Market Comment Q3 2009

Through a Glass, Darkly

A consensus is forming among economists, policymakers, and business people generally that the worst recession since the 1930s is ending. Unfortunately, ending the recession is not fully synonymous with a resurgence of normal economic growth. The breadth and depth of this recession mean that it will likely cast a very long shadow. Attempts to peer into the future are darkened by unprecedented uncertainties.

There has never been a recession without a recovery. As every economic cycle bottoms, everyone with a stake in the game wonders how quickly things will return to solid growth. The answer is never clear, but the factors that pushed the economy into recession can sometimes offer clues. For example, the economic setback of the early 1980s followed soaring oil prices and inflation. The Fed (then led by current Obama adviser Paul Volcker) began a major battle against inflation that brought soaring interest rates, crippling borrowers and thus reducing business activity. The fixes were predictable: Lower oil prices and lower interest rates. In due course both appeared, and the economy was off to the races for the rest of the decade.

In the early 1990s, over-reaching real estate speculation – largely commercial but including a noteworthy housing price bubble – was naturally followed by a major downturn in construction bringing accelerating loan losses, bank failures, and less available lending. The fix? Federal agencies quickly shut down the most troubled banks, and the Resolution Trust Company was created to buy bad loans from banks in order to strengthen their balance sheets. This worked, and ultimately the federal government sold the loans at a profit.

Today? By now we know the litany. Easy money lead to irresponsible lending, primarily in mortgages that were frequently pooled and sold as securities. When housing prices reached such a peak that reversal became inevitable, many of these loans and securities proved to be of less than stellar quality. Revelations about all this struck such fear into both consumers and businesses that they (we?) closed wallets and checkbooks and even put away credit cards. Falling spending led to falling employment and falling GDP in countries around the world. With nearly everyone affected the fix is more difficult to find.

Despite aggressive government support for the biggest banks, troubled assets are still in the way of lending growth. This year, defaults have intensified in commercial real estate, further stalling new lending activity.

A long way home. At June 30 the annualized rate of real GDP is down 3.9% year-over-year in the U.S. Domestic unemployment is near 10%. Banks have suffered massive capital losses. Similar problems exist across Europe and in many Asian countries.

Consumer spending is the majority of GDP, and its share of the economy has increased over the years. In 1960 consumer spending was 63% of GDP, and that percentage has increased steadily to 71%. Returning to normal economic growth will be difficult without consumer rejuvenation, which in turn will be difficult without employment growth. There is some evidence that employment may be stabilizing, but that is not the same as growing. Business has sufficient capacity to grow for a while without much hiring. Restoration of normal conditions may take a while.

Then why are stock markets doing so well? Through September 29, the S&P 500 was ahead nearly 20% year to date and a whopping 57% from its panic low on March 6. As great as that sounds, the index remains 21% below its year-end 2007 level.

It could be all about earnings. Two different approaches are taken in creating earnings forecasts: bottom-up and top-down. Using the S&P 500 as an example, in bottom-up forecasting, analysts’ estimates for all 500 companies are tallied and aggregated. Top-down forecasts are created by economists applying their estimates of the next year’s overall percentage corporate profit change to current year earnings of the index.

S&P 500 earnings fell 35-40% from 2007 through current 2009 estimates and are anticipated to resume growth in 2010. The current top-down forecast from S&P’s own economists calls for S&P 500 earnings per share of $52.63, a gain of nearly 10% from the 2009 estimate. The bottom-up forecast from S&P’s own analysts reaches $72.96 per share, a gain of nearly 35% from the comparable 2009 number. At Goldman Sachs, one of the more rigorously analytical Wall Street investment banks, both top-down and bottom- up estimates are near $75. The greatest increases in estimates come from a restoration of profitability in the finance sector and the impact of higher oil prices on energy sector earnings,but in Goldman’s view all sectors but utilities will show double-digit percentage gains despite lackluster economic growth.

As with stock prices, even the high end of the range of estimated earnings rebound leaves the absolute level well below the 2006 record.

How can earnings recover? Businesses of all sizes, especially publicly-traded companies, began cost-cutting as soon as the recession began. We have expressed the view that traditional recessions caused by too much inventory were less likely because of today’s flow of information. Ironically, that same information flow allowed businesses to cut costs – largely through cutting people – when a slowdown was instigated by external sources.

Stock valuations remain within reason. The disastrous slide in stock prices throughout 2008 and into the first quarter of 2009 was more than a response to the deepening recession. It was the end result of a wave of selling by hedge funds who had to de-leverage, mutual funds responding to client demands for cash, and other investment pools that were forced to sell by their lenders. While every sale requires a buyer, during these times prices had to fall a lot to reach levels where buyers could be found.

At the worst, prices were far below any rational valuation level even given the earnings decline. In our own Price/Value Analysis the S&P 500 in total was selling at 62% of fair valuation at the March 9 bottom using the most pessimistic earnings forecast and an interest rate far above the current level. Most of the stock market rebound is simply a return to rationality after a period when abject fear dominated markets.

Today, if forecasts of a large earnings rebound are accurate, stocks prices generally remain historically cheap, and prices are within reason even if earnings gains are more subdued. The stock market gains this year have been accompanied by rising consumer confidence that is just beginning to show up in spending. Even modest consumer spending gains plus cost-cutting measures already in place may allow a corporate earnings recovery that should fuel further stock price gains. Perhaps confidence will improve further, fueling still stronger consumer spending and leading to higher employment.

The title of this issue is excerpted from a verse in I Corinthians 13 where the word glass actually means a mirror. The near-term future is not reflecting clearly just yet, but if we regain confidence in the longer term, our own actions can help clarify the picture.