First Quarter 2009 Review and Outlook

First Quarter 2009 Review

After a tumultuous and devastating 2008, investors looked forward to the New Year with a measure of hope, if not conviction, that the Obama administration might bring about the kind of change that would reinvigorate the economy and restore investor and consumer confidence.  Those hopes for a brighter future were immediately called into question as continuing poor economic news combined with disappointing corporate earnings and additional problems within the banking industry to dash investor optimism.  The markets withered under this assault of depressing news and fell every week of January.  In fact, even the inaugural address by the new President failed to turn the tide, with the popular market averages suffering their biggest loss of any inauguration day in U.S. history. By the end of January, the markets recorded their worst January on record with the DJIA down 8.8%, the S & P 500 Index falling 8.6% and the Russell 2000 Index collapsing 11.2% (the worst performance since this index was created in 1984).

February dawned with a continuation of disheartening economic news.  Weekly jobless claims rose to new records, industrial production continued to decline, the housing market plumbed new lows, and consumer confidence was abysmal. With earnings season in full swing, corporate executives were in somber moods, providing little if any guidance for the coming quarters.  With the fixed income markets still largely open to only the most credit-worthy corporate borrowers, many companies initiated plans to conserve their cash by slashing capital spending plans, curtailing pay raises, implementing additional staff layoffs and cutting dividends to shareholders. With news that the fourth quarter 2008 GDP (Gross Domestic Product) fell by 6.2%  (further revised in March to a negative 6.3%) and indications that the first quarter 2009 GDP could be even worse, the markets continued to work their way lower throughout the month of February.

In this regard, the $787 billion economic stimulus bill passed by Congress and signed by President Obama in mid-February was widely criticized as being poorly structured and unlikely to create many jobs during 2009.  In fact, the Congressional Budget Office stated that most of the spending would actually take place in 2010 and beyond when there may be little need for the stimulus. Adding to investor concerns were President Obama’s budget proposals, which were viewed by many as a decisive move away from private sector initiatives and incentives and toward government solutions to the problems of economic growth.  It is good to remember that the Reagan tax cuts unleashed the greatest growth period of the U.S. economy and were based on the belief that the business of business is creating jobs while the business of government is creating the conditions for prosperity.

For those who fear mismanagement, rising debt, high taxes, increased regulation, legislative usurpation of liberty, or markets held captive by politics, there is much to be worried about in the Obama agenda. It would appear that, in one fell swoop, his administration is attempting to undo all the major benefits of Reaganomics.  Without question, Obama’s $3.6 trillion budget is full of bad news for investors and affluent individuals.  Raising taxes on wealthy individuals and businesses will stifle and curtail creativity, penalize venture capitalists and ultimately lead to slow growth and fewer new jobs.  Furthermore, Obama’s spending blueprint would include an increase of $1 trillion to the already unsustainable spending growth of the country’s entitlement programs which will encompass a “down payment” on government-controlled health care and education.  There is also envisioned a $1.5 trillion tax increase to shackle small businesses and investors that are the prime sources of new business ventures and new jobs. In addition, there will be significant increases in energy costs for families and businesses with the imposition of a “cap and trade” plan.  Overall, the Obama plan would bring about an explosion of the country’s national debt, doubling the debt in five years and tripling the debt in the next ten years.  Ultimately, this approach will likely debase the U.S. Dollar, raise the inflation rate, reduce living standards and threaten the U.S. with bankruptcy.

With all this to ponder, analyze and digest, it should not be surprising that the markets turned in a truly appalling performance for the month of February.  The DJIA fell an additional 11.7%, the S & P 500 declined 11.0% and the Russell 2000 plummeted 12.3%. For the first two terrifying months of the new year, the DJIA declined a jaw-dropping 19.5%, the worst first two months of the year in its 113-year history.

When March began, there was little reason for optimism and markets continued their   relentless decline to new lows of 6,547 on the DJIA and 666 on the S & P 500 Index on Monday, March 9th.  At that juncture, a widely-leaked memo from the CEO of Citicorp that the firm was profitable for the first two months of the year provided an initial spark for a market rally.  Not be outdone, the CEO’s of J.P. Morgan Chase and Bank of America quickly offered similar statements followed shortly thereafter by General Motors stating that the firm would not need an immediate injection of additional Government funds due to the effectiveness of various cost-cutting moves already implemented. As the market rally gathered momentum, there were scattered signs that the economy was doing a little better, including an increase in retail sales, an uptick in consumer confidence, a rise in durable goods orders and a variety of other data that was not as bad as once feared. While these news items were not especially noteworthy in and of themselves, the cumulative effect was a gradual shift in perception to one of nascent optimism. Furthermore, there was growing evidence that while the economy was in poor condition, those observers who monitor the second derivative of change (in other words, the rate of change of the rate of change) saw some indications that the economic decline may be nearing a bottom.

