Cumberland: Dammit! This is NOT the Great Depression.
Dammit! This is NOT the Great
Depression.
October 26, 2008
Bear markets fall into three categories: (A) the most common is the
cyclical bear; they average about 20% to 25% down from peak to trough. (B)
Occasionally we experience a secular bear; they typically decline about 45%
to 50% from peak to trough. (C) Lastly and most rare is the devastating
bear; these declines are 75% to 90% calamities like the Japanese collapse
in the 1990s or the current selloff in Chinese "A" shares. America's most
devastating bear was in the Great Depression era. Stocks lost 90% of
market value from peak to trough in 1929-1933.
This current 2007-2008 bear market is in the middle category; it is a
secular, "45% bear." Evidence suggests that it is nearly over. The Dow
peaked at 14165 on October 9, 2007 and the S&P peaked at 1565 on the same
day. At the moment it looks like the US stock market probably bottomed one
year later on October 10, 2008 at 7883 intraday on the Dow Jones Industrial
Average and 839.80 intraday on the S&P 500. Both indexes' peak-to-trough
declines are about 45%.
The post-World War II history of bear market bottoms suggests that these
bottoming levels will be retested and may be temporarily breached. That is
not unusual at the end of a secular bear market. Sometimes the test sets a
new low but it usually does not last very long. Sometimes secular bears
end in a sharply defined climax. Other times they just peter out. The 45%
decline in the 1973-4 bear is a good example of a final December low being
set without a climax.
Cyclical bears happen during protracted economic growth cycles. They tend
to complete their time quickly, then the primary growth trend resumes.
Cyclical bears are much too mild a reaction when there is a full-blown
recession as we have today.
Secular bears occur when there is some major economic inflection point in
the longer-term trend; they often have easily identified speculative
features. If you use the S&P 500 index to measure it, the current secular
bear market arguably peaked in 2000 with the tech stock bubble. If you use
the Dow, the demise of the financial sector marks a second bubble bursting
within this secular bear market timeframe. The run-up of oil to $147 a
barrel and its subsequent collapse is another feature of the present
secular bear. And lastly, there is the widely spread impact of the housing
market collapse.
Devastating bears are extended versions of secular bears. Americans need
to examine the Great Depression era to see our last one. A devastating
bear requires a government policy failure to occur. Devastating bears
happen when there is an absence of credible governmental attempts to
counter them with stimulus. The sequence is that first the government
policy fails and then the secular bear morphs into a devastating bear.
In a devastating bear, the government acts with too little and does it too
late to stop the carnage. We are seeing that now in China with the "A"
shares. Only after a 65% decline has the Chinese government started to
seriously intervene. We saw it in Japan. We may be seeing it in Russia if
Putin's policies continue to dismember his fledgling market system.
We saw it in the US in the Great Depression era when the Federal Reserve
remained tight in the face of deflation. It was the Fed tightness in
1928-1929 that triggered the stock market crash. Stocks had become the
speculative sector. The Fed continued to drain liquidity in 1930, and that
triggered bank failures. In those days there was no federal deposit
insurance. Banks failed and people lost their money.
A seminal event usually marks the end of a secular bear and/or the start of
a devastating bear. In the Great Depression era the event was the failure
of the Bank of the United States. On December 11, 1930, the NY banking
superintendent closed this bank and left 500,000 depositors stranded.
Prior to that date, bank failures in the US were mostly limited to smaller
rural institutions. The Bank of the US failure resulted from the inability
of the banking regulators to achieve a merger with two other NY banks.
The secular bear of 1929-1930 became a devastating bear in 1931. Then the
federal government and a young Federal Reserve failed to be the lender of
last resort. The aftermath of the Bank of the US failure exacerbated the
1929-1930 US recession into the 1931-1933 Great Depression. That failure
also triggered the financial and economic turmoil spreading into a global
contagion.
The rest of the Great Depression-era history is well known. Federal
stimulus wasn't applied until 1933. Depression-era money and credit
contracted and collapsed. There was 25% shrinkage. One out of four
American workers was unemployed. Deflation ruined the economy. Elsewhere
in the world, economic and financial turmoil led to political regime
changes. In Europe the Nazi party achieved power in Germany in 1933.
The failure of Lehman Brothers is the modern-day equivalent of the
Depression-era failure of the Bank of the United States. In 2008, the
Lehman failure induced global contagion. What is different now is that the
government's policy reaction has been precisely the opposite of that during
the Depression period.
The Federal Reserve's cash infusion is massive and clearly contrasts with
the Depression era. Liquidity is created and not withdrawn. With the
start of the commercial paper facility, the Fed's balance sheet will have
tripled its size in only a few weeks time. In the Depression erait
contracted.
