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2008, A Year to Remember Forget January 2, 2009 Jonathan Golub, CFA Chief Investment Strategist Justin
2008, A Year to Remember Forget January 2, 2009 Jonathan Golub, CFA Chief Investment Strategist Justin

2008, A Year to Remember Forget

January 2, 2009

Jonathan Golub, CFA

Chief Investment Strategist

Justin Gordon

Research Associate

I think I speak for all of us when I say “Goodbye and Good Riddance” to 2008. While the past year may not have been unprecedented (the 1930s come to mind), it’s been far worse than any current investor has ever seen. Anyone predicting the events of 2008 at this time last year would have been thought insane.

Summary of Market Activity

Stocks

S&P 500 declined by 38.5% in 2008 (37.0% including dividends); Down 51.9% from peak to trough (10/09/07-11/20/08)

Volatility

VIX peaked at 81 (11/20/08), 5 times the average over the prior 5 years

Oil

Peaked at $147 (07/14/08) then plummeted to $35 (12/24/08) Gasoline began at $3.05, ended at $1.65, and peaked at $4.18 (07/11/08)

Rates

10-year US Treasury yields fell to 2.2% (12/31/08) from 4.0% (06/30/08) 3-month T-bill yields fell into negative territory in December

Credit

High yield spreads peaked at 20% over Treasuries (12/16/08) from 5.6% (12/31/07)

Source: Standard & Poor’s Corporation; CBOE; New York Mercantile Exchange, Reuters; US Dept of Energy; Federal Reserve; Bloomberg; Merrill Lynch

… and then there’s Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, AIG, Merrill Lynch, Washington Mutual, Iceland, the devastating Madoff scandal, a bailout of the auto industry, and more.

On the bright side, thanks to an aggressive statement by the Fed on December 16, a capital injection into Citigroup, a lifeline to Detroit, and welcomed cabinet appointments by Barack Obama, the market rallied 20% from its November lows, finishing the year down “only” 38.5%.

2008 Market Returns

While the market has been in decline for the past twelve months, breaking the year’s movements into smaller time periods is always useful. 2008’s market gyrations are best explained by their flirtation with or avoidance of apocalyptic events. As the chart below illustrates, it was the fallout from the Lehman bankruptcy that did the majority of the damage to markets, driving volatility and risk premiums through the roof.

S&P 500 (38.5%) (13.1%) (6.6%) (36.9%) (51.9%) 20.0% 2008 12/31/07 - 03/17/08 03/17/08 - 09/15/08 09/15/08

S&P 500

(38.5%) (13.1%) (6.6%) (36.9%) (51.9%) 20.0% 2008 12/31/07 - 03/17/08 03/17/08 - 09/15/08 09/15/08 - 11/20/08
(38.5%)
(13.1%)
(6.6%)
(36.9%)
(51.9%)
20.0%
2008 12/31/07 - 03/17/08
03/17/08 - 09/15/08
09/15/08 - 11/20/08
10/09/07 - 11/20/08
11/20/08 - 12/31/08
Fall of Bear Stearns
Lehman Bankruptcy
Peak - Trough

Source: Standard & Poor’s Corporation

While we generally applaud the efforts of the Fed and Treasury, it is clear that allowing Lehman to fail was a colossal mistake. Yes, the stock market bounced back a bit from its nine-week, 37% fall, but credit markets have only begun to thaw. So, where do we go from here?

Outlook For 2009

We’re often asked whether the worst is behind us.

Have we yet seen capitulation? Unfortunately, we

think the bigger question is whether or not the economy can avoid a 1930s style economic malaise. If it can, then things are oversold. If not, we’re in the early innings.

Cutting to the chase, we would be underweight equities at this time for three reasons.

First, we believe that the current level of stress in credit markets is incompatible with a functioning

economy and that future flashpoints will arise.

The environment reminds us of the following anecdote.

