The Market's Recent Decline, and Why the Fed is Stuck
Below is a copy of our July letter to clients. To receive these letters free every month via email, visit our Contact Page and submit your email address. For more information about investing with Sitka Pacific Capital Management, visit www.sitkapacific.com or email us at firstname.lastname@example.org.
After a strong start the market reversed lower in the second half of July, leaving the S&P 500 with loss for the month. For the first time the Dow Industrials closed - for one day - above 14,000, but was unable to continue higher and also ended July in negative territory. We are in the seasonally weak summer period for stocks when the market usually makes little headway, and the recent weakness may be the beginning of a typical seasonal decline into the fall. It is also possible that the reversal this month could prove to be the start of a larger bearish trend, which we'll talk more about below.
Since hitting a low in June, Treasury bonds staged a modest recovery that turned into a more substantial recovery as stocks turned south. The technical damage highlighted in last month's letter is in a mixed state: the 10-year Treasury bond has rallied back into its long-term bullish channel, but the 30-year Treasury bond remains in bearish territory. Trying to judge whether bonds will be able to hold on to these recent gains is truly guesswork at this point. Although it would certainly be welcome to see Treasuries regain a long-term bullish footing, for now the odds remain that a new long-term bearish trend in bonds is establishing itself.
While there has been some volatility in natural resource stocks lately, it is not abnormal for this time of year - especially given the recent volatility in the general market. Oil traded as high as $77 in July, within $3 of its 2006 high. The US dollar continued lower against other major currencies, reaching a new low against the Euro and the British Pound (among others).
This month we're going to look at the stock market's reaction to the slowdown in the housing market, and then look at the market's rally since 2003 in the context of the steadily devaluing US dollar. You may be surprised to learn (or perhaps not) that the rally in stocks over the past few years has been less about the economy and more about the macro situation we find ourselves in. These are important trends to be familiar with as the economic landscape changes, and they will continue to influence our allocations and market exposure in the coming years.
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We'll probably look back at this time a year from now and see that the Fed was either behind the curve in reacting to the emerging weakness in housing and the economy, or they were ahead of the curve by remaining focused on inflation while the economy went through a ‘soft-patch' brought on by the housing market and then recovered. - March 2007
While we are not yet a year from this past March, it has become clear over the past four months that the Fed is not ahead of the curve on inflation or behind the curve in reacting to the deteriorating housing market - they are both. And in a very real sense, the Fed is stuck where they are. The weakness in housing has prevented them from raising rates to combat growing inflationary pressures, for fear that higher rates will exasperate the credit tightening that is already taking place in the mortgage market and send the economy into recession. But they (so far) have been unwilling to lower rates, perhaps because inflation expectations are rising and the dollar is already in a severe downtrend against most major currencies. If they were to announce a rate cut now, the dollar would most likely take a severe hit and inflation expectations could increase further. The problem is that while the Fed has held rates steady, both the inflation situation and the housing downturn have worsened.
|CPI Percent Change in 12 months, ending in June|
|Food and beverages||2.8||2.8||1.5||3.5||2.6||2.3||2.2||6.2|
|Education & Communication||1.3||3.2||2.2||1.6||1.5||2.4||2.3||3.1|
|Other goods and services||4.2||4.5||3.3||1.5||2.5||3.1||3.0||4.1|
|All items less Energy||2.6||2.8||1.8||1.5||2.2||2.2||2.5||2.8|
|All items less Food||2.8||2.8||1.5||3.6||2.7||2.3||2.1||6.2|
|All items less food and energy||2.6||2.7||1.9||1.1||2.2||2.2||2.6||2.3|
For an example on the inflation side of the equation, the price of oil has now climbed back to $77/bl, not far from its peak in 2006. The price of oil affects many things from gasoline to food, and you can see this in the table on the right showing the June Consumer Price Index (CPI) data from the Bureau of Labor Statistics. Items in Red highlight categories strongly influenced by energy prices.
The headline CPI number came in at 2.3% year-over-year in June. This number is what you usually hear reported in the press, which makes the inflation situation seem relatively benign. But this number is actually all items less food and energy, shown in the bottom row in the table. Since energy and food prices can be quite volatile, the Fed and press like to focus on the data with food and energy stripped out. That may (arguably) make some sense from an academic point of view, but since we all consume energy and we all eat food the headline CPI number bears little resemblance to what we experience in real life.
When you look at all items (top row), which includes food and energy, you can see that the CPI increased 5% over the past year. You may also notice that many of the numbers in the 2007 column are noticeably higher than in previous years. (In case you're wondering, the Housing number is not based on average home prices but an equation based on rents) This increase in inflation is the problem faced by the Fed and judging by their meeting minutes they are certainly aware of it. This may be part of the reason the Fed has maintained their stance that inflation is a top concern, and one reason they have not been willing to even suggest lowering rates in response to the housing market.