The fiscal stimulus coming from the federal government is also huge. We
expect the cash deficit of the US to exceed a trillion dollars a year for
the next two years and then only slowly decline. Other central banks and
governments around the world are responding in a similar way.
The turmoil of 2007-2008 and the present recession will not become another
Great Depression. The characteristics of global governments responses
after Lehman are enough evidence to reach that conclusion.
We can forecast markets now that the unwinding of Lehman Brothers' failure
and its aftermath is coming to an end. For stocks the post-secular bear
market recoveries have been very robust. They can double from the low and
achieve 50% of that move in the first year of the new bull market.
This autumn, stocks were hammered along with bonds as the hedge fund
unwinding trade took place during the weeks after Lehman's failure. Hedge
funds were long stocks and bonds and hedged with credit default swaps and
other derivatives. Lehman's failure introduced a counterparty risk
premium, and that "blew up" the hedges. The vicious sell-off ensued.
We believe it is nearly over. Friday morning's limit down in futures is an
indicator of climax activity at work. We saw similar stock futures trading
activity at the 1987 stock market bottom. The actual trading after limit
down was not a continuation of the plunge. It appears that the rate of
change in the sell-off has turned from its extreme. It may still be
negative, but it is less negative than at the stock market bottom.
Credit spreads are finally narrowing from their extreme and unprecedented
peaks. There are many measures of this financial market stress and all of
them are narrowing. Some more than others, but all have ceased widening.
In the United States we are witnessing the largest fiscal stimulus combined
with the largest monetary stimulus since the World War II era. In WWII the
US maintained interest rates at 3/8 of 1% on short-term T bills, and the
deficit ran above 10% of GDP. The government's debt-to-GDP ratio exceeded
100% at the end of the war. Current government policy will take the
deficit over $1 trillion, and US Treasury bill interest rates have already
seen their lows at levels similar to WWII. When this turmoil has run its
course, the federal debt-to-GDP ratio will again exceed 100%.
This entire government stimulus will work positively on the nominal prices
of stocks and on unfreezing the credit structure. Furthermore, the housing
market will be a direct recipient of this stimulus and is now likely to
bottom in 2009. The extent of housing deterioration has already reached
extreme levels not seen in the last half century.
We think it is time to get focused on the recovery period. It is time to
move from cash to stocks and bonds. Not Treasury bonds but other bonds.
High-grade tax-free municipal bonds were yielding 6 ½% in many
jurisdictions. That sector has started to thaw and the prices of bonds
have gapped higher (yields lower). We are buying them for our clients as
we watch yields drop from the "6-handle" to the "5-handle". We are
selecting structure so that we can achieve potential capital gains in
addition to the coupon. We expect to see this market rally to a
"4-handle." Detailed inquiry into the composition of each bond is now more
critical than ever.
Stocks are now so cheap as to compare with levels seen at the 1987 and 1974
bottoms. The S&P 500 is now 10 times its trailing 2007 earnings and the
lowest price-to-book in decades. The Treasury bond yield / S&P 500
dividend ratio is the lowest since 1979. Sentiment measures and volatility
indicators are at extremes rarely seen.
All these measures say it is time to own stocks for longer-term investors.
And other measures suggest that the demand for stocks will be huge once the
malaise gives way to a better outlook. The ratio of uninvested and
potential cash to the aggregate value of the stock market is estimated to
be above 40%. That is the highest percentage of uninvested cash in
history.
At Cumberland, positions in US Treasury bonds have been sold with the
exception of TIPS. TIPS are trading at nearly a 3% real yield, and that is
a good entry point.
In sum, the eye of the hurricane has passed. We still have high volatility
and high risk and a recession in progress. We are now focused on the
economics of the aftershocks as the hurricane center moves away. The
maximum storm surge was felt in the aftermath of the failure of Lehman.
Now the water has receded and we are assessing the damage. Like Katrina,
this too shall pass. And the rebuilding will add to GDP and enhance
tangible and financial assets.
Longer-term targets are now estimable. We believe a multi-year economic
recovery will commence by yearend 2009. The US GDP will be about $17 to
$18 trillion in five years. The stock market at that time will likely
equal or exceed the GDP in aggregate value and reflect earnings
commensurate with that change. We expect the S&P 500 to achieve a level
between 1700 and 2000 at some point in the next five years.
It is time to buy the dips and get positioned if you haven't already done
so. We have been scaling into stocks and bonds and have picked up the pace
in the aftermath of Lehman's failure. Cumberland's stock accounts are
nearly fully invested using exchange-traded funds. Our bond accounts in
taxable and tax-free bonds are positioning to imbed these extraordinary
high yields. Cash reserves are being reduced to minimum levels.
