Matthew Greene : Northwestern Mutual - Economic Commentary - December 2008 : Article: Economic Commentary

Economic Commentary - December 2008

Clare Zempel

Economic and Investment Strategies Consultant

Overview

Economic and market conditions have continued the deterioration that started in mid-September, when policymakers allowed Lehman Brothers to fail. To recall, Lehman’s failure quickly spilled over to AIG (American International Group) and the Reserve Primary Fund, which became the first public money market fund to “break the buck” – to see its share price fall below a dollar. These shocks – this financial crisis – spurred investors to shift into the safest available assets. Stocks and riskier fixed-income securities were sold en masse and their prices plummeted. Increased demand for the safest assets – short-term T-bills – drove their yields down toward zero.

In reaction to the financial crisis, households and businesses have curtailed spending in order to conserve cash. The result has been that economic conditions have weakened progressively and substantially. The National Bureau of Economic Research (NBER) now seems certain to declare that a recession started in 2008’s third quarter, if not earlier. The consensus now fears that the current recession will be long and deep, continuing well into 2009 or even 2010.

Serious risks do exist but it remains possible that the consensus overestimates them. In mid-March 1980, President Carter threatened to impose credit controls in order to contain inflation. Households and businesses slashed borrowing and spending overnight. The economy and the stock market went into freefall that spring but rebounded sharply once the credit-control threat was removed that summer. The current financial shock is worse than 1980’s credit-control threat, but it remains possible that it could be resolved sooner than feared.

On the positive side, real interest rates have declined to levels that ended recessions and bear markets in the past. Oil and gasoline prices have dropped precipitously, which in effect constitutes a major tax cut for consumers. Absent the credit crisis, low real rates and lower oil prices would promise an imminent economic rebound. The credit crisis has undercut that promise but, in pointed contrast to their inaction in 1929-1932, nations and central banks worldwide have moved to contain the threats. Those actions have started to produce positive results. Fear remains extreme but that is common just when conditions are about to improve. Caution is in order, but remain faithful to asset allocation plans.

Economic and Market Update: The Continuing Discussion

The fearful reaction to the credit crisis that erupted when Lehman Brothers failed in mid-September persisted in November. This is reflected in the steep slide in consumer confidence and sentiment about economic conditions and prospects, in sharp declines in retail sales and automobile sales, in further increases in risk premia (credit-risk spreads) in the bond market, and in further erosion in common stock market prices. (Figure 1.)

Debate continues about when it started and how severe it will be but there is little doubt that a recession is in process. It seems improbable amidst all the bleak news but it is possible that the downturn could be shorter and shallower than feared.

In March 1980, President Carter threatened to impose credit controls. His motivation was to curb spending in order to contain inflation. Inflation had risen above 14.2% in February and was about to peak at a record-high 14.6% in March and April. The public’s reaction to the threat to impose credit controls was to all but stop borrowing and spending. Real GDP – the most comprehensive inflation-adjusted economic activity measure – fell at a 7.8% annualized rate in 1980’s second quarter – the second steepest decline in the

post-war period. The threat to impose credit controls was rescinded in July, and the recession ended during the third quarter. (Figure 2.)

In August 1990, Iraq invaded Kuwait, oil prices soared, and a bear market and a recession started instantaneously. People remembered two earlier periods when oil prices “spiked” – 1973-1975 and 1979-1982 – and severe downturns followed. Armed with such painful memories, consumers and businesses curbed spending, and investors sold stock, both without hesitation. In the end, the 1990-1991 recession and bear market were shorter and milder than usual, thanks to international cooperation and Operation Desert Storm. (Figure 3.)

Until mid-September, the economy was in a slowdown and the stock market was in a serious correction. Whether the slowdown was a recession or the correction was a bear market were debatable propositions. In mid-September, when Lehman Brothers’ failure spilled over to AIG, the Reserve Primary Fund and other institutions, the “shock effect” on consumers, businesses and investors was powerful. In this respect, 2008 seems similar to 1980 and 1990.

Since the problems in real estate (falling prices) and the financial markets (losses and fear) are far from trivial, stemming the economic and stock market slides will require that the credit markets continue to return to normal. Based on the sharp decline in LIBOR

(London Interbank Offered Rate), commercial paper and other important short-term interest rates, considerable improvements in this direction have occurred. Progress in reducing fear in the bond market has been much more limited to date but it has started to unfold. (Figure 4.)

