January 2009 Market Commentary
After a disastrous performance by equity markets in 2008, the general consensus is that equity markets could do better in 2009. Performance estimates by some bullish prognosticators range from 10-30% which would be welcome but no where near enough to make up for the losses suffered since October 2007. For broadly diversified long-only investors, it could take many years to reach portfolio values achieved in October 2007. Nonetheless, there are some opportunities to construct some defensive long/short portfolios and also engage in some broader macro themes for individual and institutional investors.
Are US Equity Markets Cheap?
Some market analysts expect S&P 500 2009 earnings to be $40-$60 per share. With the index at roughly 900, this equates to 15.0x the top end of 2009 estimated earnings and is not cheap despite the massive percentage drop in equity indices. From a psychological perspective, investors may believe that since markets have fallen as much as they have since October 2007, then they must be ready for a rally. A short-term rally is certainly possible given the reaction to a new administration and the anticipation of a very large stimulus that now includes the prospects for increased tax cuts. The problem is that Keynesian, or supply induced stimulus, may not work as well in the current economic environment.
This is simply due to the fact that the multi-year credit boom fueled a massive glut across residential and commercial real estate and just about everything tied to that boom. There was significant second-order demand tied to the construction boom such as capacity expansion of industrial equipment, appliances, and other equipment and goods. But how does this tie to a cheap or expensive market? In many cases, industrial companies, retailers, and other participants in the credit-induced construction boom expanded operations in 2007 and even in the first half of 2008. This means that the overhead costs across these companies is larger relative to years prior to 2007 and it also means that these companies need firm pricing power for their end goods and steady demand to leverage the new and larger cost base to drive earnings growth.
This probably won’t happen. It’s more likely that 2009 demand will decline which will pressure capacity utilization and ultimately earnings. This is starting to be evident with companies like Caterpillar (“CAT”), which recently reported a much larger drop in profits than expected, despite sales that were not as severely impaired. Even worse, prices for certain goods are likely to come under pressure meaning even if demand stabilizes, excess capacity will pressure earnings. Earnings growth is what drives equity markets so it’s very difficult to justify a 15.0x EPS multiple for 2009 earnings. In addition, with consumers experiencing significant strain, it’s difficult to see them using any additional stimulus for anything except deleveraging personal balance sheets. This is the right thing to do but won’t do much for jumpstarting earnings growth.
With a surplus of goods available, prices will continue to fall across a variety of products and goods. This is deflationary and throwing money at the consumer in the hopes that they will buy more stuff that they don’t need will likely not work. Given this economic backdrop, it’s easier to make the case that 2009 earnings could be under strain and justify earnings multiples compression that is more typical with bear markets which would equate to roughly 500-700 for the S&P 500.
Focus on Expense Tailwinds and Headwinds
Despite the rather grim overview of where equity markets could be in 2009, there will be specific themes that investors can capitalize on. In normal economic periods, sales growth is leveraged through a company’s corporate structure and drives earnings. Since significant sales growth for many industries will be very hard to come by, earnings growth will be largely predicated by improvements in expenses so analysts that can get a sense of what expense tailwinds or headwinds are present, will be able to implement successful long/short strategies.
One area that can provide a significant tailwind is the deflation of commodity prices. For example, a company like Hanesbrands (“HBI”) is reliant on the cost of cotton for production of its apparel. Cotton prices were in the $0.70+ per pound range earlier in 2008 and averaged in the mid $0.50 per pound range in 2007. However, in the second half of 2008, cotton prices were below $0.50 per pound and cotton forecasters would not be surprised to see cotton prices under pressure through the first half of 2009. HBI was also able to pass through price increases to its retailers so it firmed up its pricing power for 2009 meaning that sales volume for HBI could decline in 2009 but earnings growth could still be achievable because the cost savings in cotton could offset a certain level of declines in sales volume. The same analysis can be applied to companies facing other commodity cost inputs where those costs have dropped off considerably but end pricing power has been maintained. Dairy costs, for example, have declined considerably and companies that rely on dairy for a significant portion of cost inputs that raised their selling prices in recent years could also stand to benefit from some potential earnings surprises.