On the housing side of the equation, consider the following example. Countrywide Financial, the largest mortgage lender in the country, reported their second quarter results last week. Not only had earnings and revenue declined 33% and 15% respectively from 2006, but they disclosed that default rates on their prime mortgages (loans made to borrowers with good credit) had more than doubled in the past year from 2.2% to 5.5%. The rising default rate in the sub-prime arena, which had climbed to over 20% from 13% a year ago, was already well known. But the news that default rates are now climbing among prime borrowers suggests the effects of the housing decline are not staying contained within the sub-prime realm, as many had hoped. In fact, the data suggest the problems in sub-prime are only the beginning of a spreading default "contagion" within the mortgage market.
Countrywide's CEO, Angelo Mozilo, was quoted during the earnings conference call as saying housing prices are falling "almost like never before, with the exception of the Great Depression." With the Dow and S&P 500 hitting all time highs in the past month and everything appearing rosy, this is hardly the assessment we would expect from the leader of the biggest mortgage lender in the country. Last Tuesday when Countrywide released their earnings and the news about the increased prime default rate hit the wires, the Dow declined more than 200 points. The market then continued to sell off and recorded its largest weekly loss since 2003, with major indexes down between 4%-7%.
There is no doubt a stark contrast between the problems in the housing market, which have never occurred at this scale and not been accompanied by a recession, and the strength of stocks prior to last week's sell off. However, the rally over the past 6 months may have been based partly on the assumption that problems in the sub-prime mortgage market would not spread, resulting in a housing downturn that would not weaken the broader economy. The news on prime mortgage defaults from Countrywide may have shattered that assumption.
Even if that is the case, it is certainly not the entire story behind last week's record decline. In addition to the economic risks associated with housing, there have been strong technical headwinds building over the past 8 months. The chart below shows the Nasdaq Composite (in black) along with a measure of market breadth (in red) on the Nasdaq. Breadth refers to the number of stocks participating in a rally or a decline; when the line goes up it means more stocks are moving higher than moving lower, and when it goes down it means more stocks are moving lower than moving higher.
During a healthy market advance we generally see most stocks moving higher, which would be shown by a rising red line. Taking a look at the chart, you'll notice that breadth peaked all the way back in December of last year and since then new highs by the market have not been accompanied by new highs in breadth - indicating a weakening rally. More dramatically, since May (marked by the vertical red line) the number of stocks advancing with the headline Nasdaq Composite index has fallen almost straight down. A lower high in breadth is usually all the warning the market gives get before beginning a correction, and a decline in breadth on the scale we've seen over the past three months is nothing short of extraordinary in light of the market's continued advance. The rally over the past three month was particularly narrow and "hollow," and the sudden drop back to May's levels shows how fast those weak rallies can unwind.
Last week's decline was likely one of two things: it was either part of a seasonal correction that will prove temporary, or it was the first sign that a larger bear market has begun. The most remarkable aspect about last week was not the decline itself, but that the market exhibited some technical extremes which have only been seen a few times over the past 20 years. Also, some very important sectors broke their trends from their 2002 lows on extremely high volume. These events certainly add to the likelihood that a bear market has begun. However, the market remains in a positive cyclical environment heading into next year and a sharp sell-off like this is often a prelude to a continued rally. One thing we can be sure of at this point is the market will be quite volatile over the next few months, and at least in the short-term there is more downside risk.
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We have spent a lot of time lately talking about long-term market cycles of inflation, valuation and real asset out-performance. These are very important treads in the economy and markets and they will continue to shape the investment landscape going forward. It has been approximately 7 years since the current cycle began, and for the most part the forces shaping these trends are still under the radar of most investors - which is typical at this stage. In the past these cycles have been 15-20 years in length and it's usually not until the second half that these themes catch on with the masses. Not coincidently, it is also during the second half of these cycles when the most dramatic investment gains are seen.
Since stocks began their current bull market in earnest in the spring of 2003, the S&P 500 has now rallied approximately 100% after losing 50% from 2000 to the lows of 2002. That puts the index right back at its 2000 high near 1550 - a 0% net gain over 7 years, excluding dividends. However, that feat of reaching its old high may not be as impressive when we dig a little deeper. That 0% gain is in Dollars, and over the past 7 years the dollar has been devalued on numerous fronts: by inflation, by lower exchange rates with other currencies, and also by the increasing price of commodities and precious metals. In effect, a dollar in 2007 doesn't buy close to what a dollar in 2000 did.
