Bottom is In?

Dan Greenhaus is at the Equity Strategy Group at Miller Tabak + Co. where he covers markets and portfolio theory. He has contributed several chapters to Investing From the Top Down: A Macro Approach to Capital Markets (by Anthony Crescenzi).

This is his most recent commentary:


With the market up a bit over 1% marking the potential for the first
four day rally since May, more and more people are jumping on the
“bottom is in” memo and indicating that a piling back into equities is
the correct portfolio strategy. I wanted to touch on this assertion as
well as a few other ideas floating around seeing as how people have
forgotten that the “bottom is in” idea has been thrown out there each
and every time this market has managed any rally whatsoever only to see
it move lower (From the same people who brought you the wonderful idea
of decoupling).

With respect to the bottoming idea, as one might expect and I have noted
in the past, I have several problems with this thesis, beginning with
the idea that one needs to predict or identify a “bottom” in order to
get constructive on stocks. This is ridiculous and anyone with any long
term investing horizon should agree. To begin with, this bear is about
to enter its 14th month which lags, in length, other bears of similar
force including ’29, ’37, ’73 and ’00. Furthermore, the average
recession in the post WWII era is 10 months, which is the length of time
that gets tossed around on TV and in print as representing an “average”
recession. Of course, what we’re living through is among the more
forceful recessions in history, so in reality we should compare it to
recessions prior to WWII. If you do that, the average length of a
recession is more like 18 months which would imply that we have some way
to go, economically speaking, before the end of this recession. Since
stocks on average tend to bottom about three or four months before the
end of any given recession, a case can be made that the “bottom” or
optimal entry point from a nominal standpoint is still time off.

With that said, one does not purchase stocks because there is little to
no chance they can go down, hence violating a previously identified
“bottom.” No, you purchase stocks because in the long run, they provide
attractive returns either when compared to other risk assets or simply
on their own merits. Like Warren Buffett noted in his NY Times
editorial, I have no idea if stocks will be higher or lower tomorrow or
next month, but I do know that certain companies will make it through
the current malaise and the prices of those companies currently provide
investors with attractive entry points from a valuation standpoint.
Stock prices reflect a very, very long run set of earnings assumptions
and while the current earnings disappointments are unavoidably part of
the equation, so is the rest of the long stream of earnings that will
come afterwards. In the meantime, prices could go lower yes, but that
is why one scales into markets that exhibit the type of volatile trading
we are witnessing (Bespoke notes this is the most volatile period in
history) or protects their investment either buy purchasing protective
puts or selling covered calls against their long positions.

Given that, there are a few issues facing equities that should be of
concern and the first is attractive yields on a variety of fixed income
products including certainly municipal bonds as well as investment grade
corporate debt. Each morning, I pass along a chart of Moody’s
Investment Grade index, currently 5.75%. Some other measurements of
high grade bonds are yielding anywhere from 6%-8% and at yields that
high, investors would be hard pressed to justify piling into equities
when they can mine the high grade market for yields north of 6% with
lower risk. While corporate issuance stalled out not very long ago, we
have seen a recent pick up in issuance in part due to the elevated level
of interest in locking in those yields.

On the other side of the scale, high yield bonds continue to push higher
with the KDP High Yield index pushing through 17%, among the highest
yields of the cycle. While high yield bonds never approached 17% during
the recession earlier this decade, they did reach their peak about the
same time the S&P was hitting its lows indicating that in the current
cycle, we would have to see a pullback in junk yields before any
meaningful bottom in equity markets would/could materialize. I would
imagine that those yields would be coming down soon, the combination of
continued government interventions greasing credit wheels as well as the
60% default rate implied by the market simply being too high (this
coming from someone who is not a high yield analyst).

Additionally, equities are going to continue to be hit with bad news.
On several fronts, we’re dealing with economic data that rivals, some of
the weaker periods in our recent history:

-Jobless Claims at highest level since 1982 (excepting one outlier of a
reading in 1992)

-Continuing claims highest since 1982

-Housing Starts and permits are the lowest of all time, dating back to

-Case-Shiller home prices show record YOY decline

-Chicago’s PMI was the lowest since 1980

-NY Fed survey at a record low

-Philly Fed survey lowest since 1990; new orders component was lowest
since 1980

-ISM mfg index was lowest since 1982

-ISM non-mfg index is at the lowest of all time, dating back to the
middle of 1997

-Consumer confidence as measured by the Conference Board hit an all time
low last month

-Consumer spending fell 3.7% in Q3, the lowest reading since Q2 1980

I could go on, but you get the point. I note this data and the depth of
the declines because I wanted to emphasize that those declines are not
over. Economic data continues to get worse and with the economy having
fallen off a cliff in October and November, the next batch of economic
readings should be even lower leading to, one can posit, a 4%-5%
contraction for Q4 GDP. Payrolls are going to decline by 300K or so
next week and the unemployment rate is probably going to spike to 6.7%
or so bringing the total number of people unemployed this year alone to
1.5 million. To some immeasurable degree, the bad news is priced into
the market however the continuation of that bad news is not. Nobody
knows how long and how deep this recession will be and as long as the
data keeps getting worse, any potential rally in equities will be capped
as growth and earnings forecasts continue to be revised lower (this
cannot continue indefinitely but it is continuing now).

Returning to the impending GDP contraction, this would be the worst
economic contraction since Q1 ’82. On a side note, during the 12
quarters that make up ’80-’82, GDP contracted 6 of those quarters but
the stock market managed a 30% gain thanks to the last two quarters of
1982. If you subtract those last two quarters, the beginning of the
multi year bull market, the stock market was basically flat from the
beginning of 1980 until the end of Q2 1982. This current bear market
and poor economic period began in the fourth quarter of 2007 accompanied
by equity declines in five straight quarters (including the current one)
despite only two very, very modest negative readings on GDP (Q4 ’07 and
Q3 ’08). GDP contraction is going to certainly be more pronounced in
the 4th quarter and one would imagine the 1st quarter of 2009 as well.
That said, there is nothing to say that the S&P must decline in quarters
in which GDP contracts (although it has each of the last five times but
did rise in both Q4 ’90 and Q1 ’91 when GDP contracted 3% and 2%
respectively). In fact, going back to the 2nd quarter of 1947, the
first period for which I can find quarterly GDP data, the economy has
contracted 36 quarters and during those periods, the S&P has actually
managed a gain of 1.03% (if you include the current quarter, assuming
GDP will be negative, then the gain is a mere .05%).

The point is that while I have been advocating the beginning of the
portfolio construction process, there is still downside risk to equity
markets. We have entered a range where, in the long run, investors with
patience will be rewarded, but those same investors must brace
themselves for additional volatility as well as a series of disturbingly
bad economic reports. This could all be made worse by the continuous
failure of government interventions to have any positive effects,
adverse negative effects from those same interventions, the very real
possibility of a GM bankruptcy filing and, thanks to additional
deleveraging and the forceful deterrent of impending lower prices, the
continued withdrawal of the US consumer from any activity whatsoever.

They say you should buy when there is blood in the streets. They just
don’t say to wait until its waist deep.

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