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Recently, Van Kampen Strategist, Rick Golod spoke to Financial Professionals about recession, recovery and where he sees opportunities in the markets. Following is an excerpt of Rick’s comments from April 10th. I believe the economy is in a mild recession. While plenty of economic data supports this view, the debate over whether we are or are not in recession is no longer the important argument. From here forward, investors need to ask: “How long will it take to recover and what will the trajectory look like?”
Finding support at 1270
I believe an inflection point occurred when the Fed participated in the JP Morgan/Bear Stearns acquisition and afforded new liquidity provisions to primary banks. Prior to the Fed’s intervention, the stock market was hemorrhaging, with forced selling by hedge funds trying to meet margin calls triggered by FASB Rule 157 (which requires firms to mark to market their mortgage-backed securities). While this forced selling alone could have taken the market down even further, Dr. Bernanke stepped up to stop the bleeding and did so in a very public way – essentially, the Fed took that risk off the table. However, I believe any further problems in the financial sector will be dealt with privately.
In other words, I do not expect another major shoe to drop. The S&P 500 has been trading in a range of 1270 to 1375. We’ve seen that support level hold a couple times, including March 17, the day of the Bear Stearns announcement. I was surprised the market did not fall further with the demise of the country’s fifth largest investment bank, but while it fell below 1270 at one point during that day it closed at 1273. At the top of the range, my analysis indicates that 1375-1380 seems to be the resistance level where the market backs off and selling begins again. As long as the market remains in this trading range, we won’t have a clear idea of the direction of the market.
That said, I think 1270 is a reasonable bottom, especially considering that this level is down 18% from the October 2007 peak. This is consistent with pullbacks in previous recessions. The average market decline of the past 10 recessions was 23%, but we need to take a closer look at what is built into that number. By way of comparison, in the 1973-1975 recession, the Fed was raising rates, which they are certainly not doing in today’s environment. To take a more recent example, stock market valuations were at a historic high going into the 2001 recession, whereas today’s valuations are closer to historic lows. Excluding those two recessions, the market fell on average 17% in the other eight recessions. Moreover, the market peaked about two and a half months before each recession began, and bottomed about four months into the recession.
But if 1270 does not hold, I believe the market has the potential to bottom in the next 90 to 120 days. By that time, we may begin to see some resolution of the problems in the financial and housing sectors, allowing investors to return to looking at the rest of the economy.
Nevertheless, at 1270, I would consider adding money. I would also add money if the market breaks 1380 because rallies at market bottoms historically have been very powerful. Analysis by Ned Davis Research going back to 1948 shows that the market tends to rise an average of 16% in the first 90 days after the market bottom, 24% in the first six months and 32% in the first 12 months. While past performance is no guarantee of future results, I think this historical trend is sufficiently compelling that — even if a potential rally proves to be a bear market rally — it would be difficult to ignore.
Brace for a W-shaped recovery
I’m not surprised when I hear that “it feels different this time” – and I have been hearing it frequently. The Conference Board consumer sentiment reading came in at a five-year low, while another reading indicates sentiment has not been this low since 1992. We are also dealing with financial problems that may be on par with those of the Great Depression. While these events feel different, I’m not sure the result will be any different. That is, every economic contraction has been followed by a recovery. For me, the questions are: “What is the magnitude of that recovery? What is the duration?”
I believe the recovery will be W-shaped, rather than V-shaped. The government’s stimulus package will likely fuel a mild boost in the third quarter that could filter into the fourth quarter. After that, however, I expect the economy to return to a below-trend growth rate of one to two percent, driven largely by depressed consumer spending. There are a number of reasons I anticipate spending will weaken after the stimulus is spent. First, consumers’ spending ability is highly correlated to payroll growth, so declining payroll growth for the past three consecutive months does not bode well in that regard. Additionally, unemployment is likely to continue rising. In fact, some economists are predicting a 6-6.5% unemployment rate by next year. What is even more troubling, in my view, is that two-thirds of all jobs created in the past 12 months have been in the restaurant and government sectors—sectors with a notable proportion of lower-wage jobs.