Healthier credit markets are the sine qua non – the “without which not” – in the case for a shorter- and shallower-than-feared recession, but the decline in oil and gasoline prices should also counter the worst-case scenario. Crude oil’s price has fallen from $147 per barrel around Independence Day to around $50 in the week before Thanksgiving. National average gasoline prices have fallen from just above $4 per gallon to just above $2 over the same period. This should do much to help repair consumer pocketbooks. (Figure 5.)

If the credit markets continue to return to normal conditions and oil prices remain low, then the recession could be milder than expected. That could in turn support a rebound in common stock prices soon.

How Can We Know When the Stock Market’s Decline Will End?

Watch the stock market news on television for an hour and the odds are that you will be confused even about the facts. If an economic statistic like employment is reported to have risen, that would seem to be positive news. Until someone notes that the number increased less than it did last month and worries that the trend could be turning downward. Or until someone else frets that further increases in jobs could raise wages and salaries, which could lead to more inflation, which could in turn compel the Federal Reserve to lift interest rates, which could in its turn raise the odds that a bear market and recession will erupt.

The focus will then shift to the market’s prospects and “what you should do with your money now.” This segment will feature a “bull” and a “bear” in part for “fairness and balance” – but more so because conflict attracts more viewers than consensus does. Such a debate could be useful if it exposed and evaluated new facts and interpretations, but that seldom happens.

The problem with exposure to too much conflicting information and opinion is that it can lead to paralysis or to emotion-driven decisions. In investing, the downside for the paralyzed investor is that he or she will never invest and never participate in the market’s substantial long-run rise. The upside is that, once invested, the paralyzed investor would hold his or her position and capture the market’s long-run return. The emotion-driven investor is more likely to let fear drive sales into market declines and to let greed drive purchases into market advances. Such a “sell low and buy high” approach is destined to produce disappointing results.

Is there a better way to take a stance on the stock market’s prospects? One that is simple in execution and reliable in outcome? This writer thinks that there is. It is an approach that focuses on just three indicators – two are “fundamental” and one is “technical” in nature. Equally weighted, these three indicators provide useful clues about the stock market’s direction.

The first fundamental indicator is the change in interest rate levels. The two most important rates to follow are the 10-year T-Note yield and the federal funds interest rate. (Other interest rates that are worth a look are the 3-month T-Bill yield, the Federal Reserve’s discount or primary credit lending rate, and the BAA corporate bond yield.) (Figure 6.)

The rule here, derived from extensive testing, is that a 10% rise in these interest rates is bearish for the stock market and a 10% decline is bullish. The reason that this should work is that rising interest rates tend to lead to an economic slowdown and weaker corporate profits. Rising interest rates also tend to draw investors from stocks and into fixed-income investments. Falling interest rates tend to lead to faster economic expansion and a rise in corporate profits. Falling interest rates also tend to make fixed-income investments less attractive relative to common stocks.

The second fundamental indicator measures how stocks are valued relative to bonds. Some think that it is sufficient to look at how stocks are valued based on the P/E, or price-to-earnings ratio, alone. The problem with this approach is that the market seems to care more about how stocks are priced relative to an investment alternative like bonds, than about how stocks are priced relative to their own historical record.

An inconvenience here is that the P/E ratio is not comparable to the yield on a corporate bond, while the E/P, or earnings-yield ratio, is directly comparable. Recalling fractional arithmetic, to derive the E/P ratio from the P/E ratio, we just divide 1 by the P/E ratio. So, a P/E ratio equal to 20 is equivalent to an earnings-yield equal to 5.0%. And that 5.0% earnings-yield on stocks

can be compared directly to whatever the yield on a corporate bond happens to be. (Figure 7.)

If the corporate bond yield is 10.0% when the earnings-yield is 5.0%, then the bond-yield/earnings-yield ratio would be 2.0. If, on the other hand, the corporate bond yield is 2.5% when the earnings-yield is 5.0%, then the bond-yield/earnings-yield ratio would be 0.5. In the first case, bonds yield twice what stocks do, and are more attractive than stocks, which are overpriced relative to bonds. In the second case, bonds yield half what stocks do, and bonds are less attractive than stocks, which are underpriced relative to bonds. Since the P/E ratio is 20 in both cases, it is clear that it is the interest rate that determines whether stocks are overvalued or undervalued.

