Despite Fears, Recession Could Be A Healthy Correction

The recession worries that we have held for quite some time have now engulfed Wall Street. Last week, stocks took a pounding to start 2008 after two key economic reports for December pointed to recessionary conditions. Last Wednesday, the Institute of Supply Management’s [ISM] Manufacturing Index plunged to its lowest reading since April 2003 recession, and Friday's employment report for December was the weakest since July 2003.

The stock market, which leads the economy, in many ways already reflects a recessionary, or stagflationary, environment. Although the S&P 500 is only 10% below its 52-week highs, a number of sectors of the market, such as banking, real estate, and consumer discretionary, have suffered much deeper losses and are already in bear market territory. As an indication of the poor "internals" of the stock market, only 32% of the stocks listed on the New York Stock Exchange are currently trading above their 200-day moving average (a measure of intermediate term trend).

We view this recession (we’ll go ahead and call it that even though the official government figures may never ultimately confirm GDP contraction because of the systematic under-reporting of inflation) as a healthy process of correcting financial and economic excesses. In the most recent expansion, these excesses principally occurred in the financial and real estate sectors, which is where the greatest pain is now being felt as excesses are unwound.

What are the implications of the present stagflationary environment for stock prices? In the near term, it is difficult to see how the broad equity market can prosper while earnings expectations are adjusted downward to reflect economic realities. However, three factors will limit the downside: (1) the investing public is already quite pessimistic, which is bullish from a contrary opinion standpoint; (2) the Federal Reserve will continue to cut the Fed funds rate and take other measures to relieve the credit crisis; and (3) investors will increasingly conclude that falling money market yields and the meager yields on investment grade bonds do not compensate for inflation risks and will maintain (and increase when the news backdrop improves) commitments to stocks.

So while we expect the stock market to remain challenging and volatile, looking out over the balance of 2008, and in light of the damage that has already occurred, we can envision as much, if not more, upside as downside in stock prices. With respect to the S&P 500, we see downside risk to 1300 and upside potential to 1600. (Friday’s close was 1411) We think small-caps, which are now 16% below their 52-week highs, still have greater downside potential, and would continue to orient portfolios towards larger-cap stocks.

With respect to international equities, we would make the following observations:

1. Emerging markets economies will, in all likelihood, decouple from the U.S. and other developed regions in terms of economic growth, but their stock markets will not. Emerging markets stocks have strongly outperformed for six years now and have produced a total return of over 450%. As a consequence, the asset class has become over-exploited from an investment standpoint. Investors should be careful about buying dips on the assumption that E/M stocks will quickly make new highs, as has been the case over the past several years. Whereas the S&P 500 is trading near its 52-week lows, E/M indexes are 40% above their 52-week lows. Even when adjusted for their superior growth and massive currency reserves, emerging markets are no longer cheap on a relative basis. An additional looming risk is a correction in the price of oil, which seems likely in the months ahead. In short, investors should be selective about adding to core E/M positions. With respect to the emerging markets position in our portfolios, we are making a fund substitution this week, replacing the iShares ETF (EEM) with the Vanguard fund (VWO) that tracks the same index. Through better index tracking, VWO outperformed EEM in 2007 by over 400 basis points, and has an expense ratio of 25 basis points versus 74 basis points for EEM.

2. The out performance of European developed markets stocks in 2007 was entirely driven by the appreciation of the Euro versus the U.S. dollar. At 1.48 USD/Euro, we view the Euro as overvalued and expect a correction of 10% or more in 2008, which would be a drag on the performance of stock (or bond) holdings denominated in Euros or related currencies (e.g. the Pound).

If the Euro does correct to the downside versus the U.S. dollar in 2008, as we expect, it will likely create a better buying opportunity in gold than exists today. Gold had a great year in 2007, with 31% appreciation, and has gotten off to a strong start in 2008, but given that we foresee a correction in both the Euro and in the price of oil, both of which are highly correlated to gold, we would advise being patient and selective with new purchases of gold.

One asset class that attracted our attention after last week’s stock market carnage is REITs. REITs had a large correction in 2007, dropping 17% in value, and lost an additional 8% in the first week of 2008! REIT indexes are now yielding approximately 5.5%, which is up from a trough yield of 3.8% reached in January 2007. Relative to 10-year Treasury yields, REITs are trading at a positive yield spread of 150 basis points, the most attractive level in over three years. Hence, asset allocators taking a more passive approach to allocation decisions can now re-enter the asset class at reasonable relative valuations. We are going to hold off on adding a REIT position to our model portfolios, however. On an absolute yield basis, we’d like to see REITs above the 6% level, and we believe that is a realistic expectation given that real estate is likely to remain out of favor with investors and Treasury yields are likely to move higher in 2008.

Comments

[lefty]

J.D. ! The stock market does NOT run or lead the economy. Personal cash flow does. This countrys economy would crash if the general public did not pay income and sales tax. A large, public, company, powered by robots and no employees, would make a ton of money while the country goes broke.