Commentary

Equity markets have historically rallied when the economic slump is at its worst

We believe there are promising signs that the financial crisis is nearing a stabilization point and that the recession may only be one of average duration and depth.

In previous commentaries, we have explored the idea that the equity markets are often a leading indicator of economic conditions. In other words, an equity market slump has often preceded an economic downturn, and conversely, equity markets often rally ahead of an economic upturn—even as forecasters are predicting the reverse. What might the historic "wisdom of the markets" tell us about where we are now and what will come next?

The prescience of the market is a topic that Barton Biggs deftly explores in his latest book Wealth, War, and Wisdom (John Wiley & Sons, Inc., 2008). Mr. Biggs, a well-known financial expert who served as chief global strategist for Morgan Stanley for 30 years, considers the history of the financial markets during extreme times and how well the markets anticipate the future. With characteristic insight, he delves into wisdom of the markets—that is, how the crowd of market participants can see the path to the future, even when the press, economists and market forecasters cannot. He writes:

The London stock market deduced in the early summer of 1940, even before the Battle of Britain at a time when the world and even many English despaired, that Britain would not be conquered. Stocks made a bottom for the ages in early June although it wasn't evident until October that there would be no German invasion in 1940 and until Pearl Harbor 18 months later, that Britain would prevail.

Similarly, the German stock market, even though imprisoned in the grip of a police state, somehow understood in October of 1941 that the crest of German conquest had been reached. It was an incredible insight. At the time, the German army appeared invincible. It had never lost a battle; it had never been forced to withdraw. … No one else understood that this was the tipping point. (Wealth, War, and Wisdom, page 12.)

We agree with Mr. Biggs' view that somehow, the collective wisdom of thousands of individual decisions in the marketplace is much better than those of any one "expert." This market wisdom is one of the principal factors that makes capitalism work so much better than a central-controlled economy. Moreover, Mr. Biggs' analysis provides a reminder that is particularly important in volatile markets: As we attempt to determine the bottom of the market or the end of a crisis, the markets may have already responded. Because of this, we encourage investors to stay focused on the long-term and to stay in the market with a disciplined strategy.

Although the volatility in the markets is disconcerting and the depth of the credit crisis is still not fully known, we believe there are promising signs that the financial crisis is nearing a stabilization point and that the recession may only be one of average duration and depth. For example, the VIX Index (a measure of implied market volatility) is at a multi-year high, and typical of a level at which market price reversal may occur (see Figure 1).

Fig. 1: Market Volatility (April 3, 1998 - March 28, 2008)
Source: Bloomberg LP

Recap: 1st Quarter, 2008

During the first quarter of 2008, investors contemplated the depth of the credit crisis, the probability of a U.S. recession, and the prospect that the United States could lead the global economy into a recession. Against this uncertainty, equity markets experienced their worst quarter in five-and-ahalf years. The S&P 500 Index declined 9.45%, the Nasdaq retreated 13.88%, and the MSCI World Index fell 8.91%.

Over the past five months, we have heard much about global markets decoupling as the United States falls into a recession. So far, however, the global markets are acting in unison, as the chart below shows (see Figure 2). This is not entirely unexpected. During periods of investor panic, correlation among global markets typically increases, as well as volatility. This anxiety feeds upon itself, throwing monkey wrenches into risk management models and perpetuating additional selling. Ultimately, however, we believe that the saner forces of collective market wisdom will prevail.

Fig. 2: Global Equity Market Performance - Return % (January 1, 2007 - March 31, 2008)
Source: Bloomberg LP

Outlook

Many investors are preoccupied about the future impact of recessionary pressures on their portfolios. This may not be the most relevant consideration, given the equity markets have often acted ahead of the economy. Investors may be better served by evaluating what has already occurred in the equity markets. As we wrote in our February commentary, we believe the markets have already discounted an average recession, as evidenced by the nearly 20% correction in the equity markets since last October. The markets have also discounted a financial industry crisis on the order of the Savings & Loan (S&L) crisis of the early 1990s.

So then, the real question regarding portfolio positioning would be "are we in for the worst recession and financial crisis in a generation?" If so, the markets have another significant decline ahead. If not, the markets appear to be well along in the correction phase, and one should position the portfolio for the next up phase. We believe it is more likely that the United States is facing a normal recession than the cataclysmic meltdown that some fear.

The Fed has lowered rates considerably in the past six months, including an emergency 75 basis-point rate cut on March 18, in an effort to get ahead of the curve and support the markets in the wake of the Bear Stearns implosion. We believe the Fed will continue to do everything possible to support the financial system and that normal lending functions will resume. The real interest rate is now negative for short-term government paper; something you typically see near the end of a recession.

In addition to the Fed's more sweeping rate cuts, steps have been taken to shore up individual entities. For example, Congress provided liquidity on the order of $200 to $300 billion to Fannie Mae and Freddie Mac's balance sheets—an aggressive measure to support the asset-backed and mortgage markets. Only a year ago, discussions centered on reducing risk in Fannie and Freddie's balance sheets and moving their leverage lower, akin to a typical financial institution. More recently, the Fed worked in concert with JP Morgan to avoid a collapse of Bear Stearns, a move which has surely prevented cascades of damage to the financial markets.

