We were asked to make a presentation at a local business association’s holiday dinner. Below is a copy of our remarks supplemented by the Q&A that followed the formal presentation.
First and foremost, everyone at Apollo Wealth Management would like to wish you and your families a safe and happy holiday season. We hope 2008 will be a prosperous year for us all.
We are grateful for the opportunity to be with you at this time of year. There are a lot of familiar faces in the audience so we expect great questions like last year.
Tonight we’d like to share our economic outlook for 2008. We’ve entitled our remarks “The Coming Recession?” to emphasize the incredible amount of uncertainty and seemingly contradictory information underlying the current state of affairs.
The close of 2007 continues the post 9/11 cyclical recovery although at a more modest pace. That’s to be expected after three very strong years and 17 Fed rate increases.
Housing seems to be the only sector struggling at the moment. Otherwise we have an economy growing at a moderately strong and very manageable 3.5%.
Our country’s twin deficits – trade and budget – are slowing. The weak Dollar has boosted exports while last year’s fiscal spending exceeded revenue by a modest 1.2%.
The real concern at this point is the so-called Credit Crunch and its ever-growing impact on the economy. Banks saddled with toxic loans are afraid to lend, borrowers are struggling to make payments, consumer spending is slowing and, for many of us, our homes which tend to be our biggest asset are losing value.
Why is housing such a big deal? Consider that consumer spending represents about 70% of GDP. If we agree that our homes are our largest asset then it logically follows that falling prices lead to what economists call the negative wealth effect – our lack of ability and willingness to spend based upon how “poor” we feel.
On the flip side we have corporations with extremely healthy balance sheets, lots of cash and manageable debt loads. Profits have skyrocketed over the last three years due to productivity gains, controlled spending and investments in favorable capital projects. We’re at a level as a percentage of GDP that we haven’t seen in 40 years.
Yet we haven’t had a commensurate rise in stock prices. This makes valuations on a PE basis very attractive.
Exports are strong as the weak Dollar and the global infrastructure boom propel foreign spending.
The wildcard is fiscal policy. Although government spending represents maybe 10%- 15% of GDP, we cannot ignore the uncertainty over which party will occupy The White House.
We could go on for hours with our charts and graphs and statistics but will keep our remarks brief in the interest of time. We know from last year there’s a great demand for the back and forth of Q&A.
That being said, we’ll end our prepared remarks with a prognostication for 2008. We expect economic activity to remain positive. We expect continued conflicting data to exacerbate The Fed’s struggle between promoting growth and controlling inflation.
Housing will continue to be a drag on the economy while exports and business spending should remain strong.
And although the consumer will continue to fight falling home prices and rising energy bills, we believe reports of the consumers’ demise will be greatly exaggerated. Many a time the US consumer has been discarded…counted out…left for dead…and each time they’ve continued to spend and spend and spend. When it comes to money we often say one thing but do another. The truth is in our actions.
We don’t see a recession in 2008. It may feel like one…but we don’t expect to see a single quarter of negative growth let alone the two consecutive quarters needed.
That concludes our brief remarks as we invite you to share your thoughts and questions.
YOU MENTIONED THAT HOME PRICES ARE FALLING BUT ARE THEY AFFORDABLE?
Great question. While we see price declines in speculative markets such as Florida and economically depressed markets – think areas associated with The Big Three automakers, we have stable or rising prices in areas with strong wage and job growth. Seattle comes to mind.
Your point is a valid one in that affordability based upon fundamentals is the real story.
Prices for new and existing homes recently peaked at 3.5 times average household disposable income. That figure has historically been 2.5 to 2.75 times going back to 1975.
Today that figure stands at about 3 times. The implication is there’s still room for home prices to correct.
OK, SO WHEN WILL THE HOUSING MARKET STABILIZE?
June 8, 2008. (laughter)
I’m sorry. I couldn’t resist having a little fun. It is the $64,000 question, isn’t it?
I won’t insult everyone by suggesting there’s a predictable end to this. Rather, I think a fairly obvious point is worth mentioning because it tends to get drowned out by the negative media coverage. Housing prices will stabilize when housing starts fall far enough below existing inventories to clear the market.
