Green Shoots & Crabgrass

Posted on May 22, 2009 by David Laidlaw

There has been enough evidence recently to determine that the worst strains in the financial system are behind us.The results from the government’s stress tests indicated that the largest banks needed to raise about $75 billion in capital. After a flurry of activity during the past week, those banks have already raised over 75% of that amount including the $13.5 billion stock offering from Bank of America earlier this week. The fact that private investors are risking their own money is a very positive sign that the crisis has passed. Three-month LIBOR rates are down in the 0.6% range from over 2% last year and banks are lending to each other and not fearful that their short-term loans will notbe repaid.

Measures of volatility have also decreased markedly.The VIX (a volatility index derived from futures prices) is trading at about 30 which is lower than any time since Lehman Brothers went bankrupt in mid-September 2008. In November of last year, the VIX reached 80 and the index was as high as 50 earlier this year. For reference, the long-term norm is a reading of 20.

Finally, oil prices have almost doubled to about $60 per barrel from their levels earlier in the year. Commodity prices reflect expectations regarding future demand and supply. Assuming supply is flat to slightly higher, the market is indicating that it expects demand to increase as the global recession abates.

We are bullish, but not unreservedly so given continued areas of concern.Even though the rate of increase in unemployment has slowed, high levels of applications for unemployment suggest that the level of joblessness in the population is increasing. These increases will dampen consumer spending and the overall economy. Our trading partners are also in bad shape as depicted graphically on the front page of this morning’s Wall Street Journal. Japan and Germany’s export driven economies contracted at over 15% and 14% per annum respectively during the 1st quarter of 2009.Crippled by the global recession and the early stages of the H1N1 virus, Mexico’s economy contracted at an annual rate of over 21% during this period. These numbers indicate that US exports will slow since our trading partners will not have the resources to purchase goods and services from us.

Even though stocks have rebounded 30% since the lows reached in early March, we expect long-term returns from stocks from their current levels to be superior to the alternatives (cash, bonds, real estate etc.). However, if last year’s losses caused too much anxiety indicating that a lower risk profile is more appropriate,then it would be prudent to reduce your equity allocations now. This change would lower risk, but also decrease potential investment returns going forward.