There are also indications that the SEC may revisit the fair value accounting standards of FASB 157, or at least recommend a more practical application of this standard than the aggressive position taken by auditors and the press. FASB 157 has forced a new standard of asset valuation, which has had a hand in triggering the financial crisis. The standards unleashed a process of price discovery and a rush to liquidity not unlike the junk bond crisis of 1990s, which was precipitated by forced selling of low-grade bonds by savings and loans. The rule had the effect of forcing public corporations to restructure their balance sheets or sell less-liquid assets. The sell-off caused prices to drop, which caused balance sheets to shrink, forcing additional selling and de-leveraging, and on and on. This damaging cycle has been well under way, but there are signs that it may be abating.

While FASB 157 may have improved transparency, it also made many balance sheets appear weaker under an unrealistic measure. Additionally, corporations were required to adopt FASB 157 at a rate that we believe to be more rapid than responsible. We believe a standard like this is best phased in over a very long period of time, so that its application does not negatively impact the normal functions of the marketplace. Regulations that appear fair and reasonable on the surface can be destructive when the "rules of the game" are changed in an aggressive and ultra-conservative manner.

It is our hope that the Fed receives increased support from the European Central Bank (ECB) and the Bank of England to fight the systemic risk in the financial system. Inflation in Europe has hit a 16-year high so the ECB has its hands full. Some additional coordinated effort to reduce systemic risk would go a long way in fighting the lack of confidence in the credit system. Up to this point, the ECB has doggedly focused on inflation, and has been able to all but ignore the financial crisis. This is because business lending has remained strong in Europe, even as the banks and insurance companies show signs of stress and the LIBOR rate stubbornly remains at a wide spread to Treasury bills. Part of the ECB's lack of action may be a result of the weak dollar and the United States' exporting of inflation via the trade deficit and dollar policy. The ECB is also dealing with a more restrictive labor market, which would become difficult to manage if wage inflation takes hold while layoffs are restricted.

Home prices will most likely continue to fall and bankruptcy rates will continue to increase in the near future. We believe this will spark another round of concerns and testing of the viability of the credit default swap market (CDS), and possibly, another testing of market lows. In most down phases of the market, the price pattern has historically resembled more of a "W" than a "V," and this second leg (the second downward stroke in the "W") often shakes out any weaker investors. The housing market may take a few more years to clear inventory and find a reasonable bottom. We believe the credit markets will likely clear more quickly, but with more fury.

Looking back and looking forward

Over the years, we've been reminded time and again of a saying popularly attributed to Mark Twain, "History may not always repeat itself, but it often rhymes." In other words, although every market cycle is different and the past can't predict the future, history can provide much-needed perspective.

In a number of ways, the current market and economic environment is reminiscent of 1990. Then we had a recession, a credit crisis (in junk bonds), a real estate crisis, and the bursting of Japan's stock and real estate bubbles.

	Recession and S&L Crisis of 1990 (12/31/89 - 12/21/90)	Current Environment (3/31/07 - 3/31/08)
S&P 500 Index	-20%	-19%
Nasdaq	-31%	-24%
Year-over-Year Inflation (CPI)	6.11%	4.03%
10 Yr Treasury Note*	8.07%	3.41%
6 Mo Treasury Bill*	6.74%	1.48%
Real Estate Economic Impact	3% GDP	3% GDP (est.)
Financial Industry (S&P 500 Financials Index)	-41%	-41%
Global Markets (MSCI World Index)	-30%	-24%
* Yields as of 12/31/90 and 3/31/08 Source: Bloomberg LP and Bureau of Labor Statistics
Fig. 3: U.S. Financials Sector (1990 and Today)
Source: FactSet / S&P

As the table and Figure 3 indicate, the similarity in the financial markets' response between these two periods is remarkable. Of course, although the two periods are similar, they are not equal in many ways. The 1990 recession was different because it was partly caused by an oil price shock resulting from the first Iraq war. Corporate debt-to-cash-flow levels today are much better than in 1990, and inventory levels are much leaner today than in 1990. The export side of the economy is more robust than in 1990, but the trade deficit is larger. The S&L crisis of that time appears to be close to the same size as today's mortgage crisis, but the solution to the problems will be different. The credit unwinding process may have much further to go this time as the total leverage in the system is much greater, although the cost of leverage is lower. Overall, corporate America is in better shape now than in 1990 while the U.S. dollar is more troublesome and the credit markets are more levered than in 1990.