A patient walks into the emergency room with a 107 o temperature. He asks the doctor how long the

fever will last. The doctor reassures him that by this time tomorrow the fever will be down. The question is whether he will be cured or dead. 107 o fevers are incompatible with life.

Second, we believe that the economy is more likely to recover than not (our unscientific odds are 3:1); however, we are uncomfortable with the risk/return trade-off given the potential downside. In addition, we think it’s important to look at an investment decision in context. If things head south, you might lose your job or watch your business fail, the value of your home will fall, your annuity contract or pension plan might not payoff as expected, and your local municipality might be insolvent. Not to over-emphasize the negative but if things turnout poorly, your stock portfolio might not be your biggest worry.

Third, upside opportunities play out over time. Market trends tend to be long lived — consider the run between 1982-2000. If the economy recover there will be plenty of time to invest. We’re very comfortable missing the initial bounce should markets rebound.

Market Barometer In October, we established a subjective barometer to indicate the level of risk that

Market Barometer

In October, we established a subjective barometer to indicate the level of risk that we saw to our economic system. If the worst case outcome was a dramatic, self-reinforcing downward spiral, then the scale would be a measure of its likelihood. “Low” might represent a 1/10,000 chance. “Severe” would indicate that we were on the precipice.

SEVERE

SEVERE

HIGH

HIGH

ELEVATED

ELEVATED

GUARDED

GUARDED

LOW

LOW

We believe that we were on the edge twice in the past year — first, when

Lehman was left to fail; and second, when Treasury made the decision to

Market Barometer In October, we established a subjective barometer to indicate the level of risk that

redirect TARP funds away from troubled assets, causing a near-failure of

Citigroup.

We put the current rating at “High” but believe that we will be back to “Severe” sometime in 2009.

Economic Indicators All Point South

On December 1, the poobahs at NBER (National Bureau of Economic Research) responsible for declaring a recession finally pulled the trigger. What’s interesting is that as bad as it feels, the economy actually edged out a positive gain over the twelve months ending September (the most recent data available).

GDP 12% 10% 8% GDP is -0.5% when quoted on quarterly change annualized 6% 4% 2%
GDP
12%
10%
8%
GDP is -0.5% when
quoted on quarterly
change annualized
6%
4%
2%
0%
0.7%
(2)%
YoY
(4)%
50
55
60
65
70
75
80
85
90
95
00
05
Source: Bureau of Economic Analysis

NBER takes a variety of indicators into account when declaring a recession including growth and jobs. On the labor front, the US economy lost almost 2 million jobs in the first eleven months of 2008, and it appears that things are only beginning to get ugly. At 6.7% the unemployment rate is still rather benign, only slightly worse than the long-run average of 5.6%. Don’t be fooled, the only reason the rate didn’t jump more in November was because disillusioned workers dropped out of the labor pool.

Non-Farm Payrolls Monthly 94 00 02 90 08 06 92 96 98 04 600 Most recent

Non-Farm Payrolls Monthly

94 00 02 90 08 06 92 96 98 04 600 Most recent (533) (400) (200)
94
00
02
90
08
06
92
96
98
04
600
Most recent
(533)
(400)
(200)
0
200
400
3 mo avg
(000s)

Source: US Department of Labor

While the first official reading of fourth quarter GDP arrives in late January, monthly data — from industrial activity to retail sales — clearly indicates a precipitous drop in economic vigor.

ISM (Manufacturing)

04 00 06 92 94 02 90 08 96 98 32.4 30 35 40 45 50
04
00
06
92
94
02
90
08
96
98
32.4
30
35
40
45
50
55
60
Contractionary (<50)
Expansionary (>50)

Source: Institute for Supply Management (ISM)

ISM’S most recent reading of 32.4 (01/02/09) indicates a rather severe fall in manufacturing. (Scores below 50 indicate a contraction.) While we live in a service-based economy, the ISM Manufacturing Index provides a excellent read on turning points in the economy. The rapid deterioration in ISM is consistent with anecdotal evidence that everything froze up in October and November.

