Wednesday, May 27, 2009

Bull Market?

On March 9, 2009, the S&P 500 Index bottomed out at $676.53, a decline of 25% from the $903.25 close on December 31, 2008, which in itself represented a decline of 38.5% for the year.  The March 9th close was the low point in the market since August 1996 and technically represented a support level that, if broached, threatened to take the Index down to 500 or below.

The reason for all of this, of course, is the worst worldwide recession since the “great depression” of the 1930s.  It has aptly been called “the great decession” or the “great recession” and none of us born since the 1930s can remember anything like it, nor did many expect it to be as severe as it has been.  There is no question that, given the severity of the underlying failures in the financial system, it could easily have morphed into a situation rivaling or even surpassing that of the early 1930s, if the U.S. Federal Reserve had not pumped vast amounts of money into the banking system, as well as literally becoming the buyer of last resort in the short-term money markets, a role that few, if any, would have imagined. 

Fortunately, it now appears that the Federal Reserve and the U.S. Treasury have averted the threat of further significant deflation and have effectively placed the nation’s largest banks on life support.  Nevertheless, the banking/credit system is still not functioning properly and virtually every sector of the economy continues to struggle, resulting in increasing unemployment numbers and a distinct reduction in spending both by businesses and consumers.

So, that said, why has the S&P 500 Index rallied 30+ percent from its low in March (which some are now terming a “generational low”) to its current level around 900?  The answer probably is that most people believe a depression scenario has been averted as the “less-bad” character of economic data exposed deep discounts in equity valuations.  A further rally from here implies expectations of significant economic strength.  Indeed, things do look better than they did two months ago, as well they should after massive infusions of capital into the credit markets and the largest fiscal stimulus program in history.

 But keep in mind that we are still not out of the woods.  Virtually every big bank in the country faces massive loan losses in their commercial loan, credit card and mortgage portfolios over the next year. The International Monetary Fund (IMF) has indicated that both European and U.S. banks are well behind the curve in terms of recognizing their credit related losses, expecting at least another $1.5 trillion to come.  The European economic outlook is perhaps more uncertain than the U.S., adding destabilizing pressure on the Euro currency.  Furthermore, almost everyone waits anxiously for signs of inflation and the anticipated headwinds from dramatically rising government deficits. 

 So what has happened since March is almost certainly a classic bear-market rally.  Bear market rallies are not unusual, but they can be very powerful.  They have occurred historically during periods of economic stress, when better than expected economic news is reported.  In April 1930, the DJIA rallied 53% off of the October 1929 market crash.  In all, between 1929 and 1932, the NYSE saw four 20% plus bear market rallies, preceding the actual generational low of the depression in July 1932, which was a whopping 86.4% lower than its high in the April 1930 bear market rally.

Since the current depression scenario now seems to have been averted, leaving us with “just” a severe recession to deal with, we probably have seen the generational market low and won’t see the kind of wild swings experienced in the 1930s.  However, we also believe it is dangerous to draw the conclusion that a new long-term bull market, based on a substantial economic recovery, has begun. The problems are not over yet and it is going to take longer than 18 months to unwind the excesses of the past 25 years.  The current market rally is likely to be corrected, or at least flattened out, with both peaks and valleys to come, as we go through the rest of 2009 and the first half of 2010.

We approach this environment with a cautious outlook and intend to maintain a conservative balance between equities and bonds.  Our model portfolio over the next 12 months (with the exception of client portfolios that require a higher fixed-income component) is roughly targeted to be 55-65% equities, 30-35% bonds, with the remaining cash in the U.S. Treasury Money Market Fund, awaiting opportunities.  While our cash holdings temporarily earn close to zero, we are comfortable being risk-free, as we seek further opportunities for yield in the bond market.  We believe the investment-grade bond market is in the early stages of providing acceptable long-term yields that will give our portfolios consistent underlying compound return.  Our equity holdings have participated nicely in the rally and we have and will continue to trim positions to keep our equity exposure within conservative limits.  However, if the markets and economy continue with signs of stabilization, we do like the value and dividends offered by several EVA-generating companies we follow.

This strategy has outperformed the S&P 500 index to date in 2009, as it did throughout 2008.  Most importantly, we continue to focus on preserving client capital, with a specific view toward generating some consistent compound yield.


Jack and Peter Falker