June 2009

Through late May, the Dow Jones Industrial Average Index had gained nearly 2,000 points since falling to a low of 6,547 on March 9. Thomas Dillman, Executive Vice President of Mutual of America Capital Management Corporation, explores whether the worst has passed for the U.S. economy, highlighting the importance of consumer numbers from the first quarter Gross Domestic Product report, the impact of Federal Reserve programs, and the issue of sustainable recovery.

From December 31, 2008, until March 9, 2009, the S&P 500 declined 20%. Then, from that bear market closing low of 676, the index advanced nearly 31% through mid-May. We have viewed this impressive move as a "bear market rally," or one not sustainable by healthy fundamentals. It has been driven by a huge outperformance from stocks that were, in general, the poorest performers over the prior six months, and in particular by low quality, low price and extremely undervalued smaller market stocks. However, these are also the types of stocks that usually provide the liftoff for new bull markets.

So which is it? We remain of the belief that the current rally is destined to peter out as evidence mounts that recessionary-like conditions will persist, and as any future recovery remains obscured by considerable uncertainties, especially the potential actions of the government in response to the continuing crisis in the financial and auto sectors. Such a perspective envisions continued volatility in markets—with some considerable retracement of the current rally—through most of the rest of this year.

Reasons for Rally Since March

Nevertheless, let's look at what the markets seem to have been responding to so positively. The apparent trigger for the takeoff was comments in early March from Citibank, Bank of America, and J.P. Morgan that their January and February operating performances were profitable. This news came in the midst of a panic that the banking system was on the verge of government nationalization. This latter concern was muted by the government's announcement that it was going to put the 19 largest banks through a "stress test" to determine whether they were adequately capitalized for the possibility of an extended and deep recession.

The results of the test will force some banks to raise capital. Any banks requiring additional capital would be given six more months to raise it, either in the private markets, or by conversion of the preferred shares they had been forced to issue to the federal government in exchange for TARP funds. One key tactic the government is employing to manage the financial crisis is deferring the day of reckoning in the hopes that the passage of time, plenty of Federal Reserve provided liquidity, and a very positive yield curve will help the banks work their way through their asset quality problem.

Several other significant events during March provided a further lease on life for the banking system. The most significant was the decision by the Financial Accounting Standards Board, under considerable pressure from Congress, to suspend the mark-to-market rule as it applied to so-called "toxic assets" on the balance sheets of the banking system. In addition to this modification in an accounting rule that had caused huge bank write downs in the six previous quarters, the U.S. Treasury's announcement of its Private-Public Partnership program—which would provide government loans and guarantees to private investors who, in turn, would purchase the bad loans and securitized assets from the banks—contributed to investors' sense that the crisis had eased, at least for the time being.

Impact of Federal Reserve Programs

Perhaps the most successful part of the government response to the financial crisis has been the array of programs initiated and implemented by the Federal Reserve. These programs were designed to provide ongoing liquidity to the global financial system, and, in particular, to some of its most important short-term components. For example:

• the Term Loan Facility Program provided funding for banks when the interbank lending market stopped functioning;
• the Commercial Paper Guarantee Program provided a lifeline to a market crucial to the funding of industrial and financial corporations;
• the Dollar Lending Program provided U.S. dollars to foreign central banks to prop up dollar lending abroad; and
• the Long-Term Corporate Bond Guarantee Program for financial services companies provided lower cost funding for banks and other financial service providers that would not otherwise have been able to borrow.

All of these programs have kept the system going while longer term solutions have been developed and are in the process of being implemented.

The testament to the success of these liquidity programs is the significant improvement witnessed in the credit markets, most especially on the short-term side (LIBOR, Commercial Paper), but also in the market for new bond issuance, which has substantially revived since the turn of the year. Similarly, and most importantly, long term mortgage interest rates have dropped to below 5% for the first time in decades (except for a brief interlude in 2003). This has instigated a mini-boom in refinancings and provided support in the markets for new and existing home sales, albeit with a considerable assist from significantly lower housing prices.

The economic data has also provided some comfort to investors over the past two months. There is not any definitive indication of a recovery, but the evidence is clear that the economy, both domestic and global, is no longer in free-fall. Moreover, the rate of decline has slowed, and many statistics suggest stabilization at low levels. In short, thing are less bad. We've noted in the past that markets look ahead and discount the future; that things are not getting worse portends the possibility that they will get better.