In addition, the great American consumer appears to have been humbled recently. The bottom-line is this — when you lose your job (or are in danger of losing it), watch your home value decline by 20% and your 401(k) by 40%, your inclination to go to the mall as a leisure activity is likely to shrink. As expected, this has been the weakest Christmas season in years. Retailers have been discounting heavily to lure customers. Can you say deflation?

Retail Sales ex-Autos (2)% 00 02 08 06 98 96 04 94 Most recent 0% 2%

Retail Sales ex-Autos

(2)% 00 02 08 06 98 96 04 94 Most recent 0% 2% 4% 6% 8%
(2)%
00
02
08
06
98
96
04
94
Most recent
0%
2%
4%
6%
8%
10%
3 mo avg
(2.9%)

Source: US Census Bureau

It’s Not The Indicators That Scare Us

Given all of this weakness, it might surprise you that the economic data is not what keeps us up at night. We expect economic releases and profit announcements to continue to be weak for quite some time. This negative news flow only tells what we already know — that things are pretty lousy. For this reason we have identified those indicators that should lead us out of (or deeper into) this mess — a renormalization of credit, fall in volatility, and stability in real estate values.

Indicators

Leading Indicators

Coincident Indicators

Interest Rates

Employment

Treasuries

Corporate Profits

Credit Spreads

Economic Activity

Inter-bank Lending

GDP Manufacturing

Volatility Real Estate Values

Retail Sales

When we came up with this list in October, it was our belief that credit would slowly thaw allowing economic activity to gradually improve. On a positive note, the inter-bank market has become more fluid and stock market volatility has fallen meaningfully from peak levels. However, credit availability is still quite strained.

Dislocation in Credit Markets Continues There are two huge problems in the credit markets — first,

Dislocation in Credit Markets Continues

There are two huge problems in the credit markets — first, investors are so uncomfortable with the current environment that they are willing to accept a near-zero yield from the US government for the promise of a return of capital; and second, credit spreads for anyone other than the US government are outrageously high.

T-Bill Yields

8 bps 00 02 90 06 96 08 92 98 04 94 8% 6% 4% 2%
8 bps
00
02
90
06
96
08
92
98
04
94
8%
6%
4%
2%
0%

Source: Reuters

Just as consumers have flocked to Wal-Mart to purchase safes for their homes, the security of US 3- month T-bills has driven yields to near-zero. At the same time, credit has been harder to come by for even the most credit-worthy borrowers. In many cases, the availability of credit has been non-existent. For example, on December 3, the Wall Street Journal reported that the Port Authority of New York/New Jersey auctioned off $300 million in bonds without a single bid.

Corporate Spreads (Baa)

04 00 02 90 06 08 92 96 98 5.8% 94 1.0% 2.0% 3.0% 4.0% 5.0%
04
00
02
90
06
08
92
96
98
5.8%
94
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%

Source: Moody’s; Reuters; Federal Reserve

More risky segments of the credit market have virtually seized. To put this into perspective, high

More risky segments of the credit market have virtually seized. To put this into perspective, high yield bonds traded at a yield of 275 basis points over Treasuries in June 2006. The spread now stands at 17.3% over Treasuries, down from a peak of 20.1% on December 16.

High Yield Spreads

(ML HY Index Yield – 10 Year Treasury Yield) 17% 00 02 06 08 96 98
(ML HY Index Yield – 10 Year Treasury Yield)
17%
00
02
06
08
96
98
04
20%
15%
10%
5%
0%

Source: Merrill Lynch; Reuters

Inter-bank lending is an essential part of the global banking system. Over the past twenty years, the Ted Spread (3-month USD Libor minus 3-month T-bills) has averaged 55 bps. This rate jumped to 464 bps on October 10. A coordinated global effort has pushed this back to 135 bps, a substantial decline but still meaningfully above long-term levels.

