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 May 2008 Turning Point?
Yet despite all the negatives, stocks actually held up remarkably well. That's not to say they've done well or even that they're testing positive territory, just that it seems like they should be much worse off. Aside from the financials which are still working their way through the effects of the subprime meltdown, other sectors are near the flat line with some even slightly positive. Although there's still a question of when and if the U.S. will officially slip into recession, there's an opposing belief that once the credit crisis is finally behind us, the next move is up -- possibly even strongly up. Regardless of which camp you choose, each is looking for that all-important turning point. Depending on how optimistically you interpret them, there are signs indicating it may not be too far in the future.
Yields Looking Up Not only that, short to intermediate term Treasury yields are usually a good indication of future interest rate movements. The 10-year yield quickly fell from well over 4% before the Fed started the most recent round of cuts but now that it's moving back up, it could be signaling the easing is either over or about to end. Rising interest rates are often seen as a drag on the economy, generally not a good thing. But many see it as a positive sign now. Low interest rates may have helped stabilize the economy and temper the credit crisis, but if the Fed is willing to let them drift back up and at least hold rates steady for awhile, conditions may finally be improving. In addition, falling U.S. interest rates have also taken a toll on the dollar, quite possibly unleashing a new bout of inflation. Although the Fed has been unusually aggressive in cutting rates to increase liquidity, few of their central bank counterparts have joined in. As a result, interest rate differentials have grown with our trading partners, bringing down the value of the dollar. That's why a return to more traditional levels or at least stable interest rates is seen as a welcome sign. For the first time in quite awhile, economists and investors are again seeing inflation as a greater concern than ongoing problems in the credit markets.
The Core Problem Ironically, food and energy prices are the two major costs stripped out of the so-called "core" inflation. This is the reading closely followed by the Fed and other economists. The belief is that food and energy costs can fluctuate wildly in the short-term, so removing them gives a more reliable long-term reading of inflation. Or course now, with housing costs (which are currently declining with the credit mess) representing such a large portion of the core inflation reading, it's long-term quality is questionable.
That's also why core inflation has been rather benign, but with food and energy prices still on the rise, that's likely to change for the worse. The higher these commodities climb, the greater the impact they'll have over all corners of the economy -- including those measured by core inflation. The weak dollar is often painted as the culprit and indeed, it's played a role. With crude oil and other commodities generally quoted in dollars, prices have to rise just to maintain current values relative to other, stronger currencies. But the dollar's not completely to blame. Shortages in supplies (or at least the threat of shortages) have also driven up prices. Investors and speculators seeking shelter from struggling stocks and bonds are also adding fuel to the fire. Thanks to low correlations, commodities have often been viewed as a hedge against financial assets. As investors sought their safety, demand soared, and so have commodity prices. So here's something to consider if you're thinking optimistically about the turning point: If the Fed holds rates steady or even raises them slightly, a more stable dollar won't automatically bring commodity prices and/or inflation back down. At most, it will remove one of the factors driving them up, but not necessarily bring them back to the levels of the previous decade. Unfortunately, inflation may be an unwanted consequence of the credit and mortgage crisis that hangs around for awhile. Historically , inflation has never spiked up only to depart just as quickly. There's little reason to believe that will be different this time.
No "D" In that light, one might conclude equity investors must not share bond investors' current fear of inflation. Although domestic stocks certainly haven't set the world afire, they haven't behaved as if a major wave of inflation was upon us, either. Then again, they also haven't followed traditional patterns. As you'd expect, with soaring energy and commodity prices, energy and materials companies have fared the best, +1.9 and +1.4 year-to-date, respectively. In fact energy profits have been so stellar, populist politicians are resurrecting the 1970s' "windfall profit tax" concept again. (For the record, it was a bad idea then, and if anything, it's only gotten worse with age.) These are highly cyclical businesses that tend to experience boom and bust periods. The current boom can persist for awhile longer, but the stock rally is already getting quite long in the tooth, especially when you consider the fact that near term earnings are already supposed to be discounted in current share prices. There really haven't been any safe defensive sectors in which an investor could hide. Consumer discretionary (-0.8%) and consumer staples (-2.1%) are beginning to suffer as consumer tighten their belts. Industrials (-2.4%) and utilities (-5.4%) have been negatively impacted by the slowing economy. To this point, the biggest surprise is healthcare, typically viewed as a defensive sector. That's not been the case this time however, as healthcare shares are off 9.8% so far this year. Analysts attribute this primarily to the larger pharmaceuticals which are finding themselves in the unenviable position of losing patent protection on some of their blockbuster compounds at the same time that presidential candidates are stoking up support for nationalized healthcare. Those are major drags regardless of the current position in the economic cycle.
