Unless you stopped watching the news during the agonizing bear market, and haven’t yet turned it back on, you probably know that stocks have recovered quite nicely since hitting an intraday low on March 6, at 666 for the S&P 500 (mark of the bears, or of the Beast?). The next trading day, March 9, saw the lowest closing price for all major indices. Since then, stocks are up 38%, and are actually now in the money for 2009. Now, if we could get back to break-even since the beginning of 2008….
The question now on the minds of all pundits, investors sitting on cash, and (to a lesser extent) the rest of us, is whether the rally will continue or turn out to be a head-fake, bear-market rally, only to lead to new lows in the coming months. Given that we’re pretty much fully invested, and thus enjoying the rally, our view is longer-term. Our focus is on whether the economy is recovering (it is), and whether we’re in the right stocks. Nonetheless, we’ll attempt to answer the question of New Bull Market Vs. Bear Market Rally at the end of this discussion.
There’s a lot of interesting things about such a big rally, like how the market is still down 41% from its high in 2007. A large percentage gain is a lot less impressive off of a low base than it is off a big base. This can be taken optimistically or pessimistically. For those whose glass is half-empty, that 38% gain screams “too much, too fast.” But if your glass is half-full, you’ll appreciate knowing that very little cash has yet come back into the market, as so much is still sitting in money market funds and in bank accounts.
To showcase this point, the chart below shows the performance of a select group of stocks since March 9, and for the period of 2008 and 2009 through March 9. As you can see, the phenomenal returns in stocks that could be called either “low quality” or “high beta” (meaning that when the market moves one way, they move a lot in that direction) are much greater than for higher-quality stocks. But, these huge moves still don’t make up for how dismally they performed going into March 9. Note the “higher-quality” stocks are on the top of each category.
It should be clear that this 2-month rally has been led by stocks that were just barely strong enough to survive. Before March 9, the market was understandably very concerned about these stocks not surviving, so they performed the worst. Was there any chance Wal-Mart was not going to survive any kind of Depression? (That’s a rhetorical question.) But Saks? When a stock hits $1.50 per share, that’s a lot of bankruptcy risk, justified or not. Since March 9, the leading sector has been (anyone care to wager a guess?)…. Financials! At +99%, this far outdistances the next best sector, at +49%. But they also got hit the hardest going into March 9, -78% from the end of 2007.
What does all this mean? First, it is totally normal for the market to behave like this at turning points in the economy. 2003’s recovery was identical. Everyone sells Saks because bankruptcy looms. Nobody wants Bank of America; they’re about to become “nationalized.” But now? Following some better economic data (which is the next topic du jour, see below), surprisingly healthy first-quarter earnings reports from the banking sector, and a relatively sanguine outcome of the Treasury’s “stress test” on B of A, it actually might have some value coming out of the financial crisis. As for Saks, consumer spending actually rose in the first quarter, and this was before any effect of the government’s various fiscal stimuli.
Second, it’s tempting to look at a stock like McDonald’s and wonder, “what’s wrong with McDs? Why is their train still parked at the station?” To be sure, we’re not at all grumbling, and many of our stocks have performed surprisingly well. These relative moves in the market have nothing to do with underlying business fundamentals. Instead, short-term traders have long been conditioned to ride on whatever train is moving the fastest, and when money is going into risky stocks, some of it is coming out of safe stocks.
So, where do we go from here? Patience, please.
The Economy in Two Words: Less Bad
February seems to have been the turning point for the economy. As we wrote on March 5 in our website posting, “What We Know and What We Don’t Know,” the earliest of early economic indicators showed that the economy was starting to decline at slower rates. This “second derivative of growth” nearly always turns into stabilization, then to recovery. The data that we cited included:
1) Tighter credit spreads (how much higher interest rates the market was charging risky borrowers over safe borrowers)
2) Modest recovery in ISM indices
3) Steep yield curve
4) Recovery in oil fundamentals
5) Rising copper prices
6) Consumer spending holding up surprisingly well
We also noted that, as we have said ad nauseum during this recession, don’t look to clues from the labor market. By the time employment starts to recover, the economy will probably have been expanding for at least a year.