Additionally, consumer spending is driven, in part, by the wealth effect. With home values expected to decline another 10% this year, approximately one in three homeowners will have a negative equity position in their home, potentially causing another $100 billion in mortgage loan losses. According to my research, a 10% decline in home values would reduce aggregate spending by $75 billion to $100 billion. Furthermore, rising energy and food costs will reduce disposable income. The average gas price a year ago was $2.70 and today it is $3.34, according to AAA. This $0.64 increase will act as a tax on consumers, reducing their disposable income by $83 billion. Together, that $83 billion energy “tax” and the $75 billion to $100 billion reduction due to housing sector weakness would virtually eliminate the benefit of the federal government’s stimulus package for consumers. This would not support the rapid return to growth of a V-shaped recovery. Instead, I believe the recovery will be very slow.
Position for a slower recovery
Large-cap growth stocks have outperformed following eight of the past 10 peaks in the profit cycle. Although past performance does not guarantee future results, it is probabilities that drive decision making. As I have often cited, my research shows that after a profit cycle peak and an easing cycle of three rate cuts, large-caps have outperformed mid-caps on average 75% of the time, and by a margin of 420 basis points. Further, in periods of declining earnings growth, high-quality stocks – which are most heavily represented among large-cap growth stocks – have outperformed. Finally, large-caps benefit more than other capitalization segments when the dollar weakens. In my view, the case for dollar weakening remains intact. I have never seen the dollar change direction without intervention by the world’s central banks or at least those of the G7. We may see brief periods of modest dollar strengthening, particularly against the euro, but right now the European Central Bank is holding firm, making for relatively attractive yields in Euroland versus the U.S. market that should work against the dollar.
Given these tailwinds for large-cap, I still favor a large-cap growth overweight. With a trailing P/E of 18.3, large-cap growth stocks are trading at a 28.5% discount to their 20-year average. In fact, the only segment trading at a steeper discount is mid-cap growth. Small-cap stocks, however, look expensive relative to large-caps. On a style basis, value looks overvalued relative to growth by 24%, as measured by the P/E spread between the Russell 1000 Value Index and the Russell 1000 Growth Index. As such, I believe moving into small-caps to try to time an economic recovery entails more risk than staying in large-cap, high-quality companies for the moment. Turning to sectors, it is worth first noting that a significant shift in sector dispersion (or the difference in return between various sectors of the market) has taken place. A year ago, sector dispersion was the narrowest on record, but today it is the widest on record. As a result, sector bets are less likely to be as rewarding going forward as perhaps in the past, as the spread of returns begins to tighten back to its mean level.
In most recessions, consumer cyclicals and financials have tended to advance as the economy recovers. But a slower recovery could produce an entirely different pattern. With the economy growing at 2% or less, profit margins and earnings tend to suffer. My research indicates that the sectors with the greatest risk of earnings disappointment at this GDP growth rate are the consumer discretionary, materials and financials sectors. While it remains possible for the market to rally powerfully at the bottom, as it has done historically, I do not believe consumer discretionary and financial stocks will be on the leading edge. In a slower recovery, I favor health care and consumer staples stocks. I still like energy, as I expect the dollar to remain weak. Although oil may fall below $110 per barrel and possibly into the low $90s, I believe it is likely to remain higher for a sustained period of time. Finally, a good beta trade, in my opinion, is tech companies with business overseas, which I believe have potential upside.
International equities warrant mixed reactions
Investors concerned about lingering headwinds in the U.S. may be wondering about investing overseas. My model portfolio continues to include a 40% weighting in international stocks. Although I would not be surprised if the U.S. market outperforms in the short term, I believe international markets have a number of merits.