Commodity cost tailwinds are one area long investors can explore while foreign exchange (“FX”) and pension headwinds are two items that could present attractive short sell opportunities. FX has been a significant earnings driver for many companies that have significant operations overseas in recent years through FX translation gains. The weakening of the US Dollar (“USD”) relative to the British Pound (“GBP”) and Euro (“EUR”) resulted in some extra “juice” in terms of earnings for companies across industries ranging from Priceline.com (“PCLN”), Mastercard (“MA”), and McDonalds (“MCD”). FX translation gains are “no cost” components and this, along with high capacity utilization, led to abnormally high levels of profit margins in recent years. This means that a company could have looked “cheap” because it was trading at 12.0x earnings in 2008 but could very well be trading at 18.0x earnings when factoring in reduced capacity utilization and lack of FX translation benefits. Simply stated, some of the “cheapness” of those historical earnings was illusory.
If the USD does not weaken by the double digit percentage levels it did in recent years against currencies like the EUR, FX will add far less of an earnings boost to many companies than in recent years. If one expects the USD to further strengthen against global currencies, then FX exposure for many companies could result in translation losses that further eat into any earnings growth. FX translation losses will reduce earnings, thus making these equities more expensive relative to current valuation ratios.
Another area of concern could be the likelihood for greater pension contributions for companies that maintain defined benefit plans. Some of these companies have assumed expected returns of 7-8% and have composed portfolios that have 70+% exposure to equities. Given the performance of equity markets since late 2007, many of these plans will have a significant gap between the fair value of plans and the pension benefit obligations (“PBOs”). This means that companies may, at the minimum, increase contributions to bridge the gap and possibly adjust their assumptions going forward whereby future pension expense will be higher. Assuming a lower future rate of return will generally result in a higher pension expense in future years. These expenses will be coming during a time when top line demand is slackening but has been largely ignored by the Street. These types of situations are more likely to be found with industrial companies that maintain benefit plans and also must deal with reduced capacity utilization.
Financial Markets Will Stabilize But…
The credit crisis and recession have been front page news but credit conditions have been improving. Three-month LIBOR, which was at 4.29% in October, declined to 2.19% in December and is now at 1.41% in early January. Initially it was feared that the Fed’s actions were not impacting LIBOR as Fed Funds were declining due to easing policies by the Fed but LIBOR was diverging, increasing in October when the crisis was peaking. Another indicator of progress is the reduction in the TED Spread, shown in Chart I. The TED Spread is an indicator of credit risk and is the difference between Treasury Bills (“T-Bills”) and LIBOR. Since T-Bills are risk free, the higher the spread between LIBOR and T-Bills means that market participants are pricing in expectations of higher credit risk.
CHART I: TED SPREAD (source Bloomberg)
 We’ve discussed that Keynesian policies may not help much in terms of consumption, as consumers will more likely use additional liquidity to delever their personal balance sheets. Lending relief may not help all equities but it could present opportunities with companies that have significant debt loads and stable cash flows. These companies could perform well as credit conditions continue to ease as the “penalty” for owning some of these companies compress with equity valuations improving for highly levered companies as the risk of not being able to refinance near-term debt is reduced. As credit markets ease, highly levered but cash-flow stable companies could stand to benefit.
Another asset class that could experience positive returns is corporate debt. As with equities, investors will have to be fairly picky in what they select in 2009. Credit analysis will be paramount as analysts will have to run sensitivity analyses across the board to test leverage covenants and then determine if the discount on a specific piece of debt presents an attractive risk/reward prospect. Nonetheless, the BBB rated areas of corporate debt could provide a lot of attractive opportunities. James Grant of Grant’s Interest Rate Observer highlighted an example of attractive corporate debt in a Financial Times editorial on December 4, 2008 entitled “Return-free risk” (emphasis mine).
“Few buyers are presenting themselves, however, though extraordinary bargains keep popping up. Thus, at the end of October, a Medtronic convertible bond with a 1.5 per cent coupon with the debt maturing in April 2011 briefly traded at 80.75. This was a price to yield 10.6 per cent, an adjusted spread of 1,600 basis points over the Treasury curve (adjusted, that is, for the value of the options embedded in the convert, notably the option to exchange it for common stock at the stipulated rate). Contrary to what such a yield might imply, A1/AA minus rated Medtronic, the world’s top manufacturer of medical devices for the treatment of heart disease, spinal injuries and diabetes, is no early candidate for insolvency.”
