Monness, Crespi, Hardt & Co., Inc.
767 Third Avenue
New York, NY 10017
212 838 7575
Sydney M. Williams
December 29, 2009
Market Note - Year End 2009
"The future is an opaque mirror. Anyone who looks into it
sees nothing but the dim outline of an old and worried face.”Jim Bishop (1907-1987)
New York Journal-American
March 14, 1959
“The future ain’t what it used to be.”Yogi Berra (1925-)
Man has always yearned to know what lies ahead. Odysseus consulted Tiresias, the blind prophet of Thebes. Cassandra was granted the gift of prophecy by Apollo. The Biblical period had its prophets, including men like Barnabas and Hosea. Shakespeare’s Macbeth opens with the three witches and their forecast of tragedy:
“Fair is fowl and fowl is fair
Hover through the fog and filthy air.”
Charles Dickens, in a Christmas Carol, has the third spirit, the ghost of Christmas yet to come, lead him through harrowing visions of what’s in store unless he mends his ways.
Today, with soothsayers in disrepute, we have invented analysts, technicians and economists to guide us toward the unknowable future. We know only that they are human and that their vision is not much better than that of my nine-year-old granddaughter; so we view with skepticism their forecasts, as though a yellow sign accompanies each prediction, “Caution: unknown road hazards ahead!” Extrapolation of one’s most recent experience tends to be the light that guides most. Often expert opinion proves wrong. In 1927, Harry M. Warner, one of four brothers who founded Warner Brothers, was quoted as saying, “Who the hell wants to hear actors talk.”
One year ago the credit crisis had already passed its nadir and was showing flickering signs of life. The TED spread, for example, had peaked at 465 basis points in early October 2008 and ended the year at 131 basis points. The VIX, at 40, was still high, but the decline from 85 was an indicator that confidence was waxing, not waning. While credit markets were off their worst levels, the economy, already in recession for four quarters, was on its way toward its lowest point. World stock markets, commodities (excluding gold) and corporate bonds (especially High Yield) were in decline. Gold, the U.S. Dollar and U.S. Treasuries, reflecting a flight to safety, were the lone assets to show strength in 2008.
A year ago we were concluding a period in which year-over-year losses in equity valuations were the greatest in forty years, with the S&P 500 down 38.5%. Ten year returns to the same index were negative 26.5%. Despite a 24.8% gain in the S&P 500 this year, ten year returns remain a negative 23.3%. In fact, should the market be up 16% in 2010 (higher than virtually all strategists’ predictions) the ten year return to the S&P 500 will have been negative for the third year in a row – worst than any period since the 1930s. And, yet, we now have an article in the current issue of Barron’s, entitled, “A Flat Dow for Ten Years? Why it Could Happen.” Where was Gary Gorton, a liquidity expert at Yale, in 1998, or 1999, or 2000? Extrapolation is the inference of an unknown from something that is known, so it is not surprising that quantitatively schooled analysts make use of mathematical models in an attempt to understand and forecast events, events which are more often driven by psychology or behavior rather than rationality.
As I look back over the past three Year-End Market Notes, I am struck by how far we have travelled. At the end of 2006, I started my note: “Complacency has settled over the financial markets like a soft coating of December snow.” I went on: “Within this environment, the consumer blithely skips ahead, borrowing to ensure he lives as well as the next man, while ignoring rumblings from the housing sector.” By the end of 2007 things had changed. I wrote: “Today we are in the midst of rapids and the din is all about us. We do not know how far the rapids extend or what the descent will be…” While I expected a lower market, the din became much greater and the extent and descent was far worse than anything I foresaw. And a year ago, I began my note: “This has been a year whose conclusion has been eagerly awaited.” I added: “Arguing the bull case at a time like this is difficult, even though common sense tells us that it is from ashes of such destruction that fortunes are created.”
As we peer through the haze that will ultimately dissipate to disclose the year 2010, it is, as always, difficult to see. Early in the New Year, in his State of the Union Address, the President is likely to take a victory lap on health care, regardless as to whether he has signed legislation into law and no matter what the Bill entails. With an eye on the mid-term elections, he will have to get his Homeland Security Secretary to admit, yes, there are terrorists out there, and they are at war with us, even if we are not at war with them! He may not admit it, but it is becoming increasingly obvious that reaching out to regimes such as Iran, Venezuela and Cuba has failed, and that support for dissidents is a better reflection on our democratic values. In short, we will see President Obama move closer, in this regard, to the positions held by his predecessor.