FOLLOWING THE FED’S 50 BASIS POINT CUT YOU WROTE THAT THEY AREN’T INTERESTED IN BAILING OUT INVESTORS. HOWEVER, THE MARKETS ARE PRETTY MUCH BACK TO WHERE THEY WERE PRIOR TO THIS CREDIT CRUNCH AS YOU CALLED IT. I’M NOT SURE THAT MAKES SENSE.
First my friend let me say thank you for reading our client communications. Second I wouldn’t say we’ve called it a credit crunch as much as we’ve simply borrowed from the popular press.
Look at the bond market for an explanation. Low rates on long dated securities relative to short maturities are indicative of an expectation for falling short rates. In other words, the markets expect continued Fed easing.
Lower short rates suggest higher prices due to discounting. Markets are discounting mechanisms. They look into the future and prices adjust today to reflect that outlook. Lower discount rates mean higher present values.
Another thing to consider is that day-to-day price fluctuation doesn’t necessarily reflect fair value. Plenty of buy/sell decisions are based upon emotion and shortterm thinking. It would be naïve to think there aren’t traders out there buying simply because they expect continued lower interest rates. These people have no concern for the long-term economic outlook. They’re trying to make a quick buck. I suspect they’ll continue bidding up prices on the expectation of lower rates and will bail out just as quickly at the first sign of inflation, a consumer slowdown, negative Fed comments about rates or any other excuse to take a profit.
I RECENTLY READ AN ARTICLE TALKING ABOUT WIDENING CREDIT SPREADS. WHAT EXACTLY DOES THAT MEAN? IS IT SOMETHING TO WORRY ABOUT?
Credit spreads refer to the differential between “risk-free” government securities and those of corporate borrowers. The riskier the company the higher the yield on the security. The riskiest of borrowers – the so-called junk borrowers – pay the highest yields to compensate investors for the relatively higher level of risk assumed.
Strong economic times suggest a greater amount of certainty that borrowers will meet their debt obligations. Corporate bond prices rise, their yields fall and the spread between their yields and those of “risk-free” government bonds shrinks.
The opposite is true in that weak economic times suggest a greater chance of default. Corporate bond prices fall, their yields rise and the spread between their yields and those of “risk-free” government bonds widens.
Essentially, the credit spread is a measure of economic activity. The problem is it can be misinterpreted like any other measure if viewed by itself rather than in context. I’d argue today’s widening credit spreads are less about falling corporate bond prices and more about surging government bond prices. Fearful investors are piling into Treasuries. We have the 2 year note at something like 150 basis points below Fed Funds. That’s crazy.
I don’t think widening credit spreads are anything to worry about unless and until we start to see increased and sustained rates of corporate defaults and I just don’t see that happening when balance sheets are so healthy.
WHERE’S THE PRICE OF OIL HEADED?
You’re friends with the “when will the housing market stabilize?” guy, aren’t you?
I just don’t know. Supply and demand is but part of the equation. There are lots of speculators out there manipulating prices. Geopolitical events are always an issue.
It’s been speculated there’s a “terror premium” of $20 to $30 per barrel.
Then there’s China. What will happen once they stop spending to prepare for the Beijing Summer Games?
If you want to look at the chances of recession then look no further than oil prices.
If the U.S. was headed for a slowdown then the expectation of decreased demand would send oil prices plummeting. Instead we’re looking at prices hovering close to $100/barrel.
If a more direct answer is what you seek then about all I can say is oil prices will remain volatile.
BACK TO HOUSING FOR A MINUTE IF THAT’S OK. DOES IT ALWAYS MOVE IN LOCKSTEP WITH THE ECONOMY?
Another good question. No, it doesn’t.
Dating back to 1960 there have been two instances when a decline in residential construction did not lead to recession. We saw this in 1966/1967 and again in 1995/1996.
WHAT SHOULD WE EXPECT FROM THE STOCK MARKET IF THERE’S A RECESSION? I MEAN IF HOUSING CONTINUES TO FALL THEN DOESN’T THAT MEAN MORE PEOPLE WILL PUT THEIR MONEY INTO STOCKS INSTEAD OF REAL ESTATE?
The SEC mandates sales literature contain language that “past performance does not guarantee future results” or something to that effect. That being said a lot can be learned from the past.
