William F. (Ted) Truscott, Chief Investment Officer
Oct. 14, 2008

Last week was the worst on record for the Dow Jones Industrials with a decline of 18.2%. At only 30 stocks, the Dow has never been a particularly good index, but it is a reliable indicator of sentiment about the broader outlook for the market and the economy. The bond market also had an awful week. The Merrill Lynch bond indexes registered a decline of 5.2% for investment-grade corporate debt and 10.9% for high-yield or "junk" bonds. Emerging market stocks were down 20.2% in one week and global stocks declined by 19.8%.

Concerns about the economy resulted in a 17.2% decline in the price of oil, while commodity futures declined by 10.6% overall. Municipal bonds also declined during the week on fears of the credit crunch harming states and municipalities. In short, there were not many places to hide other than Treasury bills, notes and gold. Clearly a difficult week all around, but on Monday almost everything strongly rallied as investor psychology changed for the better.

Wild intra-day moves - some more than 1,000 points for the Dow - testify to the anxiety and conflicting emotions that dominate the market. For rational thinkers, the stock and bond markets are becoming very good values and this plus good news from world governments fueled yesterday's impressive rally. While it was a relief to see such a strong rally, we believe that the market is very fragile and volatility will continue for some time. It is, therefore, important to approach the market in a rational and unemotional way.

We prefer a rational approach to these markets and what follows is an expanded and higher-level discussion of these values. I will then follow with some thoughts about the year ahead including the challenges, concerns and likely steps to be taken to combat what we anticipate to be a relatively nasty recession.

Earnings, spreads and valuation -— key drivers of the markets

Markets perform an essential function. They take account of current conditions and look into the future to derive prices for stocks, bonds, real estate and a host of other assets. Just as bargain hunters at a bazaar or flea market look for mispriced or under-valued merchandise, market participants know that they can make money buying mispriced financial assets. In theory, markets are efficiently priced and there should be few opportunities to buy at a discount. The so-called "efficiency of markets" has been debated for years.

My own view is that the market is most efficient when measured over long periods of time. However, the presence of excess greed or fear can make markets horribly inefficient in the short term. Excess fear is currently driving prices down to bargain-basement levels — just as excess greed drove prices well beyond perfection back in the 1960s and late 1990s. This provides us with an important point: sometimes the economic picture matters very little because market prices are so cheap that they more than fully compensate for the environment.

All kinds of short cuts are used to measure value. The P/E ratio (price earnings ratio) is a convenient way to represent the mathematical equation for valuing a stock — that is, the projected future profits of a company discounted to the present. The P/BV ratio (price book value ratio) is a quick way to measure whether the market values a company's assets at a premium or discount to the stated value of those assets on the financial statements. Spreads are the level that a bond yields above Treasury notes or the degree bonds measure the extra compensation available for taking the risk of investing in corporate, high-yield and dollar-denominated emerging market debt.

To get a better look at what these measures are telling us, here are some general and specific examples of a marketplace that is beginning to trade at a discount-to-actual value. The charts that follow are provided by the Bank Credit Analyst.¹

The first chart shows P/E ratios based on forward analyst estimates of the profits of all companies in the S&P 500. It goes back prior to 1980 and shows that we are now approaching forward P/E ratios last seen in the mid 1980s. While not as cheap as the late 1970s (P/E ratios can be affected by levels of inflation), this chart demonstrates that we have not seen value like this in the stock market for some time.

The next chart is a historical view of P/E ratios based on trailing one-year earnings going back to 1950. The Bank Credit Analyst points out that the current P/E ratio is little changed from levels almost 50 years ago in the 1960s. Remember that the low P/E ratios of the periods in the mid 1970s and early 1980s were driven by high levels of inflation and interest rates. There is an inverse correlation between the two.

While these charts indicate that the stock market is not that expensive based on history, the S&P 500 remains a broad measure of the market. When we start to look at specific stocks, the picture becomes much more interesting and telling. Indeed the Wall Street Journal reported on Saturday, in an excellent article, that 876 of the 5,000 stocks in the Wilshire 5000 index (a broad measure of the U.S. stock market) trade below their per share holdings of cash. This means that all other assets on the books are worth nothing in stock market terms, and clearly this makes little sense. Why does this anomaly occur? Fear. Fear and panic have resulted in tremendous short-term inefficiency in the market. Companies are on sale at a discount.