These opportunities are not likely to be frequent occurrences if one assumes the credit crisis is in its 7th inning. Nonetheless, the BBB rated areas which are somewhat “hairier” and require a bit more work at the analysis level could unearth some promising opportunities. Another segment that could reward investors is mortgage-backed securities (“MBS”), which caused significant problems for many funds and banks. These could actually be priced to perform well in 2009. The Fed started a program whereby it would buy Fannie Mae and Freddie Mac MBS essentially placing a floor in the value of MBS. However, buying pools of MBS will require significant legwork by analysts as the initial broad bump in MBS values was due to the compression of spreads.
While credit conditions are easing, banks are still insolvent and commercial real estate will pose further strains on capital markets in 2009. Although one can’t predict the actions of any government, on the surface commercial real estate does not appear to be as strong a “bailout” candidate as residential real estate and banks. In 2009, commercial REITs, specifically what some believe is the safe apartment sector, could be at risk. Some apartment REITs are located in areas where housing has experienced major corrections. With home prices falling significantly and mortgage rates continuing to decline, home sales could be set to moderate from the severe declines experienced over the past 18-24 months.
Simply stated, owning a home in certain previous bubble territories is getting cheaper while some apartment REITs expanded capacity during 2004-2007. These apartment REITs borrowed considerably on the assumption of high rental rates. However, in 2009, with so many homes on the market that are becoming increasingly attractively priced, a supply/demand imbalance in certain markets has arisen where homes, now priced to move, and apartments, are in tight competition. This matters because apartment REITs have considerable debt loads based on the assumption of high rental rates which will come under pressure as vacancies rise due to economic strains and also competition from the glut of homes available in certain markets. So despite a major drop across REIT share prices, apartment REITs could face significantly more downside in 2009.
Life insurance companies, especially those with commercial real estate exposure, may also not be out of the woods in 2009. Life insurance companies were aggressive buyers of commercial real estate and while the broader markets have appeared a bit more stable and the assumption that this is now “old news” may perpetuate, if commercial real estate experiences difficulty as the recession increases in severity in 2009, then more pressure could be exerted on life insurance companies. This sector is also facing similar dynamics to those companies that maintain defined benefit obligations. Life insurance companies have long offered guaranteed annuities, essentially promises to pay 5-8% annually. With markets down substantially and lack of transparency surrounding the broader portfolios of life insurance companies, this sector may experience difficulty in making good on those payments. Life insurers that face a shortfall in funding these annuities may need to issue stock, diluting existing holders, or may seek government assistance, presenting a political risk as taxpayer capital would be used to pay out annuity holders.
So while shorting everything in the financial sector may not be the slam dunk it was in 2008, certain REITs and life insurance companies could present shorting opportunities with substantial upside in 2009. That said, individual and institutional investors should still recognize that the financial sector could provide long opportunities in 2009. As previously stated, some areas in corporate, investment grade bonds could offer solid risk adjusted returns where coupons are stable and the bonds are priced at a significant discount. As markets ease, holders of these bond would experience attractive total returns with the combination of the coupon and increasing values for bonds. High yield could start to offer opportunities later in 2009 once defaults really start setting in. Individual and institutional investors could both benefit from backing analysts and funds that have the credit abilities to successfully navigate these markets.
Lastly, banks will struggle to lend but this could present a huge opportunity for institutional investors. The notion that banks will continue to struggle may sound as a major contradiction to the initial statement that financial markets will stabilize. Banks will lend to solid credits. Despite the difficult economic conditions, there are companies that are sound credit risks that banks will lend to but in many cases banks and their executives have all been swimming naked such that nobody really has confidence about where the next hole in the balance sheet will arise. Each hole is expensive and this is what some people struggle to understand.
I’ve been asked by some friends about why banks have not stabilized despite all of the money poured into them. The main reason is to simply understand that banks can maintain $8-$12 in assets against $1 in equity. To make things simple, if a bank has $10 in assets and $1 in equity and $1 of those assets are bad, the bank is in major trouble. Some of these banks maintained far more leverage than that, meaning it takes even fewer bad apples to wipe out a bank.