A simple way to visualize this is to look at the S&P 500 based on other currencies besides the dollar. The chart below shows the S&P 500 from 1999 in three ways: the dollar-based S&P 500 we're all used to in black; the S&P 500 priced in Euros in blue; and the S&P 500 priced in Gold in - you guessed it - gold.
As you can see, the recovery of stocks since 2002-2003 has had a very large currency component helping it along. In other words, the loss of value in the US Dollar has helped re-price stocks higher in those cheaper dollars over the past 4 years. The dollar now has a much lower exchange rate against many other currencies including the Euro, and if we base the S&P 500 in Euros it is still approximately 33% below its 2000 value. If we price the S&P 500 in Gold we find that stocks haven't recovered at all since 2003, as they are still approximately 45% below their 2000 peak. The same is true of other stock indexes as well: in Euros the Dow Industrials remain more than 20% below its 2000 peak, and the Nasdaq Composite remains more than 60% below its 2000 peak.
This was just meant to illustrate how a weakening dollar has inflated all dollar-priced assets. The inflation of financial and real assets over the past 7 years has been substantial, and everything from homes, corporate earnings, stock prices to commodities have benefited. Even though real assets have out-performed during this period, stocks have also benefited substantially - just not as much.
While stocks have kept pace with gold (and other real assets) since 2003, that may not continue indefinitely. One possible reason for such a de-coupling could be a weakening economy. Since 2003 stocks have rallied while the economy has grown and the Fed has raised interest rates, but in that strongly favorable environment stocks have only managed to barely keep up. If the economy slows enough to force the Fed to begin lowering rates in a bid to support credit from tightening too much, its very likely real assets will again significantly outperform stocks as they did during the 2000-2002 bear market.
There are also a number of possible unintended consequences of a weakening dollar, which could adversely affect stocks. For example, the fear among many dollar-watchers has been that as the dollar continues to be devalued, at some point the foreign buying of our assets - which amounts to several billion dollars a day - would slow or stop, resulting in an abrupt negative re-pricing of stocks and bonds resulting from a relative lack of demand. That outcome may not be very likely, but it is certainly possible. The good news is that foreigners purchased a record $126.1 billion of our assets in May, which shows that their appetite for dollar-based assets hasn't slowed yet.
As long as the economy continues to expand and foreign investors continue to purchase US assets with their trade surpluses, stocks will likely continue to benefit from a continued devaluation of the dollar in the way they have over the past 4 years - as long as that devaluation continues to be gradual. But with the continuing deterioration of the housing market and the potential repercussions for the economy and Fed policy, there appears to be significant risks to stocks both on an absolute basis and relative to real assets.
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If the decline from the high this month is the start of a larger correction or a bear market, we are prepared for it. There are signs, such as the recent rise in credit spreads, that the market is beginning to re-assess and re-price risk. These conditions were not present in February and suggest this decline may be different. Our first and overriding priority during periods of high risk such as this is capital preservation. While this particular environment may present some unique speculative opportunities, they are few when compared to opportunities available to those with buying power after a bear market.
In the context of our recent discussions of the cycle of contracting market valuation since 2000, a bear market at this point certainly would help bring stock market valuations down to levels historically seen at major lows - and that would certainly be a welcome development for long-term investors. After last week's decline, one asset manager (who shall remain anonymous) mentioned that they were looking to buy stocks now because they were "at the lowest valuation in 15 years." That may be true, but it is the trend of that valuation that is more important than the level itself. The price-to-earnings ratio of the S&P 500 was over 45 in 2001 and near 18 at the end of June 2007, and given that stocks have consistently returned to valuations in the single digits before consistently expanding again there are good reasons to believe it has further to go before it bottoms.
During the last major cycle of valuation contraction the price-to-earnings ratio of the S&P 500 bottomed out at 7 in 1974 and again at 7 in 1982. However, while the price of the S&P 500 hit a low at 62 in 1974, it bottomed out at 103 in 1982 - 66% higher than in 1974. So while the cycle of valuation contraction continued until 1982, after which the P/E of the S&P 500 began to expand for good, the best long-term buying opportunity for stocks actually came 8 years earlier in 1974.
This is merely meant to suggest that if we have entered a bear market, valuations could become cheap enough during the subsequent decline to turn more positive on stocks on a long-term basis - even though this valuation cycle has a long way to go. If stocks have only entered a seasonal correction, there will be more opportunities for growth heading into 2008. Regardless of the direction of the market we will continue to invest in strong trends we are more confident in while taking prudent steps to preserve your assets from significant market risks.
That's all for this month. If you have any questions about any of the topics discussed above or would like to go over any aspect of your account, please don't hesitate to contact me.