The bond market is also presenting big opportunities. I noted in our Oct. 10 Special Market Update that the investment-grade corporate market spread over treasuries of 4.75% was the widest since the Great Depression. Data from the Wall Street Journal based on Friday's activity indicates the spread is now 5.06% — another record. Spreads on high-yield bonds, according to Merrill Lynch, have widened further with its High Yield Master Index now showing spreads of 15.36% over treasuries. These wide, and in some cases record, spreads indicate that investors are being well compensated for their risk, including the risks of a souring economy.

The road ahead

The near- and medium-term future will be difficult. World leaders gathered over the weekend to work on solutions for dealing with the global financial crisis. One important outcome was an agreement by the European nations to shore up their troubled banks by adding capital and guaranteeing inter-bank lending.

Early Monday, four central banks, including the Federal Reserve, announced new measures aimed at thawing the credit markets. A key provision is providing unlimited short-term dollar funds at fixed interest rates. Also on Monday, the British government said it would invest $63 billion into the Royal Bank of Scotland, HBOS and Lloyds TSB to help the battered banks navigate through this crisis.

Bank Credit Analyst estimates of central bank and government resources used to combat the credit crisis range from $1.9 to $2.1 trillion. This includes the $168 billion tax rebate earlier this year as well as the $700 billion "Bailout Bill" and many other measures. These actions have not been enough to stem the crisis and there is a growing consensus that the government should now recapitalize the nation's banking system through direct purchase of bank equity.

The chart below depicts the real issue. Banks are tightening standards and are increasingly unwilling to lend to consumers and small/large businesses. Even worse, banks are unwilling to lend to each other and a recapitalization of the banking system may be the only way to do this.

Beyond the need to thaw frozen credit markets, it is clear that we face a much different landscape and sub-par economic growth. Here are some other trends and concerns for the future:

1. Consumers will have to borrow less and save more. This has already begun and was probably overdue anyway. The drivers will be a continued fall in home prices and tighter credit. We reiterate our view that the fall in home prices will continue and not ease anytime soon. Since consumption represents a big part of our economy, consumer cutbacks will have a big effect and we are likely to see more firms fail or enter bankruptcy over time.
2. There will likely be a flurry of new regulations aimed at the financial services industry. Most regulation will focus on the need to reduce leverage and rein in the growth of what is now known as the "shadow banking system" made up of investment banks, hedge funds, finance companies, etc.
3. The rapid deleveraging and contraction in credit means this will be a tough recession - at a minimum worse than the last two recessions in 1991 and 2001, which were relatively mild.
4. Brave politicians may even try to change the tax code which currently penalizes savings and rewards consumption.
5. Dan Laufenberg's current economic forecast calls for a return to growth in the second half of 2009. That said, we seem to be set for a period of sub-par domestic and world economic growth even after 2009. Critical to a more optimistic view is the role of large emerging market economies such as China, India and Brazil fomenting sufficient domestic demand to provide additional upside to the world economy.
6. Inflation was a major concern just a few months ago. This concern is fading fast and is now being replaced by concerns about the deflationary aspect of falling home prices and a contraction in credit. Policymakers will use all weapons at their disposal to prevent disinflation/deflation from taking hold.

Conclusion

The Economist, in an extremely responsible look at the future of the world economy, has decried the simplistic view of the financial bust as the product of greedy Wall Street bankers. It cites cheap money influenced by currency and interest-rate policies, outdated regulation, government distortion of food prices, and poor supervision as some of the causes beyond Wall Street leverage.² I would add to this list the overly indebted U.S. consumer and the inability of our nation to live within its means. Multiple causes to the problem means there must be multiple solutions, and those solutions will take time to implement.

Nevertheless, markets have seen much of this already and the panic of the past two weeks has brought prices to a level where there is opportunity in multiple asset classes. Many assets appear to be on sale except for treasuries and gold. This opportunity will disappear in short order once confidence is restored and the credit markets return to normal.

We will then face the much tougher task of trying to decide which assets and which sectors offer the most opportunity. As is always the case, it makes sense to talk with your financial advisor to review the opportunities that are available now and to think about adjustments to your financial plan in light of the challenges and changes that currently exist and will continue to evolve in the financial landscape.