Equally surprising is the poor performance from the tech sector. Going into 2008, many analysts had expected this to be a haven, well insulated from the credit crisis. Most established tech stocks are well capitalized, neither borrowing nor issuing debt. Businesses were expected to be entering a major upgrade cycle, with a lot of their equipment still dating back to the Y2k scare. So far, this hasn't happened. To the contrary, many of those businesses in need of upgrades are actually financial service businesses -- some of tech's biggest customers. Until they straighten out their toxic loans, they'll be seeking capital, not spending it. Tech (-8.6%) has suffered collateral damage. And then there's the financials themselves. Oddly, they've actually fared better than techs, down only 7.6% so far this year. Take this performance with a grain of salt, however. Financials had a nice run in April as those taking an optimistic reading on the economy saw a turning point following the Bear Stearns bailout and Citi's last write-down. Believing financials were truly at bargain levels, they jumped in driving up prices and forcing short sellers (those who borrow stock, sell it, and hope to replace it with cheaper shares later) to cover their positions. That made for a nice short-term rally, but then banks resumed the charge-offs and started issuing stock to fill capital needs. Odds are, this spring's rally in the financials will be remembered as yet another false start. Nevertheless, there's still that belief -- seemingly shared by a rising number of investors -- that once the credit crisis is put to rest, profits will stabilize and it's off to the races. It could happen any day and the sooner it does, the better 2008 will ultimately be. That's why there's such a focus on each and every little economic or profit report as investors seek definitive signs of the turning point. But here's something else to think about: The turning point may be near at hand, but the upturn may not be.
History Lesson But this hasn't historically been the case. Not only that, today's credit crisis is one of the biggest shocks to the economy in decades. Why should we think it's impact will be quick and mild? Looking at the Dow Industrials going back to 1926, drawdowns have ranged from an average of 7.3% to an extreme of 88.7% following the 1929 crash. The average duration is twelve months and the average time to recovery is nine months.
Of course you could take this quite positively, too. Aside from the extreme, those averages don't sound too bad, especially when you consider the Dow Industrials are already down over 9% from their October 9, 2007 high. Not only that, with the high last autumn, we should already be seven months into the drawdown with only five left for average. Based on that, you might think this is the time to begin positioning your portfolio for the coming surge. But here's the last thing to think about: The market (and the economy for that matter) can stop going down without going up. Although we've come to expect it from the quick, sharp selloffs and recoveries in the recent past, it doesn't have to happen that way. Instead, the economy and share prices may stabilize but still go nowhere for months or even years while the markets heal. That's precisely what happened in the 1970s which, coincidentally, was the last time the economy slowed while commodity prices were rising. It took the better part of the decade to wash that out of the financial markets so is it such a stretch to think the credit crisis will have a similar result? Arguably, that's much more likely than the rosier scenarios you're hearing about. Ultimately there will be a great buying opportunity with shares fairly or even undervalued. The economy will eventually take off. It may just take a lot longer than many people currently think. Along the way, there can be numerous false starts and fools' rallies, and each can take their toll on the overly optimistic. When the turning point comes, the best advice is to be patient and careful. As investors so painfully learned in the 1970s, there's very little reward in being early in a flat market. Search this site! Just enter you key word or words:
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ITHOUT A DOUBT, 2008 has gotten off to a rocky start. As April came to a close, financial institutions were still coming to grips with the depth of the subprime crisis. Commodity prices, led by crude oil, corn, and gold, were all not far from their all time inflation-adjusted highs and were still rising. The overall economy is slowing noticeably, with first quarter GDP matching fourth quarter 2007 GDP, up a scant 0.6%. For the first time in almost a decade, economic growth was an issue.
