"The Enemy in Sight is not the One to Fear"

Sydney M. Williams

Thought of the Day

“The Enemy in Sight is not the One to Fear”

March 24, 2010

Without a 10% decline, the market has rallied 76.1% since the lows reached on March 9, 2009. While this may not be unique in the annals of stock market history, it is unusual. Nevertheless, the S&P 500 remains 6.2% below where it was on September 12, 2008, the Friday before the Lehman bankruptcy. The market peaked in October 2007 and had already declined 20.6%. And, even that fact doesn’t accurately set the table. The October 2007 high, at 1576.09 was only 1.5% above the high reached seven and a half years earlier, in March 2000 at 1553.11.

There is little question that the market in March of 2000 was reflecting a giddy and unrealistic sense that good times would roll ad infinitum. But I would argue that in March a year ago, the market was making the opposite case – that the credit crisis would end capitalism as we know it. That risk, in my opinion, did exist in the immediate hours and days following the Lehman collapse, but by year-end, with the TED spread having already narrowed by 200 basis points, the possibility of an imminent collapse seemed increasingly remote. Nevertheless, as spreads began to narrow, stocks continued to decline.

Last year both stocks and bonds rallied (the exception being Treasuries), but money poured into bond funds and continued to exit stock funds. The rally in stocks has been notable, but pales when compared to what happened in High Yield. The Bloomberg-FINRA Index, in November 2008, had High Yield bonds yielding in excess of 25%. Today the yield is 8.76%. At the end of 2008, the spread between High Yield and Investment Grade Corporates was 1108 basis points. Today that spread is 395 basis points.

Not surprisingly, with yields close to zero, money market funds have declined from $3.6 trillion a year ago to $3.0 trillion today, but flows have gone primarily into bond funds, despite the fact that equity assets are roughly twice the size of corporate bonds – $12 trillion versus $6 trillion.

The Two-Year, Ten-Year spread has narrowed modestly – by about 11 basis points – since year end, but the curve remains pretty steep. In terms of commodities, natural gas has been under a lot of pressure, down 25% this year. Soft commodities, like wheat, soybeans and corn have also moved lower this year, while oil and gold are very close to year end levels.

Volume, which peaked during the height of the crisis, continues to moderate, though the rate of decline seems to have leveled off. Volatility has noticeably declined. The VIX, which spiked in late January, is 20% below where it was at year end and is back to the levels of three years ago. Daily volatility continues to be modest. But, in my opinion, unlike three years ago, complacency is not present.

All in all, it seems to me that, while the values that were available a year ago when fear dominated, greed is not yet widely apparent. Certainly there are macro problems, both real and perceived – Greece, Iran, Portugal, a possible trade confrontation with China, excessive sovereign debt and deficits, a possible double dip in the economy, rising taxes, inflation, deflation – but there are always macro concerns. They just tend to be ignored when complacency rules and come to the forefront during periods of apprehension. As long as these problems remain within our gun sights, they are less likely to surprise.

While I don’t find myself exceptionally bullish, it is equally hard to be very bearish. Valuations don’t appear egregious with the S&P 500 selling a little over 13X consensus estimates. However, unlike the period between 1982 and 2000, it is my guess that it is more likely interest rates will gradually rise putting some pressure on multiples. But for those who have qualms about our place in the world over the next generation or so, I recommend a book reviewed in today’s Wall Street Journal, The Next Hundred Million by Joel Kotkin. Mr. Kotkin may prove too optimistic, but at a time when the world is focused on opportunities in the East, it is eye-opening to read a book which paints a rosy future for the United States.