ECONOMIC HEALING, From Milton Ezrati, senior economist and market strategist, Lord Abbett
Financial markets began to show clear signs of healing last spring—a pattern that has continued and should support both financial and economic recovery this year. One crucial gauge of this healing is the TED spread, which measures the premium rate above Treasury bills that financial institutions charge each other for short-term loans, and typically averages between one-quarter and one-third of a percentage point. Late in 2008 and early in 2009, it widened out to more than four and a half percentage points. With this unprecedented premium the banks screamed that they had no trust and no willingness to lend, not even to each other. But by April, that premium had come in to about one percentage point, and today the TED spread has returned to normal, even actually a little lower.
In a similar way, shrinking credit spreads speak to the healing that has occurred. In the worst of the crisis, low-grade bonds had to pay a yield 21 percentage points above Treasury bonds just to get noticed—a full 10 percentage points more than ever before. But by last May, that spread had dropped substantially, and today is significantly less than 10 percentage points. These spreads are still wider than they have been historically, but the dramatic way they have come down speaks loudly to improved confidence and a renewed willingness to trade.
Along with this financial healing, signs began to emerge in late spring and summer, even as talk of a “great depression” remained commonplace, that the economic slide was stabilizing and probably beginning to turn upward. The broad-based Conference Board Index of Leading Economic Indicators, for example, begun to rise last spring, and has risen now for more than six months in succession. The consumer has hardly returned to his or her free-spending ways, but gradually the cutbacks of late 2008/early 2009 have given way to modest increases in spending. Business also has begun to increase its orders for new equipment, systems, and technology, albeit tentatively. Even in residential construction, where the trouble started, the inventory of unsold homes has shrunk sufficiently enough to slow and, if tentative signs are to be believed, even stop the decline in residential real estate prices, on average. There are even signs that buyers and builders have begun to step up their activity.
WE EXPECT TOO MUCH FROM CAPITAL MARKETS, From Dorsey Farr, PhD, co-founder and principal, French Wolf & Farr
Conventional wisdom holds that stocks are instruments of growth, while bonds provide income and stability. History does not support the conventional wisdom. This should not come as a complete surprise; memories are short and filled with clutter. Since 1980, the S&P 500 has gained 11.0% per annum, while Treasury bonds have gained 9.9% per annum. Equities outperformed bonds, but hardly by a sufficient margin to justify the widely held expectation that a 300 to 400 basis-point equity risk premium can be achieved simply through a long time horizon.
BCA Research noted recently that the only period in the last 140 years when stocks materially outperformed bonds on a sustained basis was the 1950s and 60s. What was special about this period? Initial conditions and environment: it was a period characterized by low starting valuations and bond yields followed by strong, non-inflationary economic growth.
The period beginning in 1980 was somewhat similar in terms of favorable initial conditions. Both stocks and bonds began the period priced to deliver substantial returns. Equity dividend yields in 1980 exceeded 5%, while bond yields were north of 10%. From there, inflation fell and interest rates declined, boosting bond returns. At the same time, equity price-earnings multiples rose steadily (reaching an all-time high in 1999). Things could have turned out differently, to be sure. But initial conditions certainly paved the way for success.
The beauty of starting a portfolio in 1980 is that it was nearly impossible to go wrong. If you bought bonds, you compounded at 10%. If you bought stocks, you compounded at roughly 10%. If you bought bonds and stocks, you could have done even better thanks to the magic of diversification. Indeed, almost any amount of bond exposure simply reduced volatility with very little cost in terms of foregone returns.
Today, the world looks very different than it did in 1980. While the current recession is arguably more comparable to the 1980-82 downturn than any other in the post-war era, a comparison of asset-class valuations couldn’t present a greater contrast. Equity valuations today are elevated; price-earnings multiples have returned to the top quartile of levels observed over the past 140 years. The dividend yield on the S&P 500 is a meager 2.2%, which ought to raise eyebrows. Bonds likewise are priced to deliver low real and nominal returns.
YIELD AT ANY PRICE, From David A. Rosenberg, Chief Economist & Strategist, Gluskin Sheff
Perhaps the most profound statistic regarding investor tolerance for risk lies in the high-yield market as opposed to the equity market. Companies with junky credit ratings managed to raise $2.4 billion in the first week of the year. The last time it managed to do that, the U.S. economy was humming along at over a 4% annual rate! This follows on the heels of the $147 billion of fresh supply in 2009, which was a record.
While retail investors have been avoiding the equity market, the appetite for yield—no matter the quality of the credit—is enormous as cash inflows into high-yield mutual funds and ETFs came to a huge $288 million in the week ending January 6; the twentieth net inflow in a row, totaling $5.9 billion. It may pay to note that this flurry took place even as four high-yield rated companies defaulted, which, if sustained, would imply a 9.5% default rate, which few have in their forecast (the rating agencies are between 6% and 7% for the most part versus 10.9% in 2009).
