Jerry Jordan Commentary | Fourth Quarter 2008 Investment Outlook
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The global credit crisis has reached epic proportions in the third quarter, as evidenced by the rapid demise of so many of the largest U.S. financial institutions: AIG, Fannie Mae, Freddie Mac, Lehman, Wachovia, and Washington Mutual. The collective wealth destruction resulting from the dismembering of these institutions is without precedent in U.S. financial history, at least since the Depression. Amazingly, after a week in which the U.S. financial system lost almost one major institution a day, culminating with the forced merger of Wachovia Bank on September 29, by quarter end the U.S. Congress had still failed to enact the financial rescue bill in the face of upcoming November elections.
These tumultuous events triggered a massive equity sell-off which resulted in the biggest one-day decline in U.S. stock since the 1987 crash, with the S&P 500 dropping 8.8% on high volume on September 29. This brought the S&P 500’s decline from the October 2007 peak to 30%. Foreign markets have fared far worse in this year’s market decline: China has declined 71%, Russia 57%, India 42%, and Japan 36%. 2008 has been a terrible year for equities, capping what has been the worst decade for U.S. equities since the 1930s.
After the financial events of September, we believe that it is likely that the markets are already discounting the inevitable coming changes, most notably less financial leverage and more regulatory oversight. Whoever is elected as our next president on November 4 will have a mandate for financial and economic reform.
Our portfolios faired poorly in the third quarter, particularly in the last several weeks, as portfolios aggressively shed the stocks that were winners in the first half and had benefited from the secular global trends of the last several years. As noted in the press, we are hearing of massive redemptions from hedge funds, which have owned many of these stocks. Our energy, steel, and infrastructure holdings suffered sell-offs bringing their valuations to radically low levels which presume an earnings collapse in coming quarters. We disagree with this premise, and continue to feel that our holdings offer dramatic appreciation potential.
We believe that the stock market is experiencing a selling panic precipitated by the wake of the failures of so many important financial institutions and the withdrawal of basic credit lines throughout the economy. In the wake of the big equity declines in the last month, and in view of the abysmal trailing 10-year returns for U.S. equities, investors are extremely defensively postured. As the panic selling abates, investors will begin to return to the many attractive investment opportunities that are available in this market.
The Economy & Interest Rates
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"As the panic selling abates, investors will begin to return to the many attractive investment opportunities that are available in this market." |
It is probable that the U.S. economy slipped into recession in the third quarter. Economic readings, such as trucking surveys, retail sales, and housing activity demonstrated acute weakness early in the quarter. But clearly there have been many financial dislocations caused by the credit freeze, resulting from the collapses of financial institutions during the month of September. These aftereffects will become apparent for weeks to come. For example, automobile dealers and shipping companies have been noting a big recent drop-off in business due to lack of credit.
Given the financial crisis and the eroding economic landscape, what are the prospects of the economy bottoming anytime soon? First, we believe that the global economy is currently experiencing an "air pocket" of acute weakness associated with the freezing of global credit, most clearly evidenced by the surging LIBOR interest rate spread, i.e., the London inter-bank loan rates. This indicator is a good measure of credit availability. In light of surging spreads, global central banks, led by the U.S. Federal Reserve Bank, are injecting record amounts of liquidity into the financial system. We expect that the acute credit crisis will pass in coming weeks, with or without a congressional relief bill, due to global central bank monetary injections and due to active intervention by bank regulators such as the FDIC. We are already seeing this happen with the takeovers of Washington Mutual and Wachovia Corp. in the last week of September. In the U.S. marketplace, we are already seeing a dramatic divergence between the "strong banks," such as JPMorgan and Wells Fargo, and the "distressed banks." The market is already identifying the survivors.
While the collateral damage of frozen credit lines will become more evident as third quarter earnings are released and we get September economic data, this credit freeze will likely mark the momentum low point of the recession. Monetary authorities are intent on freeing up liquidity in the banking system; if they succeed, there is plenty of demand for credit if available at low rates. Beyond the freeing up of credit, additional factors supporting a bottoming of the U.S. economy in the months ahead include 1) the continuing competitiveness of U.S. exports due to the low dollar; 2) the expectation of continuing fiscal and monetary stimulus from the government, notwithstanding the dysfunctional legislative activity of Congress; and 3) the longevity of the current slowdown, which started a year ago. For example, U.S. housing inventories, the root of the current crisis, are already down 27% from their highs. Naturally, our first assumption, continuing export growth, is predicated on the global slowdown also stabilizing, as credit is unfrozen.
We expect global short-term central bank determined interest rates to decline, especially in Europe. While we experienced an inflationary "tempest" in the first half of 2008, due to the sharp rise in commodity prices (especially oil) earlier in the year, in recent months commodity prices have experienced their worst short-term decline in 50 years! Thus, we expect inflation data in the months ahead will improve sharply. We expect long-term interest rates, especially Treasuries, to rise as rates have dropped recently to historic lows due to a "flight to quality." Most importantly, we believe the current panic affecting yield spreads will soon abate, as all panic episodes do.
In sum, we believe that we are in a recession, but that due to the climactic events of recent days that we will rapidly reach the bottom of this recession and that we should start to look for signs of improvement in the months ahead.
