Third Quarter 2011 in Review: Not a pretty picture

Posted on Posted in Newsletters

Well, the numbers are in for the 3rd quarter of 2011, and they’re not pretty. Just about everything declined, including stocks, most types of bonds, commodities, real estate and hedge funds. The only assets that rose in value were government bonds of creditworthy countries — such as the US and Germany — and gold (although even the latter has fallen -16% since its August peak).

As of the 3rd day of the 4th quarter, global stocks as measured by the MSCI All-Country World index are now in bear market territory, down -20.8% from their May peak. Yesterday, US stocks briefly breached the -20% decline that arbitrarily defines a bear market, before recovering sharply. As of today, the S&P 500 is down -16.3% from its spring high.
Interestingly, Monday’s sharp drop in equity prices occurred in the context of surprisingly good news on US manufacturing and auto sales. This is typical of the late stages of corrections, when selling takes on a life of its own. Based on the length of time since the decline started and the size of the drop so far, we appear to be in the final throws of the correction. Could yesterday have represented the ultimate bottom? Only time will tell, but it did look suspiciously like the kind of selling climax that often signals the end of a correction or bear market.
But be warned: price swings could continue to be fast and furious before stocks finally rebound for real. Remember also that once stocks start upward in earnest, they will likely continue to levitate even in the face of what would normally be considered bad news. This is because stocks anticipate rather than react, and why listening to today’s news can be so confusing as you watch stocks move in response to news that won’t be aired for several months.

2011 = 1998, ≠ 2008 (or: Greece is not Lehman Bros.)

This year’s correction continues to resemble the one in 1998, when investors feared the consequences of a collapse of Long Term Capital Management (LTCM), the huge hedge fund, and a debt default by Russia. LTCM was saved, but Russia did default. Global markets briefly fell about -20%, while the Russian stock index dove -93% over 14 months. While it took the Russian stock market nearly 5 years to recover, stocks in the rest of the world reclaimed their prior highs in only 6 weeks.

Today, we’re seeing something similar with Greece. If they default, the effects on the Greek economy will be long lasting, but the rest of the world should get over it surprisingly quickly. People are always fighting the last war, so they think that a Greek default will cause a repeat of what happened in 2008 after the Lehman Bros. bankruptcy. But the differences are far greater than the similarities:
1.The actual losses on Lehman Bros. were significantly larger than the potential write-downs from Greece, even in a worst-case scenario. Lehman had $613 billion of debt, which lost about 90% of its value immediately after the bankruptcy filing, for initial losses of $550 billion. Greece has $360 billion of total debt, with European governments, the IMF, the ECB and euro-zone national central banks holding just over half. At a write-down of 60% (which would reduce Greece’s debt to the average among nations), the total private loss exposure would only be about $108 billion, less than 1/5 the size of the Lehman losses.
2.Banks, corporations and the global economy are in much better shape now than in 2008. And mechanisms are already in place, or about to be in place, to cushion the blow through liquidity injections, bank recapitalizations, central bank loan facilities, and the like. In other words, TARP-like programs will be ready to roll before any default, rather than after the fact as with Lehman.
3.A big part of the damage from the Lehman bankruptcy came from losses in money market funds, with one very large one “breaking the buck” as a result of their exposure to Lehman. There was a run on these funds similar to a run on banks, and the US government needed to create an FDIC-like guarantee to stem the withdrawals. Today, no money funds have exposure to Greece, and most have removed any exposure to European banks that might be hurt by a Greek default.
4.Another major contributor to the damage post-Lehman, and the primary driver of the dramatic fall in the prices of stocks and other assets that occurred in the weeks following Lehman’s fall, was forced selling by hedge funds, banks, investment banks and other leveraged institutions because they had to rapidly reduce their borrowings. Today, systemic leverage is far less than it was in 2008, so forced selling is unlikely to occur.
5.Lastly, no one really expected the US government to let Lehman go down, assuming they would rescue it as they did with Bear Stearns and subsequently with AIG. And indeed they tried. So the sudden demise of Lehman came as a surprise. A default by Greece in the next several weeks will likely be the most anticipated bankruptcy in history, as investors have been preparing for it since spring of 2010.
All this being said, I actually don’t think the Eurozone will let Greece default, at least not in the traditional fashion. And they seem prepared to shore up their banks as needed, as well as helping Italy come to grips with its own financing problems. (Though Italy is far, far larger than Greece, it is also in dramatically better shape for a long list of reasons.)
No Double Dippin’
The second issue weighing on the markets lately is fear of another recession, or a “double dip.” We’ve been hearing about this periodically ever since the last recession ended in Q3-2009. While the Eurozone does seem to be at some risk of another recession within the next year, neither the US nor most other countries are anywhere close. Don’t believe me? Look at the data:
1.Consumer spending, and even more importantly, business investment, continues to rise, even during the current market turmoil. For example, chain store sales are up about +3.5% from last year, hotel occupancy has risen +4.1% and rail traffic is +3.8% higher than a year ago.
2.Both industrial production (up +3.3% in the past year) and other measures of manufacturing and service output continue to expand. Recent Purchasing Managers Indexes have been significantly higher than expected and indicate continued growth in the months ahead.
3.Layoffs are decreasing and hiring is expanding, although the pace is obviously slow. Last week, unemployment claims were the lowest since May 2008.
4.The Conference Board’s Leading Economic index, which has a decent track record of predicting recessions, is no longer falling; in fact, it recently started rising again. And it hasn’t been near recession territory since late 2009. See the graph below:

The stock market also has a good record of predicting recessions; there has never been a recession without a prior or concomitant decline in stock prices. However, there have been many instances when stocks declined, sometimes sharply, without a recession following. Years when stocks fell more than –10% but the economy continued growing include 2010, 1998, 1994, and 1987. I expect to add 2011 to this list once the GDP data are in for the next few quarters.
In short, I don’t see a recession in 2011 or even in 2012. After that, I have no opinion; it’s too far in the future.
It’s a Numbers Game
When things get bad, or people fear that things might get bad in the near future, investors tend to sell “risk” assets (stocks, commodities, lower-rated bonds, real estate, etc.) and buy “safe” assets (most often US Treasuries and sometimes gold). When the majority of investors are crowding into the same trade, prices can move very quickly (volatility increases) and overshoot or undershoot fair value, sometimes significantly. But at some point, rational investors step back and more calmly assess whether prices reflect reality. At that point, asset prices move back toward fair value and volatility rapidly decreases.
That’s what will happen when this correction finally comes to an end. And my own calm, reasoned, and slightly geeky analysis of asset prices tells me that stocks today are way too cheap and government bonds way too expensive. I’ve said this before, but things are even more out of kilter now.
I’ve got lots of numbers to back up my contentions if you wish to see them, but I’ll give you a couple of examples here.
Stock prices, as measured by the S&P 500 index, are now fairly valued only if you assume that we’re about to enter a major recession that will chop corporate earnings by over –30% (as happened in the 2001 recession) and subsequent long-term GDP growth averages a miniscule +0.5%.  If you assume instead that we’ll avoid a recession and that long-term GDP growth will be a more reasonable (but still historically low) +1.8% (what the IMF expect over the next 6 quarters), then stocks are undervalued by a whopping 55%!
I’m not saying that stocks will double if we avoid a recession, because fair value will decline once interest rates go back up. But it does suggest that prices are significantly out of kilter with the most likely reality.
Yesterday, 10-year US Treasury bonds yielded 1.78%, the lowest since the beginning of time (or at least since the US government started issuing bonds). Historically, these bonds have returned +1.8% after inflation. Do you really think inflation will nonexistent for the next decade? I don’t, either. So people buying these bonds are locking in a guaranteed loss of purchasing power over the next 10 years.
Lastly, dividend yields on stocks are now higher than on 10-year Treasuries (2.4% vs. 1.8%). We were almost there last time I wrote, but since then stock yields have risen and bond yields fallen. Dividends typically rise at the rate of economic growth plus inflation, and may increase faster than that over the next decade because companies are paying out a much smaller percentage of earnings than they usually do. Even if you’re a stock market bear, why go for 1.8% with zero growth potential vs. 2.4% with a good chance for an increase in both the dividend and the price of the stock?
The last time stocks yielded more than bonds was in 1958. But if you use an adjusted dividend yield that accounts for today’s low payout ratio, you have to go back to 1954 to find a higher spread than the current 2.95%. People weren’t too sanguine about stocks in 1954, either (which is one of the reasons then, as now, that dividend yields were so high relative to bonds). But they should have been. Over the next 10 years, the S&P 500 returned +15.9% per year. This means that $10,000 grew to $43,554 in just one decade. Will the next decade be similar? I’m definitely in the minority in thinking it will be!
Stay calm and stay rational. You’ll be in a very exclusive club if you do.
PS Trivia!
1.What was the real US GDP per capita in 1954 and 1958? What is it today? (I have the data in 2005 dollars.)
2.What were the top 3 songs in 1954 and 1958? (I don’t even care what they are today!)


Dr. Ken Waltzer MD, MPH, AIF, CFA
Founder and President – Kenfield Capital Strategies (KCS)

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