As with equities, a lot of good news would seem to be priced in—or at least whatever bad news here was has been priced out. After all, high-yield spreads have tightened to 917 bps from 4,419 bps just over a year ago despite the fact that a record total of 265 companies defaulted on their debt last year; twice what we saw in 2008 (the prior high was 29 in 2001).
GOING FOR THE CONSERVATIVE, From Stephen J. Huxley, Ph.D., chief investment strategist, Asset Dedication
Despite the obvious challenges to foretelling the markets, many clients ask their advisors to gaze into their crystal ball to predict the future, which can be more than a bit hazy.
There is one case, however, where the future value of an investment can be forecast with certainty: a Treasury bond held to maturity. When the federal government promises it will pay $1,000 in 10 years and $50 per year until then, it will happen. The US Treasury has the right to print money, so there is no question that the cash will flow. The beauty of holding a bond to maturity is its predictability. If an investor has a need to spend $50 on living expenses each year for the next 10 years plus $1000 at the end of that period, the Treasury bond will supply the cash flows precisely.
Regardless of changes in the bond market, by devoting bonds to supply cash flows, the most common risks associated with fixed income securities are mitigated. Holding Treasury bonds to maturity controls default risk, reinvestment risk, and market risk. If TIPS are used, inflation risk is controlled too. These unique features, provided only by individual bonds, may protect your client’s bond allocation in case your crystal ball is showing a chance of rising interest rates.
OPTIMISM FOR THE 2010s, From Bob Turner, chairman and chief investment officer, Turner Investment Partners
As we bid adieu to the 2000s and enter the 2010s—strange as this may seem to the chronic pessimists that have been spawned over the past 10 years—we confess to feeling highly optimistic about the prospects for economic growth, the stock market, and even the world order.
What’s most germane to us as investors is this: we are optimistic that stocks may revert to the mean, improving their performance markedly in the next 10 years relative to the 2000s. Professor Jeremy Siegel of the University of Pennsylvania has found this historical pattern: in the 14 times that stocks have produced negative returns in any 10-year period since 1926, they have bounced back to gain more than 10% in “real,” or inflation-adjusted, terms over the next 10 years—a level of performance that’s 50% above the average. This pattern is likely to materialize once again in the 2010s.
Over the next few years, several catalysts—three, to be exact—should drive the mean reversion of stocks. The first catalyst is likely to be that corporate profits continue to surprise on the upside in 2010. U.S. companies have spent most of the 2000s getting their houses in order. They focused on their best-performing businesses, jettisoned businesses that weren’t performing well, acquired good businesses, bought back stock, and cut costs (by as much as 20% in the most recent recession, by our reckoning). S&P 500 companies collectively derive about 40% of their earnings overseas, which should enable them to capitalize on a global economy growing at an above-average rate.
According to David Hale Economics, companies are generating free-cash flow of $156 billion, a 40-year high. With the S&P 500 Index now trading at about 1,100, the prospect of per-share earnings of $100 would make the market look almost downright cheap, in our view.
The second catalyst: economic growth both here and abroad should exceed expectations. With inventories and capital spending rebounding from near-record lows, with the massive fiscal-stimulus packages of the world’s governments taking full effect (the ISI economic-research firm counts a total of 787 economic-stimulus policy initiatives worldwide since the credit crisis began), and short-term interest rates at zero, the U.S. economy could grow 3-4% this year. And we anticipate that the global economic growth rate could be higher, more than 4%.
The third catalyst: investor sentiment is neutral at best and rotten at worst. Stocks have pulled off one of their biggest moves in the shortest time (the S&P 500 Index is up 68% from its bottom last March to the end of 2009), and many investors are exceptionally skeptical about any further move upward. As a result, heaps of cash has been channeled into bond mutual funds, and many of the investors who have remained in the market during the rally are trying to protect their capital gains by buying puts. Quite simply, the market is climbing the proverbial wall of worry. We see all this and ask ourselves: “Who would sell stocks now who hasn’t already done so in the past 10 years?” Our answer: very few. Also, in our view, two recessions and two bear markets have made a young generation of investors extremely wary of stocks, perhaps forever. But a newer generation of investors may discover an asset class that’s so out of favor and, along with growing numbers of traditional stock-market players reentering the game, may bid shares still higher in 2010.
Monday, January 11:
Detroit Auto Show opens
Corporate Earnings: Alcoa
Tuesday, January 12:
International Trade (November)
Same-store Retail Sales (weekly)
Corporate Earnings: KB Home
Wednesday, January 13:
Mortgage Applications (weekly)
Federal Reserve Beige Book
Thursday, January 14:
December Retail Sales
Jobless Claims (weekly)
December Import/Export Prices
November Business Inventories
Corporate Earnings: Intel
Friday, January 15:
December Consumer Price Index
December Index of Industrial Production
January University of Michigan Consumer Sentiment Index
Corporate earnings: JPMorgan Chase