Spinning the GDP Numbers

A look at the Gross Domestic Product (GDP) report for the first quarter of 2009 can provide insight into how markets sometimes behave in a manner contrary to what the data would suggest. The initial GDP report showed a contraction in the U.S. economy of 6.1%, only slightly better than the negative 6.3% reported for the fourth quarter of 2008. These two readings are among the worst for U.S. GDP in decades, yet we've witnessed a powerful stock rally despite such awful results. The explanation for the seeming contradiction lies in an analysis of the components of the GDP report.

The most significant, and a clear positive surprise, was a 2.2% increase in consumer spending. This despite a consumer sector faced with rising unemployment, work furloughs, pay cuts among those still working, rising foreclosures on home mortgages, and significant declines in IRA's and 401k's—even when the data shows the savings rate is going up and credit expansion going down! Potential explanations include (1) the impact of the stimulus program's tax rebate program; (2) high levels of early income tax rebates for the 2008 tax year; and (3) draw down of cash savings that are not captured in the National Income accounts data.

Of course, many government economic statistics get revised, and GDP is one of the most likely to experience such subsequent revision. It is our guess that the consumer component of GDP will be revised down somewhat. Nevertheless, the report of increased consumer spending was taken as a sign that the worst case scenario had not come to pass.

Another aspect of the original GDP report that was viewed favorably was the large 2.8% decline in inventories. The positive interpretation goes like this: With inventories drawn down to the lower level of current sales, any pick up in demand will translate immediately into production increases and a slowdown in layoffs. Another negative that was interpreted positively is the fact that government spending was down 3.9%, suggesting that the impact of the nearly $800 billion stimulus package is yet to come, and therefore portends improvement in future GDP results.

The net export component showed a 2.0% positive contribution to GDP growth in the first quarter. However, this was not because trade was strong, but because the decline in our exports was less than the decline in our imports. Finally, the worst number in the report was the 4.7% drop in the investment component, verification that the U.S. economy is in the midst of a severe recession. However, the positive spin is that corporate management has responded quickly and dramatically to the downturn, also indicated by the inventory reduction, and as a consequence, things are unlikely to get worse.

Sustainable Recovery Ahead?

While we've used the first quarter 2009 GDP report to demonstrate how the markets have turned negative news into a positive, market observers have documented hundreds of so-called "green shoots," the reigning metaphor for any data point that deviates from expectations in a positive way, even if the direction of change remains negative. That's the way markets work, discounting the future based on near-term changes on the margin. There is no denying that the rate of change has been positive for the majority of data points. The recent spate of earnings reports is a case in point. While earnings for the S&P 500 appear to be coming in at a decline of about 35% versus last year, that's a tad better than what the market had expected only a few weeks ago.

Furthermore, the proportion of companies announcing positive surprises is better than expected and a bit above the long-term average. Note, however, that earnings estimates for the second, third and fourth quarters of this year, as well as for 2009 and 2010 as a whole, continue to decline.

Is there a sustainable recovery on the foreseeable investment horizon? And if there is, how will it compare to the types of recoveries we've seen in the past? The answer to the first question is probably "yes," although whether it begins before the end of the current year, or is deferred into 2010, remains the debate. The answer to the second question, the more important of the two in terms of expected returns to investors, is much more difficult.

We have been saying for a long time that we believe any future recovery will be characterized by slower growth in earnings than experienced during the last 30 years. That's because the sources of those higher growth rates were massive consumer credit expansion; increased levels of financial leverage; unregulated financial innovations such as derivatives, securitization and hedge fund investing; and a regime of declining corporate tax rates. That edifice of pro-growth, pro-business initiatives is in the process of being dismantled and replaced, but by what is still in the process of being articulated.

It is clear that government will play a bigger and more controlling part. Incentives in the system and the rules of the game will be readjusted to distribute the returns of production more to labor and less to capital in the name of "fairness." The consequence is likely to be a more muted rate of earnings growth. What price/earnings multiple the market will pay for such a lower growth trajectory will be importantly influenced by prospects for inflation. Given the vast expenditures now being made by governments to arrest the financial crisis and global recession, odds favor a scenario of higher inflation in the future and thus, lower price/earnings multiples.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

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