The winter Olympics will provide a few days respite before the press of the November elections begin in earnest. The President’s poll numbers have declined. He emerged from the radical left and campaigned in repudiation of everything Bush. He spoke of restoring a favorable view of our Country by the rest of the world (by which he really meant Western Europe), and of reconciliation; he promised an end to partisan politics and vowed to clamp down on K Street lobbyists. Nevertheless, partisanship has intensified and the lucrative business of lobbying has never been so bountiful. The reality of actually running a large and diverse country has caused him, verbally at least, to moderate his rhetoric and to tone down expectations.
The Christmas day near-disastrous attempted bombing of Northwest flight 253 by the young Nigerian, Umar Farouk Abdulmutalllab was a reminder of the war many seem to have forgotten. The young man was trained in Yemen by former Guantanamo-held prisoners – the Country to which President Obama has seen fit to receive additional detainees. Despite having won a Nobel for Peace, the New Year is likely to see the President take a tougher stance on terrorists and rogue regimes. The Middle East will remain very much in the news, as Iran continues its not-so-stealthy march toward nuclear armaments and Yemen risks becoming the third battle ground in the war against Muslim extremists.
While I believe the economy is on track for recovery, the market has anticipated such an eventuality. The consensus suggests growth will be modest, which seems likely, but exports to consumers in emerging nations may provide surprise to the upside. Corporate earnings, given unusual productivity gains during the downturn and a reluctance to rehire quickly, should be very strong, especially for the manufacturing sector and particularly in the first half. Unless analysts are greatly underestimating earnings for the S&P 500 (a very real possibility, in my opinion), the multiple of earnings suggests stocks are selling (at 15X 2010 earnings) close to fair value – indicating neither unusual weakness nor strength in stocks over the next year. It does seem likely to me, however, that rates are likely to move higher during the course of the year, with the Federal Government having to sell about $1.4 trillion in securities. They have indicated an interest in extending maturities (a smart move, in my opinion, given current rates), which will add upward pressure to long term rates. At the same time, the free-riding banks have enjoyed over the past year – borrowing at virtually no cost and investing with no risk in longer dated Treasuries – is likely to come to an end with an increase of the Discount Rate coming earlier than generally expected and demands that assets be concentrated in corporate loans. Rising interest rates will put downward pressure on stock multiples. So, earnings may be better than estimated, but multiples may be lower. Previewing higher interest rates, over the past month, rates on Three-Month Treasury Bills have risen from ten basis points to fifty-five basis points. Rates on the Five-Year Note, in the same time, have risen from 2.03 basis points to 2.60 basis points.
With all the volatility we have experienced over the past ten to twelve years – from the irrational exuberance of the late 1990s to the outright fear of September/October 2008 – businesses have marched along. Google went public in August 2004 and has since soared eight fold. A re-vitalized Apple is up ten fold in the same period of time. Intractable and unbreakable chains to the past have claimed union-driven businesses, like the auto and auto parts companies, unable and/or unwilling to adapt to a changing and flatter world. Corruption and greed have buried companies such as Enron and WorldCom. Over time we are likely to bear witness to the vaporization of financial wizards who used shareholder’s and the public’s money to garner unfathomable bonuses without creating one iota of GDP. It is the way capitalism works.
Despite my “old and worried face,” mounted with white hair, I have no memory of the 1930s, but the situation does remind me of the 1970s. Following the absolute low reached in October-December 1974 and the subsequent 73% rally, it was generally a period of meandering markets – up one year, down the next. But it was a time when stock picking worked. Panic and volatility morphed into malaise; inflation picked up dramatically and growth was slow, giving credence to the theory that Keynesian economics was flawed. It was not until Paul Volcker, as Fed Chairman, killed inflation by raising interest rates in 1982, creating a short but severe recession but building a foundation for two decades of economic growth. George Melloan, late of the Wall Street Journal, warns of creeping socialism today and lays out the case for supply side economics in a new book, The Great Money Binge: Spending Our Way to Socialism. It is a book worth reading. However, my guess is that we are a few years away from the next Paul Volcker. In the meantime, with expectations ratcheted down, subdued volatility should provide an environment favorable to stock picking.
May the New Year bring health, happiness and prosperity!