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“Time, Why You Punish Me?”

Posted by Larry Doyle on January 8, 2009 2:22 PM |

I have tried to highlight that markets correct by price and time. While the National Bureau of Economic Research (NBER) has pinpointed that our current recession started in December 2007, the downturn clearly accelerated after the failure of Lehman Bros. in mid-September. You do not need me to remind you that our equity markets were down 35-40% last year.

Against that backdrop, the question on everybody’s mind is how quickly can the incoming Obama administration turn the economy around. A question I receive from friends and former colleagues is “how long” will this last. Wall Street insiders are in the business of selling products so throughout 2008, and from what I see so far in 2009, they are hedging on what I believe will be an extended downturn.

I am an optimist by nature and not one to promote a doom and gloom scenario, but let’s look at the cards that are already on the table and review past recessions that were financially driven rather than manufacturing driven. Let’s also look at forecasted earnings and what they portend for our equity markets.

I. Fed Outlook Darkens on Economy
The minutes from the December meeting of the Federal Reserve were released yesterday. In those minutes, the Fed governors highlighted “the recession could be longer and deeper than officials previously thought with unemployment rising into next year and inflation slowing substantially.”

The Fed has “sharply” reduced economic forecasts for 2009 and increased projections of the unemployment rate to north of 8%. Thus, this outlook supports the Fed’s statement that the Fed Funds rate will remain between 0 -.25 for an “extended” period.

These revised projections are no surprise to me or those who have been following my pieces. However, I believe many equity market participants are clearly and mistakenly underestimating the weight of the Fed’s statements.

In listening to many market participants and so called Wall Street veterans talk about how this economic turmoil compares to 1998 or 1994, I am reminded that the growth on Wall St. in the last decade coincided with the hiring of a lot of quantitative analysts who graduated from undergraduate and graduate programs in the mid to late ’90s. Well, those models in the black boxes aren’t very helpful right now.

Let’s go back to earlier times and review what occurred in previous economic crises that stemmed from banking and financial meltdowns.

II. “Aftermath of Financial Crises” by Rogoff and Reinhart
In the midst of ongoing reading and research, I was fortunate to come across a presentation prepared by Professor Kenneth Rogoff of Harvard University and Carmen Reinhart of the University of Maryland, entitled “Aftermath of Financial Crises.”

This work reviews a total of 18 banking crises which led to economic recessions since WW II. They put particular emphasis on 5 of these crises: Spain in 1977, Norway 1987, Finland 1991, Sweden 1991, Japan 1992. Each of the crises they studied share three characteristics:

1. Asset Market Collapse
Housing price declines averaged 35% over a 6 year timeframe. Equity price collapses averaged 55% over three and a half years.

2. Declines in Output and Unemployment
Output declines from peak to trough on an average of 9% with a duration of roughly two years.
Unemployment rises on average 7% over a 4 year time frame (they discounted this figure somewhat by a rise in unemployment in emerging economies…they projected a figure of 5+% for developed markets).

3. Government Debt Explodes
Government Deficit increases on average 86% primarily due to a collapse in tax revenues and not an increase in government bailouts (although, the world has never seen the types of bailouts currently in place here in the U.S).

A few other highlighted points in their report:

— Each of their case studies focused on individual countries because we have not had a global recession of the type we are now experiencing. The fact that it is global will inhibit the ability for the recession to be mitigated by increased exports from any one country.

— While the U.S. is now using a whole set of new stimulative tools (the quantitative easing tools we have discussed), we also need to appreciate that we are fighting a battle that has been exacerbated by the use of new tools which were supposed to moderate risk but actually accelerated risk, that being CDS (credit derivatives).


So, what does all this mean for our economy and markets? The equity markets try to reflect the forward economy and forward earnings. In regard to earnings, we have seen earnings expectations from analysts generally overly optimistic. Again, most analysts work for money managers who want to raise funds not lose them. For that very simple reason, we respect Meredith Whitney so much. She tells it like it is.

A broad based average of analysts’ expectations for earnings on companies in the S&P 500 has come down from the $80 range to now the mid $40s. Given the S&P is now trading at 915, that represents a multiple of approximately 20 times earnings. That is not cheap, in fact it is rich by historical measures. Thus, we need an earnings surprise or a price correction.

In summary, I view the Fed’s outlook as accurate although I think they are a little late in their assessment. I will somewhat discount Rogoff’s and Reinhart’s work due to the emergence of new technologies, but I need to respect their opinion that this being a true global recession strengthens their case. Earnings expectations truly concern me. One final point, just this very morning PEBO indicated that we will have trillion dollar deficits for an extended period.

Given these views and outlooks, I believe a best case scenario for the equity market is that it merely marks time and does not further retract. I have a very difficult time making a case for a rallying equity market. I am more in the camp that we will likely retest the equity lows seen on November 20th. We may penetrate those lows by another 8-10% which would bring the S&P into the 700-725 area from its current level of 915. I do believe the prices in the corporate bond market, including the high yield space, largely reflect the concerns highlighted above. I also believe that despite the Fed and Treasury purchasing government and mortgage debt, these rates will end up much higher at the end of this year than they are now simply due to the growing deficit. A move higher in these rates will potentially cause further anguish within the equity markets.

For today’s price action which encapsulates some of the points highlighted above, read the “Market’s Decline Deepens.”

“Can you teach me about tomorrow
and all the pain and sorrow running free?
Cause tomorrow’s just another day
and I don’t believe in time
Time, why you punish me?”

— Hootie & the Blowfish


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