As I type from my home in Houston, not too far from where Hurricane Gustav made landfall yesterday, I thank God that the storm didn't prove to be as bad as feared. Certainly, given the proximity to the devastation of Hurricane Katrina three years ago, it isn't surprising that the residents of New Orleans fled en masse, following the instructions of the government.
I can't help but draw the analogy to stock market investors today: Are we so close to the devastation of the 2001-2002 Bear Market that we are petrified of the current economic situation? After all, as I wrote in March, "Rarely in our lives has the stock market had such a puny return over a decade." I warned in that article not to let the many references later this year (now) scare you out of the market. I believe that the perfect storm that has pushed the market back down to its levels 10 years ago, but not the lows of the decade, is closer to the end than the beginning.
It is very easy to be bearish these days if one reads the popular press. I don't deny the gravity of the economic situation, including the fragility of our financial system. We are enduring a challenging confluence of headwinds, including the deleveraging of an overextended banking system (which goes well beyond the "traditional" banking system) and overextended consumer. The perfect storm began to brew as the government reacted irresponsibly to the situation, using its assault on the level of Fed-Funds as its only weapon and thereby cheapening the dollar.
I was extremely bearish a little over a year ago, when I confessed not knowing the end game but expecting that "President Bush will have to deal with the government takeover of Fannie Mae (FNM) and Freddie Mac (FRE)." We are very close to the end of defining the extent of the mortgage problem, as the GSEs sit at the very top of the food chain and very distant from the unheard of sub-prime originators that the market mistakenly assumed in early 2007 were the only bad apples.
I don't know how it will be resolved, but I own a small amount of FNM shares, believing that in the end that the government will recognize that it is more important to continue the charade of its off-balance sheet accounting for mortgage guaranties and keep the mortgage credit spigot open. But, that is really an aside. The bigger issue to me is where we are in the economic cycle. After all, if the largeness of the problems is now almost fully known, then it is likely that equities fully discount them.
While it is easy to be bearish reviewing the headlines, it seems easy to get somewhat bullish looking beyond them. Here is what I see:
- Stocks are a good value
- A bottom appears to be in place
- The inflation threat appears over
- Employment has remained buoyant
- We may not need "Stim 2"
No matter what metric one uses, the debate about stocks isn't that they are or aren't cheap, just that they could get cheaper. The typical very large stock trades at just 13-15X forward EPS, quite attractive in a 4% risk-free rate for the next 10 years and still so incorporating corporate bonds. As one can see in the chart below, valuation is not a constraint to investing in stocks.
I was somewhat surprised by the weakness in the early summer, but I believe that the market put in a good technical low in July. Of course, the low volume has made it difficult to really trust it at this point, but several other aspects encourage me, including the relative strength of small-caps, the transition of leadership away from Energy stocks and the fact that Financials appear to have a good low too. While we are certainly not in an uptrend, it is worth noting that the move from the peak to the July low wiped out about 46% of the move from the lows of 2002 to the peak in 2007, consistent with typical bear markets. The Russell 2000 chart looks much more bullish, with a solid double-bottom that was tested and now crossing/rising moving averages.
As I mentioned earlier, I was very concerned a year ago about what I feared would be an inflationary response to the popping of the housing bubble. Sure enough, Bernanke acted for quite some time as though he had nothing in his artillery except the Fed Funds rate. In March, though, things began to change, with the focus shifting towards dealing with the real problems. While we can all argue about whether or not the liquidity efforts of the Fed or Treasury were effective, I believe that we can all see that the tone changed when Bear Stearns collapsed.
As I have conveyed in the past, there is no interest rate that can induce people to lend when they expect not to be repaid. The cheap dollar strategy fanned inflation fears and caused speculative interest to shift to commodities, especially oil. What a terrible time to have an energy spike! Our sluggish economy should have seen pressure against rising prices, but global demand (or perceptions) obfuscated domestic reality. There are many theories to explain currency exchange rates. I find it astounding how volatile the relationship between the dollar and the euro has been and challenge anyone to use purchasing power parity or any other theory to justify it.
In any event, it looks like the long slide in the dollar and the inexorable climb in oil (and other commodities) is over, freeing the hands of the Fed and reducing the likelihood of rate hikes, which would be the wrong signal. If I had to guess the value of the Euro and the price of oil a year from now, I would suggest $1.25 and $80. While I don't think those levels are necessary for the market to do better, I am confident that they sure would help a lot.