If we go back to the period beginning at the end of World War II we see that every recession (averaging about 10 months) was preceded by a stock market decline (averaging about 9 months) of about 26% as measured by the S&P 500.
I think it’s safe to say a change on this order of magnitude isn’t out of the question.
Indexes of riskier stocks such as the NASDAQ, Russell 2000 and EAFE would probably suffer additional declines whereas the Dow and S&P could do significantly better.
ARE THERE ANY SECTORS THAT DO OK IN A RECESSION?
Well, I suppose it depends upon the definition of doing OK. On an absolute basis the answer is no. On a relative basis it’s yes.
Again going back to the period beginning at the end of World War II we find sectors such as consumer staples, health care, utilities, financials, IT, energy and materials outperforming the S&P. Consumer discretionary, industrials and telecom have underperformed.
But buying these sectors as defensive measures doesn’t guard against losses. Take utilities as an example. Have they outperformed? Sure. But investing in utilities has meant losing an average of 15%. Now that 15% loss is better than the 20%+ on the S&P but it’s still a loss.
THERE’S A LOT OF TALK ABOUT THE FED NOT REALIZING HOW BAD THINGS ARE. WHAT’S YOUR OPINION ON THE JOB BEN BERNANKE IS DOING?
I’m not sure things are bad. The media tells us things are bad and we feel like things are bad but there are too many positives to ignore. As mentioned, exports are booming, corporations are profitable, balance sheets are healthy, the world is investing in infrastructure, etc.
I think Bernanke may be behind the curve a bit. Yes, that pun was intended. The guy is a career academic. He doesn’t necessarily have the contacts someone coming from industry would have. Maybe he isn’t as in touch as he should be or we’d like him to be.
But what he’s done has been more than adequate. He’s simplified and made transparent communication from The Fed. He’s made clear The Fed is interested in promoting functioning financial markets – that anyone who benefits as a result of Fed action be it investor or speculator or homeowner isn’t even an afterthought.
These beneficiaries are mere byproducts.
Even so, even if things are truly bad, one has to wonder when the head cheerleader is Jim Cramer. Check out YouTube if you missed his late summer rant on CNBC.
I think the best way to encapsulate his true purpose – to entertain rather than educate – is by quoting Henry Blodget who wrote back in January, “(he embodies) the essential conflict in the American financial industry: the war between intelligent investing (patient, scientific, boring) and successful investment media (frenetic, personality-driven, entertaining).”
I won’t knock his track record. Mr. Mad Money became rich running his hedge fund but he lost all credibility when he began hocking his wares like Ron Popeil. Lots of sizzle – not sure where the steak is.
ARE WE GOING TO SEE CONTINUED VOLATILITY AND, IF SO, WILL THAT MAKE IT EASIER OR HARDER TO BEAT THE MARKET?
We were lulled into a false sense of security with fairly stable markets due to a decoupling of the risk/reward relationship. The last five years was a period where exposure to “risky assets” such as small and foreign companies garnered attractive returns.
The re-pricing of risk is underway. I expect it will continue. The result will be sustained and possibly heightened volatility.
As for beating the market, well, that’s wishful thinking. At Apollo we’ve never been big fans of benchmarking. It’s imperfect and arbitrary.
I think a great way to make the point is by quoting someone for whom we have a great deal of respect. The following is from Marty Whitman of Third Avenue Management:
“To be a long-term investor means that you have to accept the fact that you’re not trying to keep up with the benchmark and with your peers on a short-term basis. So by definition, every now and then, you will lag.
The Berkshire Hathaway annual report shows a record of (Warren) Buffett over 40 years. It’s extraordinary. But you can spot very quickly three or four years where he did worse, sometimes much worse, than the S&P 500, which is his benchmark.
But it doesn’t matter. We’re not talking about a sprint, we’re talking about a marathon. Over 40 years, he did extraordinary work.
I am willing to put up with the slight irritation associated with the fact that I may lag my peers. I mean, it was not so slight in the 1990s, because I lagged for a few years, and as a result, I suffered from considerable redemptions. But I think the long-term investor…has to be willing to put up with short-term pain to achieve longterm gains.”
