Roadmap to the Future

Last September, we began an in-depth study into the history of financial crises and bear markets. The context then was not yet dire (Lehman had yet to fall), and we reminded ourselves, and our clients, that market timing is only reliable when viewed after the fact.

Our primary goal was to understand the sign posts along the road to recovery and how, if at all, we should position client portfolios differently. We use the term “sign post” to make the important, but subtle, distinction between a futile goal of predicting the future (especially the timing of the market bottom) and the realistic goal of understanding what the future will look like as it is unfolding. Stringing together those sign posts creates a roadmap, which can give us comfort that things are proceeding in the way (though not necessarily at the time) we expect. Or, if not, in what corrective action may be required.

This piece summarizes four key points that will be elaborated on in a longer whitepaper on this topic which we expect to release later this month.

1. Positive Equity market returns are often not ”permanent”

The equity markets reflect participation in economic activity, but the markets and the economy do not move in lock step. There is always so much uncertainty about the prospects for companies (information about even their current performance is delayed), and about prospective monetary and fiscal policy, to say nothing of the fear and enthusiasm of market participants, that the market frequently surges only to fall back. This “two steps forward, one step back” pattern means that much of the time an increase in market value is temporary – values will fall to a lower level at some point in the future. The graph below demonstrates the periods of temporary growth (entire gain is lost in an ensuing decline), decline, and permanent gains. But, even “permanent” gains can only be judged over potentially very long periods of rear-view perspective.

2. Be cautious about investing based on reported economic performance

Because investors, as a group, are forward-looking, equity market returns change direction well in advance of a change in economic conditions. The graph below charts the level of the S&P 500 against growth in the economy. The equity market has peaked (P), on average, three quarters earlier than a recession in the general economy (the beginnings of the shaded areas) and has bottomed (T), on average, 2 quarters earlier than the end of the recession.

Economic data is reported with a delay. Consequently, current economic “news” (about economic conditions in the recent past) provide very little information about the future returns of the equity market. For example, the end of the most recent recession (which began in March 2000) occurred in November 2001. The National Bureau of Economic Research (NBER) made the announcement on July 17, 2003 – 20 months after the recession officially ended. That period was unusual in that the equity markets continued to get worse for over a year after the economic trough (identified in retrospect), and there was some question about whether the economy had entered another recessionary period. The S&P 500 trough was October 4, 2002 and had returned 24.40% by the time of the announcement.

The end of the previous recession (the March 1991 trough which ended the eight month recession starting July 1990) was announced on December 22, 1992. The S&P 500 trough was five months earlier on October 11, 1990 and the index had returned 59.85% by the time of the announcement.

3. Corporate earnings are a lagging indicator of market returns

Over the last 25 years, there have been five periods (the five red lines below) of declining earnings growth (not necessarily negative earnings, just slowing growth) for the companies in the S&P 500 during those periods. This includes the current period of declining earnings which started June 2004. Four of those periods resulted in falling earnings (negative growth) and only three resulted in recessions (indicated by the dashed lines in 1991, 2001, and the current). The most recent earnings trough in 2001 (point 9) coincided with the end of the recession and was unusual because earnings rebounded well in advance of the S&P 500. The August 1998 trough in the S&P 500 occurred 4 months prior to the earnings trough of December 1998 (point 7). The September 1991 trough in earnings growth (point 5) happened six months after the end of the 1991 recession in March, which itself followed the October 1990 S&P 500 trough by 5 months.

4. Unemployment is a lagging indicator

Because consumption is such a large part of the US economy, many investors are focused on measures of the financial health of consumers, including consumer confidence, income, and employment. While headlines about mass layoffs can strike fear into the hearts of investors, employment has become an unreliable indicator of economic growth, much less of market returns. Since 1948, unemployment cycles have tended to span (rather than precede or follow) the 10 recessions – on average, the trough for the unemployment rate (i.e. peak employment) occurred 7.4 months prior to the beginning of the recession and the peak unemployment rate occurred 4.7 months after the end of a recession. The most recent peak came 19 months after the “jobless” recovery from the 2001 recession while the prior peak came 15 months after the 1991 recession.