In the two months since then, all of these metrics have shown further improvement. Even labor market data have turned around. Weekly unemployment claims have been steadily falling for a month now, the ADP monthly employment report showed a much smaller job loss in April (the government reports its numbers tomorrow), and the Challenger “Announced Job Cuts” index has fallen dramatically. The next steps in an eventual labor market recovery would include an increase in hiring of temporary workers, as well as a continued rebound in jobless claims and employment numbers.
One of the most important pieces of economic data is the quarterly GDP report. It doesn’t provide any “leading” information, but it does show a comprehensive look at how the economy is faring every quarter. The headline number from the 1st quarter report was that production fell at a 6.1% annual rate from the 4th quarter to the 1st quarter. This was nearly the same rate of decline as from the 3rd quarter of 2008 to the 4thquarter, and doesn’t seem like much good news. But under the surface is the good news: final sales fell only 3.4%, compared to a drop of 6.2% last quarter. Final sales tracks changes in consumer spending, government spending, and business investment. It strips out foreign trade and changes in inventory, and thus it shows how much the U.S. consumed during the quarter, as opposed to how much it produced. The discrepancy between production and final sales was the enormous drop in inventories, which happens near the end of all recessions, and enables future growth, as companies “restock” their depleted inventories. And government spending was actually a negative contributor in the 1st quarter, which will inevitably turn into a positive going forward.
Again, we caution that the economy might not yet be expanding, though we believe that will be happening imminently. For now, the data show that the economy is “less bad,” which is an improvement from “getting worse.”
As for corporate America, profits of cyclical companies will be headed up fairly soon. The inventory adjustment is a massive headwind for sales, but will probably abate in the next couple quarters. Companies are benefiting from lower commodity prices and cost reductions, from cutting headcount to reducing capacity. Foreign markets are showing signs of life, so global operators can extract better sales growth from overseas operations. The best-managed companies are able to buy assets on the cheap from distressed competitors, and have the cash flow to buy their stock back at depressed prices.
Looking out into our crystal ball, we see an imminent economic recovery. We were never concerned that it wouldn’t eventually come, but were more concerned with the ramifications of everyone else worrying about it, which could have led to extreme dislocations in the economy, such as consumers hunkering down like they did in the 1930s. Alas, it appears that nothing even close to that has happened.
Our greatest concern is looking out a few years, after the recovery is in place. The Fed will eventually need to unwind its massive monetary stimulus, raising interest rate targets in the process. The Treasury’s fiscal stimulus will run its course, and the threat of higher taxes will loom. Combine these headwinds with a consumer that might still be inclined to increase his savings and reduce debt, and we could see the recovery not last as long as the typical expansion.
While many strategists are forced to predict the recovery in terms of letters (notice their shapes), like L (no recovery), U (gradual recovery), or V (sharp recovery), our friends at Strategas are calling for a “square root shaped recovery!” For those mathematically challenged, the square root symbol looks like (ignore the x):
So, looking from left to right, you see a drop, then a recovery, then a flat line.
As with everything during this economic and financial crisis, we’re putting our thinking caps to the test to try to best position portfolios for a recovery, but one which may or may not last very long. Enduring companies can, by definition, endure any environment, which is why so many of them can be owned through all cycles. But we could be looking to make small changes that complement our pantry of consistent-growth companies.
Bull Market or Bear Market Rally?
Honestly, we don’t know, but we have a good feeling that we’ve already seen the lows of this cycle. How distressing would it be for stocks to go all the way back down and test those lows? Very. It is possible, but we don’t see it as likely. It will depend on two things: the recovery in credit markets, and the recovery in economic data. As we wrote earlier, usually a turn in data from negative to less negative eventually leads to a turn into positive growth. But there are always bumps along the road. Some data might backslide for a month or two. The labor market recovery might not take hold for awhile, leading investors to wonder whether there will be a recovery. A bank may unexpectedly stumble badly, testing the Treasury’s mettle to backstop all big banks. And then there’s the GM mess. This is why we still expect something of a correction; at what time and level, we don’t know. For those sitting on cash, waiting for this correction, it’s painful to watch the market go up everyday. We can’t say for sure whether the market will go back below today’s levels, but the answer is probably yes. But for those of us with a longer view, we believe stocks are rallying for the right reasons (a recovering economy), and should continue to do so as the economy recovers. Valuations are still extremely cheap, and cash is still waiting to come back into the market.