I. Introduction
For investors, 2008 was the annus horribilis, to borrow Her Majesty’s term. The implosion of an
obscure corner of the capital markets—securitized subprime mortgages—a year and half ago gradually led to a “credit crunch” (a liquidity crisis) that evolved into a financial (or solvency) crisis that in turn saw financial colossi fall to earth. Thereafter it became clear that, in a classic negative feedback loop, the pain had ramified far beyond the capital markets, as a recession now officially declared to have begun 13 months ago deepened and spread globally. Then, as if tragedy had descended into farce (however tragic for his victims), Mr. Madoff’s stock market Ponzi scheme was exposed, further sapping confidence and providing a Gatsbyesque punctuation to the end of an era.
The causes of this debacle have been explored a number of times previously in these pages but to
summarize: globalization, massive trade (and fiscal) deficits, enormous capital inflows, easy money and towering debt, technology and deregulatory zeal. Of course, those human constants—instant
gratification and greed—powered it all.
II. The Economy
As noted above, the current recession is now 13 months old, which makes it already longer than the last two and approaching the longest since the Great Depression—those of 1974-75 and 1981-82—at 16 months each. At this point it is likely to last two years or so. Third-quarter GDP growth was a relatively pain-free –0.5% (annualized), but consensus expectations foresee a very severe –5.0% annualized contraction for the fourth quarter. Similar declines must be anticipated over at least the first half of this year as a sharp rise in unemployment to over 7% and an unprecedented 3.1% quarterly drop in consumer spending (which is over 70% of GDP) have their full impact on the broad economy. At the crux of the financial crisis itself and also an important factor in the recession is housing. On th one hand, construction of new homes has flatlined in the face of a tremendous overhang of unsold homes (11 months’ worth), many after foreclosure. On the other hand, the average price of houses sold has fallen 23% from the peak and likely will decline another 10 percentage points or so.
The policy response to these woes has been rapid and in many ways unprecedented. The Federal Reserve has cut the fed funds rate essentially to zero and thus entered what economists call a liquidity trap but more colloquially is known as pushing on a string. Consequently, it has been forced to engage in open market transactions (“quantitative easing”) to introduce more liquidity into the system. Thus its balance sheet, which had run in the $800 to 900 billion range for years, has ballooned to $2.2 trillion and may yet double that amount. Meanwhile the Treasury has been trying to unfreeze the banking system by injecting some $350 billion of TARP money into banks’ balance sheets (and a few other members of the deserving corporate poor, like Detroit) though evidence of its success is scant. With monetarist (or Friedmanite) remedies essentially exhausted, the old Keynesian pump-priming rick, otherwise generally discredited, has been pulled out of the economists’ grab bag, and a massive fiscal stimulus is now inevitable. The numbers being bandied about are simply breathtaking, but expect them to approach and perhaps exceed the T-word in coming weeks. You heard it here first.
All of this frenzied government action, of course, began not as conventional remedies for a recession but as a prophylactic to prevent debt deflation. This is a panic form of deleveraging that can have catastrophic consequence as the real value of debt rises, making repayment more and more difficult and massive default and bankruptcy inevitable. Alas, given the scale of remedies applied or expected, eventual inflation is a given. The world’s appetite—especially China’s—for U.S. government debt is not infinitely elastic so higher interest rates and therefore higher prices throughout the economy are going to be the price that we will have to pay for their succor. At least our children and grandchildren will pay them back in inflated and thus depreciated dollars.1
III. The Capital Markets
It is obvious that despite a relatively auspicious outlook at the beginning of the year, 2008 produced a disaster of historic proportions in the capital markets. All asset classes and all sectors (save Treasury obligations and cash) were pummeled. From its peak in October 2007 the S&P500 stock index thus fell 52% a year later, the second worst decline in over a century. This despite the fact that corporate balance sheets and earnings were solid at the beginning of the year and stock valuations hardly frothy. It was not so much a bear market, whether cyclical or secular, as a panic of the 19th century variety. Either way it made the collapse of the tech bubble in 2000-01 look relatively benign.
Since late November, stocks have rallied 20% or so, and the market’s tone has improved marginally. Still, the historical record does not support hopes for an early full recovery. Thus, since WWII it has taken an average of four years to get back to the previous peak even though it can also be said that over the longer term a very strong snap-back typically follows the kind of panic that we experienced in late 2008.
It should also be said that the devastation visited upon stocks in this country and abroad was exceeded in degree in the corporate bond market. If stocks today are priced for recession, corporate bonds are priced for depression. In fact, investment-grade bond prices forecast unimaginable default rates simply because of the panic-stricken flight to quality that took yields on Treasury bonds to levels not seen since the Great Depression. Just imagine: today a 10-year Treasury bond pays a paltry 2.4% whereas in 1984, when inflation had been beaten down to 4%, a 30-year Treasury bond yielded a whopping 14%! In other words, 25 years ago investors had no faith in the Federal government’s ability to protect them from the ravages of inflation whereas today they see it as the only bulwark against the Armageddon of deflation.
After all the shock and awe, how damaged do stocks actually look? Relative to Treasury bonds they look very attractive, but that is only because the Treasury market looks like another bubble as for the first time in 50 years the yield on the S&P500 exceeds that on 10-year Treasurys—and by a wide margin. Relative to corporate bonds (even of the same issuer), stocks look less attractive simply because corporate bond yields were pushed so high in the credit crunch. On an absolute basis, current price-earnings multiples are not particularly cogent because corporate earnings are disappearing fast. Still, on a more “normalized” basis (which looks at prices in relation to average real earnings over, say, the last 10 years), they look fairly valued—the cheapest in 20 years. Yet it must be said that they do not look truly cheap.
After a classic panic, it may seem fatuous to speak of “sentiment,” which one might think would be horribly bearish now. In fact, for professionals sentiment is a contrary indicator, and from that
perspective it is quite positive now. No one has ever satisfactorily defined “capitulation,” a necessary purgative at the end of a bear market, but the fourth quarter of 2008 bears a strong resemblance. For example, volatility rose spectacularly as measured by the so-called VIX, known as the index of greed and fear. Thus, during the so-called Great Complacency it cruised along at around 15 to 20 (on a scale of 100) but then virtually overnight shot up to over 80. It has since retreated to around 40, which is at least neutral.
More positively, there is massive cash on the sidelines. Thus after large-scale net withdrawals from stock and bond mutual funds, 37% of total fund assets are now parked in money market funds. Also, while it is not possible to measure the phenomenon (because hedge funds2 are not legally required to disclose their holdings), it is likely that they are sitting on large amounts of investable cash at this point as a result of their tremendous deleveraging, much of it from forced selling due to the combination of collateral calls and redemption notices.
So, there are grounds for hope but none for a quick recovery. We face a significant period of
consolidation—for the binding up of wounds and the making of penance.
Jerome W. Anderson
January 9, 2009
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