Here’s another gem. It’s from the September 30, 2007, Tweedy, Browne semiannual report:
“When we arrive at our desks in the morning, we are not thinking about whether or not we will be able to beat a stock market index…Rather, we are simply trying to use business-like thinking and analysis…An index is simply an unthinking, statistical listing of a broad group of companies, and we know that it can be a daunting competitor over various time periods despite its rather random construction.
We accept the fact that there is a certain amount of randomness, particularly in the near term results…”
What Marty Whitman and the folks at Tweedy, Browne are saying is that beating the market is a myopic goal measured against an imperfect and random yardstick. At Apollo we couldn’t agree more.
Beating the market allows us to feel good about ourselves, boast to our friends and feed the instant gratification monster. But it does nothing to solve the problem of providing an inflation-beating, risk-adjusted return specific to our respective situations in order to ensure our financial security. This is the goal of investing – the end justifying the means.
IS A FOCUS ON DIVIDENDS A GOOD IDEA IF CONGRESS LETS BUSH’S TAX CUTS EXPIRE?
Sure. Dividends are great. Favorable rates are but icing on the cake.
Dividends tend to be a considerable component of total return over the long-term.
The contribution rate is something like one-third dating back to 1926.
Keep in mind that dividend yields on par with high-quality bonds suggest resilience in the face of market declines. Prices would be supported to an extent by the dividend.
Do we have time for one more question? We do? OK.
I’M NOT QUITE SURE I FULLY UNDERSTAND THE HOUSING SITUATION, CREDIT CRUNCH, CDOs, SIVs AND THE LIKE. CAN YOU TAKE US THROUGH IT ALL?
Wow, talk about going out with a bang. OK, I’ll see if I can’t come up with a 3×5 index card type summary.
The world has been awash in liquidity for several years. There’s no single culprit.
The Fed propped up the economy post 9/11 with a negative real Fed Funds rate.
The Japanese promoted exports via low interest rates with the “Yen carry trade” a natural byproduct. The Chinese recycled their Dollars from their trade surplus into Treasury securities which held down long rates and, finally, the Middle Eastern countries have done the same with their Petrodollars.
The low rates allowed the private equity and LBO crowd to bid up prices where expected profits would come not from strategic combinations but from financial engineering.
It’s a logical outcome in hindsight that asset prices climbed across the globe. This wasn’t limited to high quality assets driven by fundamentals. Instead, junk bonds, commodities and real estate soared. Rising prices meant compressed risk premiums forcing investors to reach for return by assuming increased risks.
The big Wall Street banks have never been shy about making a quick buck selling the product du jour. They rolled out something called Collateralized Debt Obligations – or CDOs – which are structured financial products. Think of them like a car loan.
The loan is the obligation backed by the car which is the collateral. In this case the product was the obligation with a pool of mortgages as the collateral.
The rating agencies were complicit although it’s unclear whether they knowingly played the part. The theory was that the risk of the underlying mortgage pool was minimized because it was spread across a wide swath. They gave these CDOs high credit ratings meaning they were safe for purchase by money market funds, insurance companies, etc.
Now if we buy into the idea that Wall Street greed led to a full scale bubble then we have to logically conclude that the bubble has to pop. Every kid knows there’s a point when the fun of bubble gum leads to a messy face.
Eventually some of the mortgages went bad. Fear spread as uncertainty over what was in the mortgage pool underlying each CDO became reality. The solution was and continues to be as it always has been – sell now and ask questions later. It’s this rush for the door that has pushed down prices and increased volatility. The byproduct is a piling on type of selling by leveraged investors facing margin calls.
Ultimately a point is reached where everyone fears everything so no one wants to do anything. It’s a bunker mentality. Just hunker down and wait for the storm to pass.
Markets cannot function in this type of environment. For markets to work there needs to be an abundance of buyers and sellers – of lenders and borrowers. This is where The Fed stepped in by providing liquidity in hopes of promoting continued lending. Of course The Fed can only do so much. They can provide the liquidity – they just can’t force lenders to lend.
That’s the short course. Hopefully it answers your question. If you’re looking for a much more eloquent explanation then check out the New York Times archives.
There was an article back in August I believe entitled “The Unforgivingness of Forgetfulness” or something like that. It’s a great summary of the shell game played by the banks that put together these structured investments.
Thanks again to everyone for such great questions. We appreciate the opportunity to speak with you again this year and hope to be back next holiday season.