Weekly Update - December 5, 2008

Resilient Despite Economic Woes!

The market lost 2.3% on the S&P and 1.7% on the NASDAQ last week but that performance was much more interesting when viewed in context of what transpired. We expected a pullback following the extreme performance from the prior week and the market responded by dropping 8.9% on Monday to start the week. But then, the market showed its resilience by increasing 7.3% over the next four days despite an avalanche of bad economic data. The strength shown by the market was very encouraging in light of an economy that continues to worsen. No doubt the economic woes will continue well into 2009. However, the market appears to be showing more resistance at current levels probably due more to the fact the market had been way oversold even after consideration of the ongoing and deep recession.

Economic Conditions Worsen!

We finally got the official word on what we all already knew, we are in a recession! In fact, the experts now say we have been in recession for one year, since December 2007. That is no surprise to us as that has been our prediction all along. But last week brought stark data on just how bad the economy really is. The ISM manufacturing index came in at 36.2, the lowest reading since 1982 and far below the level considered contraction. The ISM Services index also hit record lows. November same-store sales reported declines and continuing claims for jobless benefits reached a 26-year high. Some reports have the percentage of home loans at risk of default (foreclosed loans and those with late payments) at record levels. Of course, the biggest news was that payrolls declined 533,000 in November, the largest decline in 34 years! Obviously the unemployment rate continues to rise as companies across many industries rush to announce more job cuts. The automakers testified on Capitol Hill to receive bailout funds, but no agreements were reached. The prospects for the auto industry are indeed very dim, as GM reported a decline in November sales of 41%. On a positive note, the government is looking at initiatives to help drive mortgage rates down and interestingly, mortgage applications showed an increase over the prior week. Also, gas prices continue to fall after hitting a 4 year low, and lower prices will help improve cash flows and confidence. But the real story is housing and employment, both of which have to improve before the economy can make headway and start growing again.

Market Beating Foresight

Despite the overwhelming bad news, the market only lost 2.3% and in fact, gained significant ground over the last four trading sessions. What could account for this resiliency? We think the stock market has reached oversold levels given a 53% decline since October 2007 highs. That and the fact that the market has largely already accounted for much of the bad news just released. There is little doubt in our minds that the economy is bad and that only time and perhaps government intervention can turn the tide. Next week will bring additional reports on unemployment and retail sales. In addition, there is speculation that a bailout plan for automakers may finally be settled. Given the weight of bad economic conditions, the government will likely implement other initiatives to help provide support for the economy. Obama will likely push additional measures when he takes office in the new-year. These efforts will help the economy over time, but it is still likely to be well into 2009 if not year-end, before we start to see an economic revival. Short term these government measures will help, but we are also concerned that inflation over the long term may again rear up as we struggle with growing budget deficits as a result of these government interventions. The market has risen in eight of the past ten trading sessions, a remarkable feat considering the plethora of bad economic news. We view this as a positive sign for the market, a sign that lends support to the argument the market may have established a trading range bottom. We think the worst may be over for the stock market, despite the poor economy. However, that does not mean the market will not drop further, in fact the market trend will likely remain very bumpy or even rocky over the next three to six months.

For short-term investors, a bumpy market will provide many profitable opportunities on both the short and long sides of the market as the market swings back and forth within a 100 point trading range. For now, long investors should stick to the defensive industries such as utilities, healthcare, and consumer staples. Stick to those companies that have strong balance sheets, are well capitalized, and have high cash levels, as those are the companies that will survive and even prosper in difficult economic times. For speculative investors, maybe now is the time to consider a play in oil, as prices have hit multiyear lows. No doubt oil demand will be pressured in the coming year with the global slowdown, but perhaps prices have moved down too far too fast. Also, what about the bubble in Treasuries, as the flight to safety, along with the Fed’s buying initiative, has pushed 30 year treasury yields to their lowest levels ever! This bubble will eventually burst as they always do, and when that happens, investors on the short side of the treasury market will make a killing. We do not expect treasury prices to fall immediately as the Fed will likely cut short term rates again in December. But rate cuts will stop sooner rather than later, and treasury prices will begin to fall and the shorts will prevail. Overall, equities remain at compelling price levels despite an economy that has a long way to go before it gets better. We are planning to invest some of our cash into stocks over the next few weeks as we find good opportunities and would suggest that investors sitting on cash do the same. Patience will reward the long term investor as positive momentum and confidence will eventually return. Investors buying stocks at these levels will be rewarded in 2-3 years even if they are early in calling the market bottom. Despite a difficult year, all of our portfolios still show positive returns since their inception, which is truly exceptional given that corresponding market returns all show significant losses.

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