Investment Outlook, April 2009

The roller coaster ride continues.  In the first nine weeks of the year, the U.S stock market (as measured by the S&P 500 Stock Index) fell 25% and then shot up 18% before the end of the first quarter.  While that rise has continued into early April and has made us all feel a little better, we are hardly out of the woods.

Three months ago, we laid out several predictions for 2009.  Here’s an update on those:

“Bad economic news will continue to dominate the headlines.  Job losses and the unemployment rate will continue to mount.”  The unemployment rate has jumped to 8.5% and job losses so far this year are estimated at more than two million.   Since the start of this recession, more than five million jobs have been lost.

“In the aggregate, corporate earnings will drop precipitously.” Trying to predict an aggregate earnings figure for the companies in the S&P 500 has become a parlor game on Wall Street.  Everyone has an opinion, the dispersion among estimates is very wide and only the lucky will get it right.  Even long term averages are distorted by the very high earnings of a few years ago which gave way to huge write-offs that effectively canceled out those earnings.

“The markets will continue to be highly sensitive to new government intervention.”   With the stimulus package now the law of the land, AIG and the automakers are high on the minds of economic policymakers.  Talk of bankruptcy for GM and Chrysler no longer spooks the market and there is growing consensus of the need to get on with it.  The markets reacted positively to the Federal Reserve’s announcement of further plans to buy mortgage-backed securities and even Treasury securities.  However, we are uneasy about the implications of one arm of the government issuing massive amounts of debt and another arm of the government printing money to buy the same securities.

In addition, we think it is unlikely that the Treasury Department will get a lot of private partners lining up for its PPIP (the Public-Private Investment Program to buy toxic assets from banks).  First, the spread between the bid and ask prices for these securities is very high – closing the gap will not be easy.  Second, the softening of mark-to-market accounting rules will make it less likely that banks will want to sell.  Finally, Congress’ propensity for changing rules after the fact (think 90% tax on AIG bonuses) will make hedge fund managers very reticent to join the program in hopes of making big profits. 

“The thaw in the credit markets will continue, but setbacks are likely.” Corporate bond and municipal spreads have tightened a lot over the quarter, although they are still at relatively high levels.  However, defaults have been slow to appear and we expect recovery rates to be much lower than prior experience.  We would not be surprised to see a few public bankruptcies back spreads up somewhat in the next few months. On the plus side, creditworthy companies are beginning to take advantage of the low rates and issue debt selectively, if it can be used to shore up their balance sheets.

“Faced with disappointing earnings and competition from bonds, stocks will have a hard time sustaining a rally.”    The accuracy of this statement will be tested in the next few weeks as we get corporate earnings reports for the first quarter.  After the March rally, the stock market was still down more than 10% in the first quarter.  We would not be surprised to see the market retrace some of the gains of the last few weeks as the reality of the decline in corporate earnings hits home to investors.

“Government will continue to expand its role in the private sector. “  Just ask the executives at the auto makers or AIG about this statement.  Perhaps the best indicator of how far we have come was not the firing of then GM CEO Rick Wagoner but rather Matt Lauer’s (NBC Today Show) question of Fritz Henderson (new GM CEO):  “Sir, to put it bluntly, don’t you report to the President of the United States?”

Healthy banks, such as Goldman Sachs, are trying to convince the government to take their TARP money back.  So far the government has declined.  Ultimately, we expect that the government will have no choice but to pick winners and losers by taking their money back from the winners and funneling it to the losers to pay off their obligations.

“Risk management is the order of the day for client portfolios.”    We have maintained a very conservative posture -- we have not rebalanced into stocks since last August.  Instead, we have significantly increased bond positions in corporates or municipals, often using closed end fund special situations as attractive ways of investing in these markets.     Within stock allocations, we continue to use the Essential Growth Portfolio℠ alongside mutual funds that tend to offer more downside protection.   So we don’t see the need to increase the risk profile of client portfolios.  Rather, we believe attractive returns can be earned by prudently taking advantage of lower risk opportunities currently available.

April 8, 2009