I believe that one of the more interesting aspects of this slowdown/recession has been how jobs have held up despite some obvious challenges. I am not surprised, as I have previously mentioned a couple of dynamics that are restraining job-slashing. First, companies haven't really hired that aggressively, choosing instead to invest in technology to boost productivity. Second, many companies learned in the last recession how difficult it can be to regain workers after trimming back. More than ever, in our service economy with its need for high-skilled information-based workers, companies can't assume that the talent pool will always be there when they need it.
As one can see in the chart below, typically during recessions (shaded in gray), job growth slows and then goes negative, perhaps after the recession has ended. Growth peaked at about 2% over two years ago, a level that is more associated with the median employment growth over the past 30 years. We have declined to zero over the past year - not bad considering the fallout in housing construction and the mortgage industry. Monthly changes in the non-farm payrolls typically fall by 400k or so in the early days of a recession. Especially expressed as a percentage of the overall payrolls, today's reports are not at all consistent with this usual reaction by employers.
Yet, as one can see in the bottom panel, consumer confidence is certainly consistent with a recession and the usual fears of job loss that impact spending. While employers remain cautious in hiring and have certainly cut overtime, it appears that they are indeed hanging onto their employees.
My final observation that we may not need another round of stimulus checks (though they sure might come anyway given the season) relates to the whole gasoline impact on consumers. For the first time in my 43 years, which includes a couple of other spikes in gasoline costs, the U.S. driver is apparently changing his behavior. Mass-transit ridership is up, scooter sales have soared, consumers have apparently become more careful in their planning to minimize gasoline usage and small cars have become sexy again.
I believe that $4 gasoline has had and will continue to have a meaningful impact on the American psyche and driving behavior. Yet, gasoline prices are likely to fall continue their fall to $3, especially if we get through hurricane season without major refinery damage. The impact on a family from that decline could be great. If one assumes that a typical family with two workers drives 20K miles a year and gets 16 miles to the gallon on average, the total demand works out to be 1250 gallons per year. The potential reduction in their costs, then, would be $1250, which is quite significant. I believe that this "found" money could end up fueling some discretionary spending and addressing what must surely now be some pent-up demand.
So, I see a market where valuation seems to be friendly, where the bottom appears to perhaps be behind us, where the macroeconomic headwinds seem to be more clearly defined and potentially abating, where job-loss fears are probably exaggerated (leaving consumers overly pessimistic) and a very clear pathway to freed-up discretionary dollars. I can't help but conclude that retailers could be in for a good Christmas, especially if we get the typical lift in sentiment that follows a Presidential election.
The best measure of the Consumer Discretionary sector is the SPDR XLY, though it contains many other types of companies beyond retailers such as home-builders, hotels and casinos. I am not prepared to broadly recommend those sub-sectors. The Retail HOLDRS (NYSEARCA:RTH) is flawed, as it represents two heavily large companies that have high sales of food and gasoline, i.e. Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST).
My focus is on specific retailers, and I find interesting ones across market captalizations. I currently own Bed Bath Beyond (NASDAQ:BBBY), BJ's Restaurants (NASDAQ:BJRI), Columbia Sportswear (NASDAQ:COLM), Lowe's (NYSE:LOW), Men's Wearhouse (MW), Shoe Carnival (NASDAQ:SCVL), Timberland (NYSE:TBL) and very recently Whole Foods (WFMI), though it is actually classified as a "Consumer Staple".
As always, I maintain a full list of my holdings on my website. If you visit my "bio", there is a very good chance that I have written about each of these names on Seeking Alpha somewhat recently. Thematically, I would share these final observations about the retailers:
- Survivors come out of a downturn stronger.
- Some purchases can be deferred for a while, but not indefinitely.
- It's not just demand potentially, but the cost picture that is improving somewhat.
- "Value" is likely to remain important given the expected continued pressures.
I wish I weren't "early", as I often tend to be, but I prefer to be early rather than late when it comes to structuring my portfolio. There is nothing worse than selling out at the bottom or buying at the top. One who buys at the top or sells at the bottom has to reverse a bad decision, which is very difficult emotionally. It can lead to years of staying out of a "good market" or staying in a "bad market" and lead to yet another bad decision!
Tying back to the original hurricane analogy above, I ask you this question: Are you prepared for the eventual passing of the storm? I can assure you that when the media and the pundits tell us that all is safe now, the price we pay will be significantly higher. I believe that the challenges of our maturing economy, while tough, aren't insurmountable and understand fully that the best time to invest is often when things look the worst. Good luck with your own investing as we move into the final third of 2008!
Disclosure: As disclosed above, I am long FNM, BBBY, BJRI, COLM, LOW, MW, SCVL, TBL, and WFMI.