Posted on July 8, 2008 by David Laidlaw
.....but, there are very few positives to report regarding the equity market or the broader economy. The residential housing market continues its descent as indicated by the most recent statistics. The Case Shiller Index which tracks housing prices across 20 of the largest metropolitan areas in the U.S. declined by 15.3% in the past year and 17.8% since the peak of the housing market in July of 2006. We do not believe that real estate price levels have to increase before the stock market rallies, but prices must stabilize since housing is still the largest asset on many families’ balance sheets. Similarly, our banks and financial institutions are still taking massive write-downs and scouring the world for capital to strengthen their balance sheets. In a research report last week, Goldman Sachs predicted that Citi will take additional write-downs worth $8.9 billion which adds to the bank’s total of $42.9 billion to date. These write-offs require the banks to raise more capital to support their liabilities which are not shrinking fast enough. The financial services sector operates as the circulatory system for the broader economy. Banks and brokerage firms provide financing to those sectors which need funds similar to the manner in which the blood provides oxygen, nutrients and hormones to various organs and cells in the body to carry out their specialized functions. Without the targeted and steady delivery of financing, the economy suffers.
The economy has yet to contract according to data on the Gross Domestic Product which grew at about a 1% annualized rate during the first quarter of the year. The second quarter results will most likely show growth rather than contraction due to the stimulus provided by the rebate checks. Even though this resiliency is impressive given what transpired in March, job losses are mounting. The U.S. economy has shed jobs each month this year with total losses equivalent to 438,000 net jobs lost. Consumer sentiment is at its lowest levels in a generation and prices for everything are rising.
Oil now trades for about $140/barrel which is roughly twice its level from last year. This increase has led to general price inflation as transportation costs and everything linked to the food industry has risen dramatically. Headline inflation (including food and energy costs) is now running about 4.2% year over year while core inflation is up a relatively tame 2.3%. Certain economists discount the importance of this current inflation because it is driven by commodity price increases. However, we do not believe it is a given that prices for everything will come down if energy and commodity prices decrease. Even if oil decreases in price, the expectation among the population that prices for all goods and services are headed higher is self-reinforcing and could lead to continued higher prices in the future.
Congress and the Federal Reserve are limited in their ability to confront the current economic malaise. The tax-rebate checks provided a short-term stimulus, but the effect of this initiative is waning. After lowering interest rates and lending to a much broader array of financial institutions, the Federal Reserve was able to prevent more systemic failures in the banking system. The Fed’s recent focus has been talking tough regarding inflation to prevent future price increases. However, the Fed’s current options are unattractive. If the Federal Reserve were to reverse course and raise rates to support its rhetoric and strengthen the dollar, banking stocks would decline even further. More banks would fail since the interest spreads they earned would decrease and they might not be able to meet their liabilities. On the other hand, if the Federal Reserve does not raise interest rates inflation will probably increase and the Fed’s credibility will be degraded.
In the face of all of these negatives, there are a few positives. Common stocks are generally inexpensive compared to historical levels and other asset classes. Ignoring the disastrous earnings from the financial sector and a handful of companies without earnings suggests that the earnings yield on the S&P 500 is about 7% based on 2008 estimates. This yield is 75% higher than the yield on the 10-year Treasury Note which stands at approximately 4%. Comparing the earnings yield to the yield on the Treasury Note is the basis for the Fed Model. The theory is that stocks are attractive when their earnings yields are higher than the yield on 10-year Treasury Note. The model also predicts that bonds are more attractive when the opposite is true and the yield on the Treasury Note is higher. We believe there is validity to this model and that stocks are undervalued now.
Our strategy is to remain fairly defensive for the time being. We will continue to buy stocks when our valuation models suggest that specific equities are undervalued even given the protracted economic problems ahead. We do not want to buy bonds or raise cash at this time since the markets will rebound when any of the problems indicated above begin to stabilize.