TED Spread

04 00 02 90 08 06 92 98 96 1.3% 94 0.0% 1.0% 2.0% 3.0% 4.0%
04
00
02
90
08
06
92
98
96
1.3%
94
0.0%
1.0%
2.0%
3.0%
4.0%
Ted Spread measures the
willingness of banks to
lend to each other.

Source: Reuters

Volatility — High But Declining

It would be logical to think that the best days in the stock market would occur in the best years. Oddly, they occur in the worst because these periods are punctuated by wild swings, the definition of high volatility.

Worst/Best Days Since 1929 Year Period Return Year Period Return 6 Worst Days 6 Best Days

Worst/Best Days Since 1929

Year

Period

Return

Year

Period

Return

6 Worst Days

6 Best Days

10/19/87 1987 Crash

(20.4)

10/30/29 Great Depression 12.5

10/29/29 Great Depression

(16.1)

09/21/32 Great Depression

11.8

05/14/40 World War II

(10.3)

10/13/08 Current Crisis

11.6

10/15/08 Current Crisis

(9.0)

10/28/08 Current Crisis

10.8

07/20/33 Great Depression

(8.9)

04/20/33 Great Depression

9.5

09/29/08 Current Crisis (8.8) 10/21/87 1987 Crash 9.1

Source: Standard & Poor’s Corporation

2008’s market gyrations have been accompanied by a spike in volatility. The VIX rose to 35 following the fall of Bear Stearns and a staggering 81 following the collapse of Lehman. As time passes after each market incident volatility subsides. That has been the case over the past several weeks with the VIX retreating to “only” 40.

VIX

Average = 21.4 80 12/31/07 = 22.5 Lehman Collapse Citigroup Capital Injection 70 11/20/08 = 80.9
Average
= 21.4
80
12/31/07 = 22.5
Lehman Collapse
Citigroup Capital Injection
70
11/20/08 = 80.9
12/31/08 = 40.0
60
50
Bear Stearns Collapse
40
30
20
10
0
99
00
01
02
03
04
05
06
07
08

Source: Standard & Poor’s Corporation; CBOE

Many of the market’s day-to-day movements can best be explained by swings in volatility. Throughout 2008, the VIX and the S&P 500 have moved as almost perfect opposites — the market falling as volatility rises. Throughout 2008 a four percent change in the VIX has generally been accompanied by a one percent change in stock prices. This simple math helps explains the market’s run since November 20.

Changes In The VIX And S&P 500 (15.0%) (10.0%) (5.0%) 0.0% 5.0% 10.0% 15.0% 10.0% Daily

Changes In The VIX And S&P 500

(15.0%) (10.0%) (5.0%) 0.0% 5.0% 10.0% 15.0% 10.0% Daily Pct Change in S&P 500 Daily Pct
(15.0%)
(10.0%)
(5.0%)
0.0%
5.0%
10.0%
15.0%
10.0%
Daily Pct Change
in S&P 500
Daily Pct Change
in VIX
(10.0%)
(20.0%)
20.0%
30.0%
0.0%

Source: Standard & Poor’s Corporation; CBOE; Bureau of Economic Analysis

Real Estate Holds The Key

Real estate played a huge role in getting us into the current crisis and will surely play a pivotal role in leading us out. Residential and commercial property remain the predominant collateral backing our banking system. As such, the financial system will remain vulnerable until home values stabilize. Concerned about additional declines, it is not surprising that banks have chosen to hoard government capital infusions rather than lend.

Real Estate Values

04 00 02 90 06 08 92 98 96 ($000) 94 $100 $125 $150 $175 $200
04
00
02
90
06
08
92
98
96
($000)
94
$100
$125
$150
$175
$200
$225
$181

Source: National Association of Realtors

To date, real estate values have declined by 21% nationwide with greater losses in hot markets like California, Florida, and other sunshine states. At current levels, it will take nearly a year to work through the inventory of unsold new and existing homes. A combination of more readily available credit and further price declines is necessary before inventories can be worked off, providing a floor to values.