One further calculation complicates the analysis but makes it easier to compare the bond-yield/earnings-yield ratio over time. This calculation is to “normalize” the ratio. To normalize this or any number, you subtract the number’s long-run average from it, and divide the result by its standard deviation. This is all easy to do with almost any computer spreadsheet. (Figure 8.)

The result – the normalized bond-yield/earnings-yield ratio – is the “Stock Market Valuation Index” shown in Figure 8. The rule here is that the higher the valuation index, the more overvalued the stock market is, and the reverse. To refine that somewhat, when the valuation index rises above 2, the stock market tends to peak and decline.

The third and final indicator is “technical” in nature. The reference here is to “technical analysis,” which is the belief that historical prices provide information about future stock price movements.

The problem with technical analysis is that there is little evidence that it can be put to profitable use in investing, once trading costs and taxes are taken into account. An exception seems to be that tracking where the S&P 500 Index stands relative to its 10-month moving average can help refine the signals from the two “fundamental” indicators (changes in interest rates and the valuation index) that were discussed earlier. (Figure 9.)

The rule here is that prospects are bearish whenever the S&P 500 Index falls more than 2.5% below its 10-month moving average. Prospects are bullish whenever the actual index is above its 10-month moving average or less than 2.5% below it.

These are the three indicators that are the components in a simple but effective approach to determining the stock market’s prospects. Anyone who is familiar with the Internet and comfortable with computer spreadsheets can obtain the needed data for free and replicate the indicators discussed above.

The last step in this approach is to weight the signals from the three indicators in order to arrive at a summary statement about the stock market’s prospects. The rule arrived at after extensive testing is to weight the three indicators equally and to let the majority rule. If two or three indicators are bullish, then the stock market’s prospects are favorable and one should be fully invested in stocks. If two or three indicators are bearish, however, one should be fully invested in T-Bills.

How well has this method worked? From December 1965 to October 2008, the experimental results from this simple stock market model were impressive. The model portfolio rose from 1.0 to 773.4 – a 16.8% compound annual total return over the almost 43 years studied. For comparison, the S&P 500 Index rose in value from 1.0 to 41.1 – a 9.1% compounded annual total return – when dividends were included (this would be the “buy-and-hold” result). With dividends excluded, the S&P 500’s return was 5.6%. The total return on the 30-day T-Bill was 5.8%. (Figure 10.)

The experimental stock model was not perfect. It suffered declines in value in 1975, 1978, 1998 and other periods. It was bullish until June 2008, so it missed the October 2007 peak in the S&P 500 Index. It has remained bearish since May, however, so it would have avoided the market’s September-November slide. For the most part, the model was bullish when the stock market was rising and turned bearish before it dropped sharply.

Could one have earned the experimental returns noted above? No. One reason is that the returns do not take trading costs and taxes into account. Another reason is that S&P 500 index funds did not exist until 1973. A third reason is that one would have needed to buy or sell stocks and T-Bills at month-end prices, and that would have been difficult if not impossible. It also seems doubtful that any individual would have had the discipline to follow the model’s signals mechanically over 514 consecutive months.

The model’s 16.8% return may have been unobtainable in reality, but one could probably still have used it to improve upon the 9.1% “buy-and-hold” result. Tests show that implementing the model’s instructions with a one-month delay would have produced a 12.1% return – much lower than 16.8% but still better than the “buy-and-hold” alternative.

A major advantage to this approach is that it does not require forecasts. Economic forecasts, potential political developments and corporate profit expectations are embedded in interest rates (bond prices) and common stock prices. The model “reads” the implications for portfolio decisions about stocks versus bills well. The model’s 16.8% return – 7.7% better than the “buy-and-hold” alternative – demonstrates that. At the same time, there is no need to predict Real GDP, inflation, the Fed’s interest-rate decisions, or shifts in Washington’s fiscal policies. In a word, the model works without ever having to watch and interpret televised stock market reports.

What is the model’s signal at this writing (November 20)? The interest rate indicator is bullish, but the valuation and technical components are bearish, and the net signal is bearish. Could the model turn bullish soon? Yes, provided that the “fear premium” in the BAA corporate bond yield declines, in line with the steep decline in the risk premia in short-term interest rates which has already taken place.

Now and in the future, keep a watch on interest rates, the earnings-yield on common stocks and the stock market’s basic technical trends. Adhere to an asset allocation plan that is tailored to your personal time horizon and preference for safety. Economic and the market conditions should improve soon.

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