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"The structural global scarcity of key raw materials, like oil and gas, will still be present as the credit crisis abates". |
The Stock Market
The dramatic events of the closing week of the third quarter 2008 have likely marked a primary bottom of the 2008 bear market! The panic selling we witnessed from the failed congressional vote on the rescue package was as dramatic as most the climactic bottoms over many decades. In final week of September, we witnessed the following:
- on September 29, the U.S. stock market experienced its worst one-day decline in history except during the stock market crash in 1987;
- on September 29, declining volume was over 96% of total volume, and declining stocks exceeded advancing stocks by 19-1, the worst since 1987 crash; the VIX indicator (a measure of investor fear) reached 48.4, the highest levels since the stock market bottom in 2002;
- the stock market is more oversold, as measured by its distance from primary moving averages, than at any time in five years;
- investor pessimism has reached historic extremes, as measured by investor sentiment surveys, and there is a "mountain of cash" sitting in money market mutual funds, particularly relative to the value of stocks;
- the yield on short term Treasury bills reached almost zero (as investors bought Treasuries out of fear of owning anything else), a level not seen since the worst days of World War II; and
- massive trading volume in the final days of September, giving panicked investors plenty of opportunity to sell.
While we believe that September 29 exhibited all the attributes of a primary panic low, we expect volatility to continue, particularly as the market absorbs bad news as third quarter economic and earnings data are released. But we believe an important bottom is being made and many stocks represent a compelling buy at these levels.
Reasons why equities represent a compelling buying opportunity include the following:
- U.S. equity risk premiums, as measured by the difference between the trailing earnings yield minus the 10-Year Treasury yield, are the highest since the inflationary 1970s;
- corporate cash levels recently reached all time highs;
- there is an abundance of compelling investment opportunities in stocks with extremely low valuations, excellent balance sheets and exciting growth opportunities; and
- as noted above, we have reached the lowest 10-year equity returns since the 1930s, and, given history, if equity returns revert to their long-term mean performance, the next decade returns will likely be substantially higher.
This has clearly been a tough time for all investors, but we believe that from troubled selling climaxes historically comes periods of some of the most dramatic positive returns.
Strategy
There is no doubt that an acute global economic storm has erupted in the last several weeks. Stories of the evaporation of credit facilities in the wake of the big bank failures and congressional inaction clearly demonstrate that there are immediate economic consequences to this crisis. Because of the magnitude of the credit panic, we expect that concerted global governmental action will mitigate this problem within weeks, as has typically occurred in the past. One month ago, most of our holdings had great fundamental outlooks and extremely low valuations. Within a month, most economically sensitive equities, like most of our holdings, have crashed in price. The month of September 2008 was the "perfect storm"!
But, like all storms, they quickly end, and long-term trends generally come back into place, provided that they are structurally sound in light of the events that provoked the crisis. The structural global scarcity of key raw materials, like oil and gas, will still be present as the credit crisis abates. The supply/demand patterns that existed prior to the crisis will generally reassert themselves, especially among developing nations. This re-acceleration should be further improved by our expectation of major global reflation.
Consequently, we continue to emphasize our energy theme, and other strategic commodities, including steel and coal. Despite the nearly 30% drop in oil prices in the third quarter, the fundamental outlook for energy-related companies remains strong. We believe oil service companies are positioned most favorably. According to industry sources, nearly all drilling programs will remain profitable with oil prices over $70 per barrel. With operations remaining solidly profitable, most oil and natural gas producers will continue to invest in exploration and production activities to avoid supply shortages. Heading into the fourth quarter, the total inventory of crude oil and petroleum products is at its lowest level since 2003. The supply/demand balance may become extremely tight even with average winter temperatures. We are in the fifth year of increased exploration and production investment, but the dramatic levels of spending have not led to any significant supply response. This is because of the age of existing production fields (and associated accelerating well-depletion rates), cost inflation, and the increasing number of projects that are in deepwater or unconventional locations. In addition, like many other raw material companies, oil service companies have paid down a majority of their debt in the past few years, and have dramatically reduced their financial leverage. They are better positioned to withstand any downturns in product pricing, while remaining able to use operating leverage to benefit from a reacceleration in demand.
Our investments in coal and steel producers were among the most disappointing in the past three months, particularly given the divergences between stock prices and underlying fundamentals. For instance, while Central Appalachian coal options contract prices are within 11% of their all-time highs and 10% above current spot rates, the stocks have declined over 60%. Also, steel company valuations are now in-line with historical trough levels (despite inventories remaining near five- to ten-year lows). When the stocks have previously reached these valuations, they have tended to appreciate significantly in the coming months, even if earnings begin to decline materially versus the prior year. We believe it would take a global depression to reduce earnings to levels that justify the current valuations. However, if earnings remain anywhere near current levels, as we expect, the returns in these equities can be especially dramatic. There were several extraordinary factors that exaggerated the pricing declines for these commodities, largely related to the Olympics-related suspension of industrial production within 200 miles of Beijing from the end of July through the majority of September. China’s Purchasing Managers’ Index (PMI) was 48.4 in July and August, the first readings below 50 (the cutoff for expansionary economic activity) since 2005. However, the measure for September has already reaccelerated, up to 51.2. Further, with PMI inflation readings at the lowest levels since December 2005, the Chinese government should be comfortable with a further easing of fiscal and monetary policies. We expect the global supply/demand balance of many commodities to tighten further as the economies of China and other developing nations begin to reaccelerate.
We have also added new positions in the health care industry, which focus on companies that will deliver strong earnings growth regardless of the economic environment. High-end medical device producers, biotechnology companies, and drug distributors are among the expected beneficiaries of increased medical spending in the next several years. Increasing numbers of Medicare enrollees and state universal health care programs (with the potential for a national mandate) could lead to an inflection in growth in patient populations and earnings for our investments in these health care segments.
We continue to avoid the financial sector, even though we believe the credit crisis will end soon. As noted above, the next few years will witness a dramatically deleveraged financial industry and substantial government oversight. These trends will reduce profitability and growth. And, despite the recent trauma among banks, many of these stocks are not inexpensive given subdued growth prospects.
Thus, we hope that when we send you our next quarterly outlook, this "perfect storm" will be just a bad memory, and we will be focused on a meaningful recovery in our basic themes.
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