Friday, March 4, 2011

"The Market - A Perspective"

Sydney M. Williams

Thought of the Day
“The Market – A Perspective”
March 4, 2011

We are conditioned by our most recent experiences. For investors (even old timers like me,) the defining moment of our careers were those few days in September, October and November 2008 when the world we knew looked like it could end. On 44 of the 63 trading days during those three months, the Dow Jones Industrial Averages gained or lost more than 1.5% – a frequency that is rare. In 1987, for example, in the 64 trading days preceding and following the single biggest percent decline in the DJIA (22.63% on October 19,) the Averages gained or lost 1.5% on only 24 days. Even so, the drop in the DJIA in 1987 during those three months was worse (-31.1%) than the same period in 2008 (-23.5 %.)

The contrast of today’s relative tranquility with those unpredictable and frightening days is causing unease among some strategists and market commentators (including myself):

                            * Many investors have lost confidence in the concept of long term investing, given the fact that the market is trading at the same level it was at in April 1999.

                            * The S&P 500 has see-sawed over the past decade. The S&P 500 traded at 1527.46 on March 24, 2000, fell to 776.76 on October 9, 2002, rallied to 1565.15 on October 9, 2007, collapsed to 676.53 on March 9, 2009 and has now rallied back to 1330.97 – nearer its peak than its trough.

                             * Stocks have provided long term compounded returns of about 6% for the last twenty years, slightly below the CAGR for the very long term, suggesting we may be near fair value.

                             * U.S. Treasuries (along with corporate debt) command very low interest rates, implying the next major moves in rates will likely be up.

                             * The monetization of debt and recent commodity price increases suggest forthcoming inflation.

                             * In part that caution simply reflects the age-old belief that when stocks are going up we know, at some point, they will turn down, and vice-versa – a version of Hyman Minsky’s notion that stability leads to instability.

As the market rallied over the past two years, volume has moderated. Volume on the consolidated tape for the first two months of this year is running about 27% below where it was two years ago, but up 14% from last summer. Many investors who bailed out of the market in 2008 appear to be returning to stocks, as flows into equity mutual funds have turned positive this year. In general, volume appears to be roughly at the level it was in 2007. It is our sense that high frequency trading is gaining as a percent of volume; and, helping volume, ETF assets, now in excess of a trillion dollars according to Birinyi Associates, have increased 26% since June. Fundamental, individual stock investors appear to be among the missing.

A unique factor of the 2007-2009 market collapse was that it was, in reality, a function of credit markets that failed – a very different catalyst than 2000 when absurd multiples catapulted stocks into decline. By the end of December 2008 credit markets had substantially recovered, and that recovery has persisted. Today, the TED spread, at 18 basis points, is about where it has been since September 2009. The yield on the FINRA-Bloomberg High Yield Corporate Bond Index at 7.83% is 1700 basis points below where it was in early December 2008. The markets are telling us that credit is no longer a problem. During 2010 corporate bond issuance world wide topped $3 trillion for the second year and set records in the U.S. In fact bond investors, with Investment Grade Corporates yielding 4.66%, appear to be ignoring the very real prospect of inflation. Stock investors appear, as a friend recently described them, reluctant bulls. Perhaps, with equity investors, it is a case of “once burned, twice shy.”

Whatever the short and medium term outlook for equities, they have outperformed bonds during my years in this business. (Commodities, like gold and oil – both artificially depressed in the 1960s – have done better.) When I entered the business the Dow Jones stood at 790.58. Today, the Averages stand at 12258.20, a 1450% increase. (Of course, using the GDP deflator, the DJIA in 1967 dollars would be around 2450.) A little less than fifteen years after I entered the business, in mid August 1982, the DJIA averages were 14 points lower than they had been on my first day. During the past 44 years, we have had two and a half decades of bear markets and two decades of bull markets. The country has been embroiled in three wars – Vietnam, which we lost; the First Gulf war, which had no clear victor, and now the on-going War on Terror. We have experienced five recessions, two of them severe. The market on October 19, 1987 experienced its biggest decline ever. We have been through an oil embargo, an S&L crisis and a credit and housing collapse. We have seen Ponzi schemes, witnessed the collapse of Long Term Capital and seen currency crises in nations as diverse as Mexico and Thailand. Nevertheless, inflation adjusted (and not allowing for dividends,) the market is about 300% higher than it was in 1967

Market predictions are a fool’s game, which is why, I suppose, so many of us end up on Wall Street. Nevertheless (and risking the moniker,) it seems to me that the economy is improving, perhaps better than many expected. (I believe, as I wrote earlier this week, that tax receipts are likely to surprise positively, alleviating, unfortunately, the urgency of the deficit battles. Any relief, of course, would be a reprieve, not exoneration) I also suspect that higher commodity prices (food and energy), though, will hamper consumers and may well impact earnings of those companies dependent on raw materials. However, it is important to keep an historical perspective. Most of the time volatility remains subdued and most of the time stocks do move higher. In my opinion, we are continuing to adjust for the excesses of the 1990s and from being spooked by the credit collapse in 2008. We have been correcting for eleven years and it would be my guess that we are about two thirds of the way through the process. Of course, that plus $2.25 will get you a ride on the subway.

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