The Bear Stearns bailout by JP Morgan and the Fed may be the final defining event in this credit crisis—at least we hope so. Over the past few decades, the financial markets have been hit by banking or financial market crises that culminated in a major event that marked the bottom of the short-term correction. Then, the market rallied. We had the First Penn bankruptcy in 1980, the Latin American debt crisis in 1982, the Continental Bank failure in 1984, the 1987 stock market crash, the 1990 S&L crisis and the Japanese market collapse, the emerging market rout in 1992, the Mexican peso collapse in 1994, the Long-Term Capital Management crisis in 1998, the tech and telecomm bust in 2000, Enron and Tyco corporate scandals in 2002, and now, Bear Stearns in 2008. Despite this seemingly constant stream of chaos and disasters, the S&P 500 Index has rose from 100 to 1375 since 1980—a striking testament to the strength of the capitalist financial system.

Stagflation, the next wall of worry

The Fed's first job was to stop the bleeding in the credit markets; now it must figure out a means to support the dollar and reduce the impact of global inflation. Although the unwinding of the credit cycle is deflationary, the Fed's actions have been aggressively inflationary. It appears that inflation is winning at this point since the U.S. dollar is collapsing and inflation rates are increasing around the globe. The velocity of money is decreasing globally, and we believe the markets will grapple with the possibility of stagflation unless a fiscal solution is at hand. Economic growth can mask many problems, while a lack of growth in the economy generates myriad problems. The weak U.S. dollar and surging commodity prices are signs of an excess of dollars in the global markets. These excess dollars are one of the main culprits of the asset inflation experienced in nearly every major asset class in the world over the past five years. In effect, the weak dollar is exporting our inflation to countries with a currency peg and forcing those without a dollar peg to defend their currency. As we are now experiencing, as asset devaluation occurs, the credit cycle starts to unwind and net worth declines as well. Consumers pull back spending as their net worth erodes and jobs become less abundant. This process leads to slower economic growth and less risk taking. The slowing economy is not supported by credit expansion and asset devaluation undermines value further.

Stagflation is a real concern and we believe the only solution is a fiscal response to stimulate risk taking and capital formation. Setting the U.S. economy on a growth trajectory will require a more credible response than a small, one-time cash payment. The problem is not that easy to fix, and the markets will not respond to this political deceit and foolishness. We cannot spend our way out of this recession nor devalue our currency to become competitive. We believe that tax incentives which favor job creation and new business development, and globally competitive corporate taxes and capital gains taxes would be the best course. Such measures would support the U.S. dollar, and at the same time, stimulate risk taking and capital formation.

Strategic positioning

While we believe the probability is low, it is possible that the unwinding of the debt crisis could be a protracted super-cycle, leading us to a recession deeper and longer than normal. In either case, we believe that a well-diversified asset allocation is your best defense, and can help you avoid the market timing trap.

Over the last month, the equity markets have responded positively (up 7%) to the Fed's actions, and capital is still available for the beleaguered banks. We are encouraged that investors are now being more appropriately compensated for risk, unlike in recent years past. Given that a recession has been priced into the debt and credit markets, we are finding opportunities to selectively boost our weightings to financials. At today's values, we still favor high-grade corporate bonds over government bonds or high-yield bonds. That said, we expect to increase low-grade bond exposure over the next few months as further economic weakness is realized.

We are selling volatility in the market via covered call writing and convertible structures that are short embedded options. We believe technology stocks have been hit too hard, and we are finding some very compelling values in this sector. It is likely we will also add to our consumer cyclical exposure, as most stock prices in this sector are discounting a bleaker future than we believe likely. Our strategies have been equally weighted or underweight to the energy and materials sector for the past few years. If security prices start to discount the cyclical nature of these groups, we expect to increase exposure to these areas as well.

We continue to emphasize well-run businesses with quality fundamentals, such as good cash flow and high return on invested capital. We are favoring companies that have positioned themselves to benefit from globalization and the secular trends that are transforming the world economy. Across strategies, this has led us to companies that generate a substantial portion of their revenues from non-U.S. sources.

Conclusion

It is sometimes difficult to see the way out of a crisis, markets can and do somehow adapt and move on. years have seen many crises that, at some point, looked near fatal to the markets; yet in the end, the markets grips with these events and have performed exceptionally We believe the historic resilience of the markets and economy should inspire confidence in investors, even near-term economic conditions remain clouded.

It is important to remember that the markets will always entail risk, and it is through managing risk that opportunities emerge. The risk in the markets goes hand in hand with higher potential returns. We believe, for example, that double-digit equity returns are not possible without the market concerns and volatility that we face today.

Earlier in this commentary, we discussed our belief in the collective wisdom of the markets. Of course, that does not mean that every decision about every security will always be correct. Over the near term, investor sentiment can get in the way and good companies can be mispriced. As Benjamin Graham noted, "In the short run, the market is a voting machine, but in the long run, it is a weighing machine."

In addition to having confidence that the "weighing machine" will be appropriately calibrated, we maintain a high degree of conviction in our ability to weigh the merits and risks of potential investments, and to capitalize on instances where short-term sentiment may be misguided. We remain dedicated to using our time-tested discipline to pursue the long-term growth potential of the global marketplace.