This period is NOT going to be a repeat of the Great Depression!
October 26, 2008
Bear markets fall into three categories: (A) the most common is the
cyclical bear; they average about 20% to 25% down from peak to trough. (B)
Occasionally we experience a secular bear; they typically decline about 45%
to 50% from peak to trough. (C) Lastly and most rare is the devastating
bear; these declines are 75% to 90% calamities like the Japanese collapse
in the 1990s or the current selloff in Chinese "A" shares. America's most
devastating bear was in the Great Depression era. Stocks lost 90% of
market value from peak to trough in 1929-1933.
This current 2007-2008 bear market is in the middle category; it is a
secular, "45% bear." Evidence suggests that it is nearly over. The Dow
peaked at 14165 on October 9, 2007 and the S&P peaked at 1565 on the same
day. At the moment it looks like the US stock market probably bottomed one
year later on October 10, 2008 at 7883 intraday on the Dow Jones Industrial
Average and 839.80 intraday on the S&P 500. Both indexes' peak-to-trough
declines are about 45%.
The post-World War II history of bear market bottoms suggests that these
bottoming levels will be retested and may be temporarily breached. That is
not unusual at the end of a secular bear market. Sometimes the test sets a
new low but it usually does not last very long. Sometimes secular bears
end in a sharply defined climax. Other times they just peter out. The 45%
decline in the 1973-4 bear is a good example of a final December low being
set without a climax.
Cyclical bears happen during protracted economic growth cycles. They tend
to complete their time quickly, then the primary growth trend resumes.
Cyclical bears are much too mild a reaction when there is a full-blown
recession as we have today.
Secular bears occur when there is some major economic inflection point in
the longer-term trend; they often have easily identified speculative
features. If you use the S&P 500 index to measure it, the current secular
bear market arguably peaked in 2000 with the tech stock bubble. If you use
the Dow, the demise of the financial sector marks a second bubble bursting
within this secular bear market timeframe. The run-up of oil to $147 a
barrel and its subsequent collapse is another feature of the present
secular bear. And lastly, there is the widely spread impact of the housing
market collapse.
Devastating bears are extended versions of secular bears. Americans need
to examine the Great Depression era to see our last one. A devastating
bear requires a government policy failure to occur. Devastating bears
happen when there is an absence of credible governmental attempts to
counter them with stimulus. The sequence is that first the government
policy fails and then the secular bear morphs into a devastating bear.
In a devastating bear, the government acts with too little and does it too
late to stop the carnage. We are seeing that now in China with the "A"
shares. Only after a 65% decline has the Chinese government started to
seriously intervene. We saw it in Japan. We may be seeing it in Russia if
Putin's policies continue to dismember his fledgling market system.
We saw it in the US in the Great Depression era when the Federal Reserve
remained tight in the face of deflation. It was the Fed tightness in
1928-1929 that triggered the stock market crash. Stocks had become the
speculative sector. The Fed continued to drain liquidity in 1930, and that
triggered bank failures. In those days there was no federal deposit
insurance. Banks failed and people lost their money.
A seminal event usually marks the end of a secular bear and/or the start of
a devastating bear. In the Great Depression era the event was the failure
of the Bank of the United States. On December 11, 1930, the NY banking
superintendent closed this bank and left 500,000 depositors stranded.
Prior to that date, bank failures in the US were mostly limited to smaller
rural institutions. The Bank of the US failure resulted from the inability
of the banking regulators to achieve a merger with two other NY banks.
The secular bear of 1929-1930 became a devastating bear in 1931. Then the
federal government and a young Federal Reserve failed to be the lender of
last resort. The aftermath of the Bank of the US failure exacerbated the
1929-1930 US recession into the 1931-1933 Great Depression. That failure
also triggered the financial and economic turmoil spreading into a global
contagion.
The rest of the Great Depression-era history is well known. Federal
stimulus wasn't applied until 1933. Depression-era money and credit
contracted and collapsed. There was 25% shrinkage. One out of four
American workers was unemployed. Deflation ruined the economy. Elsewhere
in the world, economic and financial turmoil led to political regime
changes. In Europe the Nazi party achieved power in Germany in 1933.
The failure of Lehman Brothers is the modern-day equivalent of the
Depression-era failure of the Bank of the United States. In 2008, the
Lehman failure induced global contagion. What is different now is that the
government's policy reaction has been precisely the opposite of that during
the Depression period.
The Federal Reserve's cash infusion is massive and clearly contrasts with
the Depression era. Liquidity is created and not withdrawn. With the
start of the commercial paper facility, the Fed's balance sheet will have
tripled its size in only a few weeks time. In the Depression erait
contracted.