Despite the apparent connection between employment and consumer spending, the equity market has shown an ability to rise without positive headlines about employment. The most recent bull market coincided with a period of unusually slow payroll growth of 0.6% from 11/01-10/08, much less than half the rate of 1.7% from 3/91 to 2/01, which itself was much slower than the 2.8% from 11/82 – 7/90. There has been a lot of speculation about the impact of technology and other productivity enhancements as well as the difference between the Bureau of Labor Statistics payroll number and the other surveys. But we believe these data tell us that the market can rise without a significant increase in hiring.

Implications

As it turns out, much of our work was drawn to debunking intuitive understandings of market returns. Equity markets typically turn during (not after) recessions, with the trough in earnings lagging by one or two quarters and the peak in unemployment coming after that. So an end to poor economic reports is not a prerequisite to stopping market declines. Further, conditions tend to reverse rapidly, making it appear darkest before the dawn.

Because of the credit crunch aspect to this downturn, government intervention will feature prominently in the recovery. With riskless short-term interest rates now very close to zero, conventional monetary policy is becoming ineffective. There are other measures available, including an aggressive fiscal stimulus package, more support for the mortgage market by Fannie Mae and Freddie Mac, a commitment by the Fed to an extended period of low rates, and outright purchases of agency or mortgage securities by the Fed.

While a consensus that the end has been reached could still be a long way off, we see a number of signposts of progress toward the end to this current period of market and economic distress:

• Government intervention to stop the panic about financial institutions and to lower interest rates, encouraging economic growth
• Initial rebound in equity indexes as speculators/investors begin to look ahead
• Extremely poor economic reports as companies hunker down and make painful cuts
• Extremely poor corporate earnings reports as companies restructure and layoff significant staff
• After their initial rebound, equity indexes lose steam and enter a trading range as investors try to sort through winners and losers in the expected recovery
• Economic conditions improve as government intervention takes hold
• Corporate earnings reports become positive due to dramatically lower costs and easy year over year comparables
• Consensus that a new period of growth has begun and the NBER eventually dates the end of the recession in 4Q08 or 1Q09 or 2Q09, albeit with an announcement of that fact possibly much later.
  

Our Tactics

While these lessons from history offer at least a cloudy picture of what to expect, it’s disappointing that we have not uncovered any reliable predictive measures. But it’s hardly surprising. If there were actually any reliable clues, they would have been discovered long ago. As much as we would like to time the markets, there is no evidence that it can be done reliably and consistently. Each recession/market downturn has its own unique set of factors.

So what can be done?

We are actively evaluating investment strategies which respond to the very attractive current opportunities in areas such as real estate and fixed income. Our research has caused us to make some changes to asset allocations, which we look forward to sharing in meetings with clients over the coming months.

Aside from the strategic decision about the overall allocation of assets, two primary tactics respond to the cyclical nature of market returns and the lack of reliable timing between the equity markets and the indicators most investors use:

Tilts toward value – Judging from market dynamics, investors tend to be overly optimistic about investments which have done well recently and overly pessimistic about investments which have done poorly. Valuations reflect these judgments at both the asset class level (bonds v. stocks, US v. international, etc.) and at the security level. We have hired Dimensional Fund Advisors (DFA) (through their mutual funds and separately managed accounts) to comb through the very broad spectrum of global public equity portfolios looking for companies which appear to have become overvalued relative to others. If the overvaluation is large enough to justify the tax and transactions costs, through DFA, we sell the overvalued and buy the undervalued assets.

Portfolio Rebalancing – “Buy low, sell high.” Rebalancing is inherently contrarian, selling the winners (after allowing them to outperform for awhile) and buying the out-of-favor. It takes courage to take a position against the momentum in the market, so we set specific boundaries so the natural desire to be part of the crowd doesn’t undermine the opportunity.

In addition to these, we are considering the costs, benefits, and real effectiveness of possible portfolio hedging strategies to soften some of the worst case potentials for future portfolio performance.

Summary

We look forward to presenting our full findings, along with modest changes to recommended portfolio allocations, in the very near future.

Jason Thomas, PhD,
Chief Investment Officer

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