The final piece of seemingly good news came toward the end of March when Treasury Secretary Geithner unveiled a three-pronged program that involves the creation of public-private investments to purchase $500 billion, and perhaps as much as $1 trillion, of troubled loans and securities on the books of many banks and financial institutions.  To encourage the participation of private equity funds, hedge funds and other pools of capital, the U.S. government will offer subsidies and assume much of the risk. As always, the devil is in the details and it remains to be seen whether banks and other financial institutions will be willing to sell their toxic assets at prices that the buyers are willing to pay.  This program is viewed by many observers as a critical step in solving the current financial crisis by purging troubled loans from the banks so that those institutions will be in a position to resume their primary lending function. In all likelihood, the tantalizing tidbits of “less bad” economic news combined with Secretary Geithner’s latest plan to solve the major bank crisis does not guarantee an immediate economic recovery.  However, for investors starved for good news, recent events were generally viewed as encouraging and helped propel the markets to three consecutive weeks of market gains to close out the quarter.

The quarter ended with the U.S. markets turning in a strong March rally of better than 20% measured from the March 9th lows. In spite of the rally, the markets recorded their sixth consecutive quarterly decline with all the popular averages in negative territory.  The DJIA was off 13.3%, the widely followed S & P 500 dropped 11.7% and the Nasdaq Composite fell 3.1%. The remainder of the world had somewhat mixed results. While the Dow Jones World Index was down 12% for the quarter (in Dollar terms), and most of Europe was in line with U.S performance, some emerging markets did considerably better.  Specifically, Russia and Brazil both advanced better than 10%.

Outlook

As we begin the second calendar quarter, the question on investors’ minds is whether the current rally represents the beginning of a new bull market or simply another rally within an extended bear market. While only time will render the answer to this burning question, there is no question that the latest rally was the most impressive of the five rallies witnessed since the October 2007 highs in the popular averages.  Although interesting from an historical perspective, there is still insufficient evidence to support the contention that a new bull market is dawning.  It is good to keep in mind that bear market rallies can be very deceiving, can last longer than most investors expect, and gradually pull sidelined investors back into the market only to suddenly turn down again with a vengeance. Surely, the next major test for the current market advance will be the upcoming earnings season which unofficially begins with the release of Alcoa earnings on Tuesday, April 7th.  With a miserable first quarter based upon all available economic data, corporate earnings are likely to be very weak.  However, the overriding question will be whether the prospect for poor earnings has already been factored into investor expectations.  If so, investors may already be looking beyond the current earnings statements and focusing instead on the anticipated economic recovery later this year and, along with it, a bounce back in corporate earnings.  With these issues clearly unresolved at the moment, it will be important to focus on individual stocks as company earnings are reported.  Should stocks hold their current price levels while reporting poor earnings, this will be another encouraging sign that most of the carnage from this bear market has already been inflicted. For the moment, however, it is advisable to remain skeptical of the current rally.  There will be considerably more bad news before this economic recession has run its course—more bankruptcies, more job losses, and more shockingly bad economic reports.  These will test the current market advance and the conviction of those investors who are convinced the next bull market has begun.

While caution is advised for the next few months, there is no doubt that the elements of an economic recovery are being put in place. As discussed on several occasions in the recent past, the economy will likely begin to show initial signs of a recovery as early as    the second quarter.  With the first quarter of 2009 likely to see a GDP decline of 5 to 6%, the second quarter will see a less severe fall of perhaps 2 to 3%, reflecting the fact that the U.S. economic decline is dramatically slowing (the rate of change of the rate of change is diminishing).  By the third quarter, GDP may come close to stabilizing and show something like a 0.0% rate of growth before giving way to modest growth of 2 to 3% in the fourth quarter of the year.  Importantly, corporate profits will follow a similar pattern and by year end 2009 should be showing healthy gains when compared to a very weak period in 2008. This background sets the stage for the return of a rising stock market later this year. While timing the actual start of a new bull market is always difficult at best, on the assumption that the stock market is always a discounting mechanism, it appears likely that a sustainable market advance should commence no later than the summer of 2009 as investors turn their attention to 2010 and a more favorable economic and corporate profit environment.  Therefore, long-term investors (those investors with a five-year time horizon) should use periods of market weakness to become more fully invested in high quality equities consistent with their individual risk profile.


Stephen K. Kent, Jr., CFA, CIC
April 2, 2009