May 12, 2009
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“Only that historian will have the gift of fanning the spark of hope in the past who is firmly convinced that even the dead will not be safe from the enemy if he wins. And the enemy has not ceased to be victorious.”
Walter Benjamin1
Bye Bye Dow 5000
On November 15, 2008, HCM warned that the Dow Jones Industrial Average could sink as low as 5000, and the S&P 500 could drop as low as 475, by the middle of 2009. At the time, the Dow was trading at 8497 and the S&P 500 at 873. We warned of the possibility of a further decline of 40 to 50 percent in equity prices based on our view that the economy was experiencing a deflationary shock that was more characteristic of a depression than a normal recession.
At its nadir on March 9, 2009, the Dow hit 6547 and the S&P 500 dropped to 676.53 (closing not intraday prices), drops of approximately 23 percent each from their November 15, 2008 prices. Since then, the Dow has rallied about 25 percent and the S&P 500 about 29 percent. Moreover, these indices seem hell-bent on rising further in the face of economic news that can only be characterized as the worst the U.S. has seen in decades. The fact that the market is rallying in the face of such negative news tells us that the market is not prepared to retest its lows anytime soon. Accordingly, while HCM views the equity market as currently valued at unsustainable multiples of earnings (by our count, the S&P 500 is trading at better than 20x 2009 operating earnings excluding charges), Dow 5000 and S&P 500 are no longer in the cards. It was a good directional call but, as is our wont, overly negative. At some point this rally will end, but we don’t expect the market to drop to depression trading levels once it does. Mea culpa.
Clearly the equity rally has been news rather than earnings driven. In order to remain at current levels, equity prices will have to gain earnings support in the coming months. Many companies are reporting significantly lower revenues due to the depth of the global economic slowdown. Those companies that are beating estimates, such as Dow Chemical, are doing so by cutting enormous amounts out of their cost structures, which over the long-term should reset their production costs at a lower run-rate. This should prepare these companies for high levels of profitability as the global economy heals. But draconian cost cuts exact a toll on other sectors of the economy, as well as on employment and the supply chain, so they are far from a zero sum game for the overall economy. Just as some companies are benefitting from these drastic measures, their suppliers and employees are suffering. This dynamic is what renders this a market in which investors are best served by active management and fundamental research, not by macroeconomic or sector-wide bets. Those types of broad bets may be profitable in the short-run but risk sharp reversals in the not-too-distant future as the effects of cost cutting and debt reduction reverberate through the economy.
The world remains captive to the dynamics of a depression rather than a garden variety recession. The economy is responding to extraordinary government actions and traditional monetary and fiscal remedies remain ineffective. Accordingly, the economy is far from out of the woods, and investors should remain cautious. While our initial judgment was that the rally would run out of steam at Dow 8000 and S&P 800, it is now apparent that those targets should be lifted to Dow 8500 and S&P 925. If the markets were to reach those levels, they would be trading at ridiculously high multiples of any reasonable earnings forecasts (something we have seen before that always ends in tears). Today, the markets are trading more on hope than facts and investors would be well-served to carefully monitor their exposure to stocks trading at higher price/earnings ratios. Investors are apt to regain their optimism faster than companies regain their profitability.
The last time the world experienced a depression dynamic, between 1929 and 1932, the Dow rallied by more than 20 percent four times, only to drop below previous lows. Thus far, the current crisis has seen five rallies of 10 percent or more that have failed to hold. HCM would not be surprised to see the market pull back from current levels at any time since there does not appear to be either earnings or economic support for current levels.
HCM remains cautious about the economic outlook both domestically and abroad. As we were writing this, the first quarter GDP estimate for the U.S. was released at a -6.1 percent annual rate, pretty much as we expected (although we thought it could be as low a -7.0 percent and it could still be revised upward or downward). This figure should not be a surprise to anybody who has been paying attention to the economy. Nonetheless, we can say with some confidence that the last two quarters will represent the trough of this economic cycle. At this point, it is apparent that the rate of economic decline is beginning to slow meaningfully. The problem is that as of yet there are scant signs of economic growth emerging anywhere around the globe.
Moreover, the glimmers of hope that the stock market and its boosters would like to believe justifies a sustainable rally are wholly attributable to the most dramatic and unconventional series of governmental interventions in the markets in history. It is not surprising that trillions of dollars of liquidity infusions and government guarantees have introduced a degree of stability into the system, but that hardly equates to a sustainable recovery. In order for that to occur, government demand will have to be replaced by sustainable sources of organic growth that are financed by equity, not debt, and productive activity, not speculation. If the U.S. economy and the rest of the world cannot begin to grow on their own, the markets will remain under pressure for years to come because the companies that comprise those markets will find profitability difficult to attain and maintain. Right now, it is questionable whether the conditions for such organic growth are being put in place or not. The only thing that can be said with certainty is that the size of government is exploding and the volume of government debt in the U.S. and elsewhere is swelling to dangerous levels.
For the moment, markets feel calmer. Measures of liquidity and volatility have settled down considerably. Short term credit spreads have all but normalized, although normal credit growth has yet to resume. Long term credit spreads are lower than their highest levels but remain extremely elevated by historical standards. But to a meaningful extent, central bank actions have had their intended effect. Nonetheless, the first quarter GDP report is strong evidence that economic healing has a long way to go. Conditions in the labor markets remain very troubling. Bridgewater Associates points out that while labor markets are normally a lagging indicator in a debt-driven economy, they tend to be a leading indicator in a deleveraging economy.2 When credit is unavailable, spending and debt payments are dependent on income, and income is generated by employment. When companies are deleveraging, job growth becomes a leading indicator of demand. Bridgewater believes that recent data suggests that unemployment is likely to rise by nearly 0.7 percent a month, and we agree that further job losses are inevitable.
Comparisons are often made between the U.S. and Japan, which remains mired in an economic slough of despond twenty years after its stock market peaked. If there is reason for optimism that the U.S. will not be consigned to decades of sluggish economic growth, it is that the Federal Reserve and U.S. Treasury have moved much more rapidly than did Japanese authorities to address the current crisis. But the U.S. is going to remain dependent on its government for growth for the foreseeable future. Joblessness, as just noted, is still increasing, and capacity utilization is going to take a long time to rebuild as many industries remain in downsizing mode. Debt destruction is still the order of the day, as a flood of troubled debt exchanges continues to hit the credit markets. HCM remains convinced that while there are many opportunities in individual stocks, bonds and loans, many traps lie waiting in the broader indices. Active management and individual stock picking and credit selection will be required to successfully navigate this environment. Passive strategies and indexing will be recipes for underperformance or worse in a world that is still replete with black swans and fat tails. Risk assets are far from out of the woods.1 Walter Benjamin, “Theses on the Philosophy of History,” in Illuminations (New York: Schocken Books, 1969), p. 255. Emphasis in original.
2 Bridgewater Daily Observations, April 23, 2009, p. 5.
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