3rd Quarter Commentary
Market Update
More Volatility Ahead
July 9, 2008
The first half of 2008 has been a difficult time for the U.S. stock market and stock markets overseas as well. After falling earlier in the year, the market rallied subsequent to the Bear Stearns debacle and closed the first six months with the worst June since 1930 (down 10% for the Dow Jones Industrials). Perhaps, more significant is that the Dow Jones Industrials declined over 20% since their October high, putting them into bear market territory. The S&P 500 has not yet breached the bear market threshold of down 20%, but is very close to doing so.
As we highlighted in early April, there are a number of positive factors supporting the market, but unfortunately there are negative ones as well which have either worsened (the price of oil) or remain unresolved. The growing uncertainty of the timing of the resolution of these negative factors has contributed to a drying up of the stock purchases and a slide in prices in recent weeks. In view of this, a review of the key negative factors is appropriate.
The credit crunch remains with us. While spreads have narrowed a bit, lending policies continue relatively tight and are likely to remain so for the foreseeable future. Both commercial and investment banks have yet to stabilize their capital situations. Stabilization, too, will take time. Meanwhile, uncertainties persist about the magnitude and timing of additional write-offs. Until clarification and confidence return to the banking system, we doubt that the financial stocks will provide the leadership necessary to sustain a stronger and sustainable stock market.
The housing sector continues to deteriorate; however, the rate of decline of both housing sales and prices is diminishing and we assume this trend will continue through 2008 and into the first half of 2009. The slide of housing prices will eventually enable liquidation of excess inventory. Anecdotally, we continue to hear stories about foreign purchases in locations as far removed as Miami and Detroit. Liquidation of residential housing inventory has begun, but it will take time to work through given the relative tightness of bank lending policies.
The reality of residential housing is that an estimated two-thirds of homes have been historically owned. More aggressive lending policies supported by the Federal Reserve and others moved this ownership to about 70%. The incremental difference is where most of the foreclosure and other problems exist currently. If the aggregate activity of the economy were to decline, which has not yet happened, then some threat might be imposed to some of the traditional two-thirds ownership.
Increasing price inflationary pressures are another source of stock market concern, although the bond market has yet to exhibit as much concern as the stock market. Most of these worries about price inflation are centered around the continuing rise of oil prices, although final product prices are also rising in a variety of sectors. Commodities, other than oil and natural gas, have either not risen as much as energy prices or do not have as much pervasive influence in the economy as does petroleum. Unlike other commodities, oil is perceived by investors to have little visibility of increased supply as a response to higher prices. While some rise in oil is attributed by some pundits to dollar weakness (the dollar has been flat since March, while the price of oil has risen 40% during this period) and index fund buying (the rate of increase in oil demand lags the rate of increase in funds buying in the past two years), the basic problem is the lack of visibility of major new supply. Consequently, speculators find this situation to be very attractive, especially given uncertainties in other markets. The price of oil is likely to continue to rise near-intermediate term until demand destruction becomes more obvious in and outside the U.S. So far, reduced driving in the U.S. and removal of subsidies in oil in some developing countries has not affected oil prices. Nonetheless, consumers and producers will adjust their use of petroleum products. A continued rise in energy prices will eventually have deflationary consequences, but timing remains uncertain.
The Federal Reserve has become a target of critical comment. Some voices want the Fed to raise interest rates to nip price inflation before it impacts wage inflation. Their argument is that negative real interest rates are supportive of increasing inflation in the future. They cite the fact that the bout with higher inflation in the 1970’s was aided by the inability to more aggressively raise short term interest rates above the rising rate of inflation. Moreover, they argue that in the current world of limited resources, the U.S. economy should be forced into a downturn to ease demand for those resources, such as oil.
These arguments have merit; however, higher interest rates might promote a greater challenge to restoring the financial integrity of the U.S. economy. In reality, interest rates are rising around the world, including Europe and China with the objective of slowing demand and containing inflation. In fact, over 50 countries are now experiencing double digit inflation. Many countries outside the U.S. are better positioned to pursue a more aggressive anti-inflation strategy than in the U.S. at this time. Hopefully, an extended period of slow growth in the U.S. and slower growth outside our borders will help contain inflation. Nonetheless, if current price inflation persists, deflationary pressures will mount and rising interest rates would only exacerbate those deflationary pressures.
At the moment, the U.S. stock market has probably determined that there is no silver bullet to overcome these negative forces over the near term. It will take some indeterminate time to work them out, thus extending the horizon when decent growth at a less inflationary pace might resume. The market may also be concerned about a rise in interest rates which might be deleterious to fragile demand. Nevertheless, as pointed out in early April, analysts’ profits growth expectations, while reduced this year, remain too high through 2009. Growth over the next several years may be constrained by the inability to grow margins as has occurred in recent years.
Short term, the market is becoming oversold. However, we are now concerned that it may take some time before some of the aforementioned issues are resolved positively. Meanwhile, the market will remain very volatile. Consequently, we are recommending increasing cash in aggressive portfolios to 20% from zero, in growth portfolios to 15% from 5%, in balanced portfolios to 20% from 10%, and in preservation of capital portfolios to 25% from 15%. Cash would be generated by equally reducing U.S. large cap stocks and International stocks (both developed and emerging).
Alternative investments, such as hedge funds in the distress and long/short categories remain attractive for fresh cash.
A. Marshall Acuff
Managing Director
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory LLC