The fiscal stimulus coming from the federal government is also huge. We
expect the cash deficit of the US to exceed a trillion dollars a year for
the next two years and then only slowly decline. Other central banks and
governments around the world are responding in a similar way.
The turmoil of 2007-2008 and the present recession will not become another
Great Depression. The characteristics of global governments responses
after Lehman are enough evidence to reach that conclusion.
We can forecast markets now that the unwinding of Lehman Brothers' failure
and its aftermath is coming to an end. For stocks the post-secular bear
market recoveries have been very robust. They can double from the low and
achieve 50% of that move in the first year of the new bull market.
This autumn, stocks were hammered along with bonds as the hedge fund
unwinding trade took place during the weeks after Lehman's failure. Hedge
funds were long stocks and bonds and hedged with credit default swaps and
other derivatives. Lehman's failure introduced a counterparty risk
premium, and that "blew up" the hedges. The vicious sell-off ensued.
We believe it is nearly over. Friday morning's limit down in futures is an
indicator of climax activity at work. We saw similar stock futures trading
activity at the 1987 stock market bottom. The actual trading after limit
down was not a continuation of the plunge. It appears that the rate of
change in the sell-off has turned from its extreme. It may still be
negative, but it is less negative than at the stock market bottom.
Credit spreads are finally narrowing from their extreme and unprecedented
peaks. There are many measures of this financial market stress and all of
them are narrowing. Some more than others, but all have ceased widening.
In the United States we are witnessing the largest fiscal stimulus combined
with the largest monetary stimulus since the World War II era. In WWII the
US maintained interest rates at 3/8 of 1% on short-term T bills, and the
deficit ran above 10% of GDP. The government's debt-to-GDP ratio exceeded
100% at the end of the war. Current government policy will take the
deficit over $1 trillion, and US Treasury bill interest rates have already
seen their lows at levels similar to WWII. When this turmoil has run its
course, the federal debt-to-GDP ratio will again exceed 100%.
This entire government stimulus will work positively on the nominal prices
of stocks and on unfreezing the credit structure. Furthermore, the housing
market will be a direct recipient of this stimulus and is now likely to
bottom in 2009. The extent of housing deterioration has already reached
extreme levels not seen in the last half century.
We think it is time to get focused on the recovery period. It is time to
move from cash to stocks and bonds. Not Treasury bonds but other bonds.
High-grade tax-free municipal bonds were yielding 6 ½% in many
jurisdictions. That sector has started to thaw and the prices of bonds
have gapped higher (yields lower). We are buying them for our clients as
we watch yields drop from the "6-handle" to the "5-handle". We are
selecting structure so that we can achieve potential capital gains in
addition to the coupon. We expect to see this market rally to a
"4-handle." Detailed inquiry into the composition of each bond is now more
critical than ever.
Stocks are now so cheap as to compare with levels seen at the 1987 and 1974
bottoms. The S&P 500 is now 10 times its trailing 2007 earnings and the
lowest price-to-book in decades. The Treasury bond yield / S&P 500
dividend ratio is the lowest since 1979. Sentiment measures and volatility
indicators are at extremes rarely seen.
All these measures say it is time to own stocks for longer-term investors.
And other measures suggest that the demand for stocks will be huge once the
malaise gives way to a better outlook. The ratio of uninvested and
potential cash to the aggregate value of the stock market is estimated to
be above 40%. That is the highest percentage of uninvested cash in
history.
At Cumberland, positions in US Treasury bonds have been sold with the
exception of TIPS. TIPS are trading at nearly a 3% real yield, and that is
a good entry point.
In sum, the eye of the hurricane has passed. We still have high volatility
and high risk and a recession in progress. We are now focused on the
economics of the aftershocks as the hurricane center moves away. The
maximum storm surge was felt in the aftermath of the failure of Lehman.
Now the water has receded and we are assessing the damage. Like Katrina,
this too shall pass. And the rebuilding will add to GDP and enhance
tangible and financial assets.
Longer-term targets are now estimable. We believe a multi-year economic
recovery will commence by yearend 2009. The US GDP will be about $17 to
$18 trillion in five years. The stock market at that time will likely
equal or exceed the GDP in aggregate value and reflect earnings
commensurate with that change. We expect the S&P 500 to achieve a level
between 1700 and 2000 at some point in the next five years.
It is time to buy the dips and get positioned if you haven't already done
so. We have been scaling into stocks and bonds and have picked up the pace
in the aftermath of Lehman's failure. Cumberland's stock accounts are
nearly fully invested using exchange-traded funds. Our bond accounts in
taxable and tax-free bonds are positioning to imbed these extraordinary
high yields. Cash reserves are being reduced to minimum levels.
This period is NOT going to be a repeat of the Great Depression!