Real Estate Inventories 90 2 6 8 4 12 10 Source: US Census Bureau 00 02

Real Estate Inventories

90 2 6 8 4 12 10 Source: US Census Bureau 00 02 94 08 06
90
2
6
8
4
12
10
Source: US Census Bureau
00
02
94
08
06
92
96
98
04
months
Existing Homes (latest: 11.2)
New Homes (latest 11.5)

A Silver Lining

There are two key arguments for a better outcome in 2009 — valuation and stimulus.

Most every asset class appears extremely undervalued using historical measures. This is true for everything from stocks to municipal bonds and distressed mortgage paper. However, those who have invested on this basis over the past 12 months have been severely punished.

Equity Valuations Versus Treasury Yields (Fed Model)

4% 70 00 75 90 65 05 80 95 85 0% 2% (10 year) 6% 8%
4%
70
00
75
90
65
05
80
95
85
0%
2%
(10 year)
6%
8%
10%
12%
14%
16%
18%
dotted = trailing)
Earnings Yield
(solid = forward
Similar to P/E
of 11.6
US Treasury Yield

8.6

2.2

Source: Standard & Poor’s Corporation; First Call

The chart above shows that the historical relationship between stock valuation and bond yields has entirely broken down. Interestingly, stocks now sport a higher dividend yield than Treasuries, something not seen in fifty years. Similar comparisons can be made for most asset classes, but this argument alone should not be the sole basis of an investment strategy.

We think the more compelling argument is that the flood of fiscal and monetary stimulus will

We think the more compelling argument is that the flood of fiscal and monetary stimulus will eventually have its desired effect. 2009 will surely start with a large gift from Congress and the Obama administration. Chairman Bernanke’s Open Market Committee recently promised near-zero interest rates for an extended period and a willingness to buy virtually any asset onto its balance sheet. We believe that the ECB and other central banks will follow suit. Their arguments for not lowering rates, to leave “powder dry” for the future, is like the argument for saving life jackets on the Titanic for the next iceberg.

Fed Funds Target and Effective Rates 4.5% 4.0% 3.5% 3.0% 2.5% Effective Rate 2.0% Target Rate
Fed Funds Target and Effective Rates
4.5%
4.0%
3.5%
3.0%
2.5%
Effective Rate
2.0%
Target Rate
1.5%
1.0%
0.5%
Jan-08
Apr-08
Jul-08
Oct-08
Source: Federal Reserve; Bloomberg

What the Fed failed to highlight in the official statement was that it has already been implementing a near-zero rate policy, and buying up assets.

Hoping To Be Wrong

So is now the time to jump in the deep end in pursuit of undervalued assets? As tempting as it seems, we’re reluctant to say “Yes”. Do assets look cheap? Sure. Is the level of stimulus compelling? You betcha. However, with credit markets holding the jugular vein of the economy in its hand, we believe the next move on our risk barometer will be to “Severe” rather than simply “Elevated.”

We still believe that renormalization is the more likely outcome and that we’ll avoid a 1930s style financial meltdown, but the odds of an adverse outcome are too high and its implications are too painful for comfort.

We’ve never hoped to be wrong more than now.

Good luck to all of us in 2009.

We think the more compelling argument is that the flood of fiscal and monetary stimulus will
DISCLAIMER The views expressed are those of Jonathan Golub d/b/a Golub Market Insights. Opinions and estimates

DISCLAIMER The views expressed are those of Jonathan Golub d/b/a Golub Market Insights. Opinions and estimates offered constitute our judgment. They are subject to change at any time without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. Each investor must make his own determination of the appropriateness of any investment. This material has been prepared for informational purposes only and on the condition that it will not form the sole basis for any investment decision. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

CIR 230 Disclaimer Jonathan Golub does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

© Jonathan Golub d/b/a Golub Market Insights, January 2009.