If any market looked like it had a true bottom in January, it was Europe. Since April 2006, Europeans have sold $140 billion in mutual funds, with January seeing the largest net redemptions in history. Lehman Brothers estimates that European households have purchased only $86 billion since September 2000. In other words, Europeans have sold everything they’ve bought over the past seven years, and then some. Lehman also showed that European households have a 32% cash position today, one of the highest levels in history.
European equity valuations are attractive, in my view, but more importantly European consumers have much healthier balance sheets. With less debt, higher savings rates and more disposable income than U.S. consumers, European consumers have the potential to drive economic growth. Finally, a good portion of the region’s ongoing earnings recession and subprime problems appear to be priced into their markets already.
Considering that European markets have been up 81% of the time following a 20% decline in P/E ratios, with an average return of 13%, I like those odds. Extreme cash positions, a decline in valuations and a turnaround in earnings revisions could bolster European equities’ chances to perform better over time, in my view. Japan has been one of the better performing major developed markets this year, although a portion of that is attributable to currency. Japanese equities are cheap, oversold and underowned. Some Chinese sovereign wealth funds are buying there. But I remain cautious on the declining wages and falling capital expenditures, which will limit economic growth. Furthermore, the strong yen will depress corporate earnings and restrain the market’s upside. To me, Japan is a classic value trap – it is cheap and will remain cheap until a catalyst emerges. I would continue to underweight Japan. With regard to the emerging markets, I tend to differ from the consensus view. Granted, the emerging markets are the world’s fastest growing economies, with good quality earnings, healthy corporate balance sheets and, in many countries, a budget surplus. However, while emerging markets may not be as vulnerable to declining growth in the U.S. as they once were, I believe their stock markets are still vulnerable to changes in money flows. In my view, a slower U.S. economic recovery and/or a potentially deeper recession could increase risk aversion, which could lead to reduced weightings in emerging markets. With the U.S. and Europe slowing, tighter global credit conditions and rising inflation in the emerging markets, I believe emerging markets will eventually slacken, likely in 2009. Given my caution here, I recently reduced my model portfolio weighting from 15% to 3%. Therefore, my 40% international weighting is composed of 37% EAFE and 3% emerging markets.
Conclusion: be opportunistic
The environment today is almost the opposite of that in the early 1990s. Consequently, asset class and sector performance going forward will look different. I think investors can benefit from being opportunistic. Hedge funds unwinding their leveraged positions could put downward pressure on the market, but will also create some attractive buying opportunities. Some of these hedge funds will likely throw out the baby with the bath water because they buy equity baskets and indexes. The cheap stocks in those indexes could present a great opportunity for an astute stock picker. Elsewhere, I see a chance for investors to be opportunistic in oil stocks. With oil prices up more than 45% since June 2007 and the stocks up only 10%, the question is why haven’t the stocks moved in tandem with the underlying commodity price, as is more historically typical? Perhaps investors are betting that the price cannot stay that high, even as costs are increasing. Consider oil stocks with high dividend payments for an attractive income stream with potential upside.
I think there are also interesting opportunities with funds whose portfolios do not follow the benchmark. These portfolios entail idiosyncratic risk, as compared to systemic risk, in that they do not move with the market. To put it another way, if you are concerned about the market, do not buy the market. I would also emphasize alternative asset classes and investment strategies that reduce equity risk, such as structured products and special situation unit investment trusts that employ a stock screening process for quality and/or yield.
In January my message to investors focused on protecting principal, whether by adding to cash positions or using investments that reduced equity exposure. At that time, I suggested using 70% to 80% of the portfolio to help protect principal or buffer against recession. Today, I would reposition 65% of the portfolio to participate in a potential recovery, especially at the 1270 level.
All investing involves risk including the risk of loss. Investments in foreign markets entail special risks such as currency, political, economic and market risks. Past performance is no guarantee of future results. The allocation mentioned in this commentary is for illustrative purposes only. Investors should consider their time frame and all of their personal savings and investments, in addition to their assets and risk tolerance level. Your financial professional can help you assess your individual situation before you make any allocation decisions.
This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.
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