Monthly Market Review: November 2008

Years from now, when reflecting on November 2008, the likely memory will be: recession to the left of us, recession to the right of us, recession all around us. Many events made news during the month, but November 2008 was all about the “R” word. Specifically: Are we in a recession? How long have we been in the recession? How deep will the recession go? How long will the recession last?

For inquiring minds, the official answer came the first day of December 2008, when the National Bureau of Economic Research announced America entered recession in December 2007. While that addressed the first two questions, answers to the remaining two are still in debate, which will dictate the market moves. Based on the consensus forecast, the current recession would persist until mid-2009, implying the recession we are in would be the longest since the Great Depression.

It is interesting that the two most severe recessions since WW2, and this current one all involve sharp increases in the prices of oil that disrupt or tip an economy with some fundamental flaws.

During both the ’73 and ’81 recessions, oil prices increased significantly prior to the start of each downturn. The ’73 recession witnessed Arab states’ launch of an oil embargo to punish the United States for supporting Israel during the Yom Kippur war. The ’81 recession was preceded by sharp oil price increases resulting from the Iranian Revolution in 1979. In both cases the economy had fundamental flaws waiting to be exploited by an outside factor – its reliance on oil supplies from a fundamentally unstable part of the world, which played the role of economic de-stabilizer very well. It is also interesting to note that, prior to these recessions the US Dollar had been consistently weakening against major currencies.

The same situation seems to be at play today. Our flawed economy today (over leveraged), encountered a drastic increase in oil prices it could not overcome. Similar to the past recessions, the US Dollar has been consistently weakening entering the December 2007 start of the current slowdown. It may be wise for market participants to keep an eye on the dollar in the future for signs of weakness, as a weak currency tends to translate sooner rather than later into a weak economy. While every recession is different, the following table summarizes some of the key statistics from the ’73 and ’81 recession and what we know about today’s economy.

Sources: Federal Reserve, Bureau of Labor Statistics, Inflationdata

This current recession is very different from the previous ones in that although we don’t yet have high inflation or unemployment, the credit crisis and the shaky well being of financial companies are threatening basic functions of economic flows, as businesses and consumers are denied loans and thus cannot conduct normal operating or purchasing activities. This is resulting in sluggish demand and limiting economic growth. Therefore it is no surprise that the auto industry is facing such an emergency, and the Big Three are begging for money on the hill.

Although the US recession only became official on Dec 1, 2008, the stock market has been screaming about a long, and severe recession for months. The chart we found by Doug Short (www.dshort.com) shows how the current market has slumped further and quicker than any other bear market with the exception of the Great Depression. If past bear markets tell us anything, it seems the current bear market will be around a little longer. However, as some might argue, capital moves much quicker now in the information age, and we might reach our bottom much earlier than during past recessions. Alternatively, others argue that faster capital movement and the increased derivatization of the capital markets could also lead to further losses before things start to turn around.

While Recession was the production for November, the show had many interesting side plots full of:confusion, anxiety, drama, highlighted by: the Big Three CEOs flying via private jet to Washington begging for money, the Citi bailout, and the free fall of oil prices.

Big Three Asking for More Money: It has been a while since AFG’s default valuation framework concluded GM and Ford (F) shares were worth no more than nil. Those companies owe more to their employees, as a result of generous offerings of post retirement benefits, than they do to the debtors that financed their businesses. Even if it is true that the compensation for working employees is comparable to their foreign competitors, as management claims, the two companies’ legacy liabilities may ultimately drag the them to their final demise.

The common wisdom is that Americans don't want to see those firms disappear and are willing to help, but the firms need to show a set of plans that bring fundamental changes to their cost structure, which have a real chance for success. Concessions from workers, vendors, dealers, and management must be made. Debt holders and UAW must work together with management to reduce debt significantly. Lastly, operations must be slimmed down and vehicle line ups must be cut further.

Our view on this issue is simple. We don’t have a problem with companies paying workers well, and we encourage it. However, we strongly encourage such compensation to take place through incentives for workers to make companies stronger and share the resulting upside. Have a fair base salary and benefits, then put incentives on the table for every employee to want the company to succeed. However, the key is that companies must be able to afford such payments through value creation and worker productivity. It is not the responsibility of a taxpayer in Florida earning minimum wage to support UAW workres earning multiples of what he makes.

Citi Bailout: It was a sad day when Citi’s (C) market cap dropped to $20 billion, and the US government had to intervene to ensure the existence of this American icon and the symbol of global capitalism. With a history dated back to 1812, it took Citi just a little more than a year to fall from being the world’s banking crown jewel to court jester. While the Citi bailout proved the “too large to fail” theory true, it only rattled deep concerns that big banks may be also too large to succeed and are pitless holes for taxpayer dollars. Investors had thought the large banks were well capitalized after the $125 billion capital injection from the Treasury through TARP, but the Citi fallout has quickly proved that assumption likely naïve. Banks’ major problems, namely depressed asset prices, increasing credit losses, shrinking capacity to fund and lend see no signs of improving, which portend poorly for the overall economy.

Oil Price: Crude oil continued to fall in November. Oil was $100 a barrel in July, is $46 a barrel now – While the rise in oil prices partly triggered this recession, a fall in oil prices will not be enough to end it. Though declining gas prices helped improve consumer confidence in November, it was not nearly enough to boost consumption as consumers grapple with massive layoffs, slumping home prices and dwindling retirement funds. Oil’s sharp and quick fall is signaling a prolonged recession in developed countries.

On a positive note, President elect Obama has assembled an excellent pro-growth, pro-free trade economic team. His choice of Hillary Clinton as Secretary of State, retired Marine Gen. James Jones as national-security adviser, and retaining Robert Gates as Defense Secretary also suggest a more centrist approach to national defense issues than what his campaign had been preaching. To tough through this economic crisis, we need a pragmatic and capable government that can keep the country safe and adopt right policies to preserve free market principles and stimulate production. It is encouraging that our new president is moving in that direction.

Fear has dominated the investor mindset and when we look at the factors driving returns in the past month, the past quarter and the past year. We find price momentum, dividend yield, and financial leverage are the most powerful factors. Investors found comfort in stocks with high dividend yield, low leverage, and bought into the theory that “stocks do well for a reason” by chasing stocks that have done well. In addition, investors also stayed away from companies with poor earnings quality, as those stocks consistently underperformed their universes in different time horizons. (Please refer to page 10, 11 of the full PDF book - click here to access and download)

Our belief is that it is almost impossible to time the bottom but fortunately the important issue is not finding the bottom but finding the point at which as investors we can earn superior returns. If you missed our recent look at this topic, please refer to Investor Psychology and Market Expectations, and Then and Now: Buyer Remorse Versus Sellers Loss, where we discuss this concept in greater detail. The bottom line is that while the emotional cost of commiting capital is very high today, the financial environment has become much more attractive and investors who are willing to take an intermediate perspective and invest now and/or over the next few months in stocks with attractive valuations are likely to be rewarded very nicely in the years ahead.

In an upcoming study the AFG research team is conducting which analyzes recent market corrections, we found that valuation generally doesn’t work very effectively entering a sell-off, but delivers superior long-term results on the way out and beyond. (Look out for this in an upcoming email.). Try as much as we could to avoid presenting this part of the review, we could not omit it, so please do not shoot the messenger. Returns from Oct 31 to Nov 28, 2008 are the following:

Comments

[public13:]

I'm curious...I keep seeing the term "consensus forecast" bandied about, but I never see it sourced anywhere. Where do are these forecasts kept, or do people just take a swag at some number based on what other stories they have read lately?

2008 Dec 05 11:52 AM