So while equity markets are forward looking, banks are still facing problems “on the ground” because the recession is picking up steam and defaults will increase. Banks and taxpayers went through hell with recapitalizations for the problems in the residential mortgage market and the derivatives tied to those, but problems in commercial real estate, consumer credit (credit card), and corporate lending could all start to rise significantly, making banks nervous about using any capital received by the government to lend. A bank could nervously be sitting on a set of loans tied to commercial real estate that it is marked at a slight discount to par but internally they expect the loan to be a non-performer.
Given information asymmetry, bank executives have no intention of coming clean but the knowledge internally that there are many more problems with their assets would make them less willing to lend out any of the capital received by the government since they may very well need that money to plug future holes in their balance sheet. This is also why hyperinflation, as some predict, should not be a problem. The issue for a bank knowing it has more problems on the horizon as defaults creep up should help people realize that a lot of this government funded capital is going into a vortex and being vaporized as soon as it goes into some of these banks as it’s set to be used for very certain, upcoming defaults and not for lending and expanding the money supply.
However, while banks will struggle, institutional investors may be able to benefit from the formation of origination funds. Rather than back funds that invest solely in the secondary fixed income market, institutional investors could benefit from investing in funds formed that focus solely on origination. Since banks will be far more selective with lending in 2009, pricing will favor those that have the ability to lend. This could be a step up from the traditional mezzanine fund whereby funds raised for lending in 2009 could lend across the capital structure, senior and subordinate, and due to the financial market constraints, could procure equity kickers such that blended returns could range from 15-20+%. Institutional investors on the hook for commitments to large leverage buyout firms that plan to free themselves from those commitments may find better risk adjusted returns by investing in these types of funds.
Respect for the USD?
Some people expect that US monetary policy will prompt the risk of hyperinflation, resulting in a USD that will basically be toast. Over the long-term, the USD and many fiat currencies could be toast but the point is if the USD is trash, other currencies will be even worse at this point. I expect the USD to maintain strength in 2009 due to interest rate differentials and growing problems in some other previously favored sectors.
The EUR was viewed as a “better” currency because the European Central Bank (“ECB”) had a single mandate of controlling inflation. Inflation is not a risk, deflation is the real risk, and that will spur the ECB to cut rates more than most expect. Secondly, one would not be surprised to see the ECB alter its mandate of solely inflation fighting. This is due to the inclusion of more emerging, Eastern European countries to the EU. These countries have different economic and financial needs than mature western economies and in some cases maintain significant current account deficits. Focusing solely on inflation could place significant strain on these younger, emerging economies that maintain these deficits.
As for other currencies, the GBP is tied to a country that is experiencing a credit-induced hangover worse than the US so there’s little reason to expect the GBP to strengthen against the USD. China’s GDP growth is expected to be in the 6% range when in recent years, GDP was 10+%. Given China’s reliance on exports, it has every incentive – political and economic – to maintain a cheap Yuan. Many Chinese citizens were pulled from poverty over the years due to its massive growth in exports and as the US consumer retrenches, China will want to make its exports as affordable as possible to the world to avoid any social or political backlash as manufacturers go out of business and Chinese citizens face the prospect of major economic hardship.
With the US at a Zero Interest Rate Policy (“ZIRP”), it’s only a matter of time for other central banks to do the same and get to what is a practicable policy in those regions. Eventually, when the economy does turn, the US may be in a position to raise rates first. The combination of these aspects could work to maintain a stronger USD longer than most expect.
Some Additional Ideas
There are a few additional, less developed ideas investors should consider. Treasury yields are considered unsustainable with yields virtually at zero and the general consensus is that investors should short Treasuries. Yields may have been artificially depressed by banks which received federal money through the Troubled Assets Relief Program (“TARP”). In these instances, banks may have purchased 3-Month Treasuries when they received TARP aid, depressing yields. However, as credit conditions ease, banks may unwind some of their Treasuries holdings, resulting in higher yields.
Another area investors may want to consider is biotech. I recall a recent report on Bloomberg television discussing the capital constraints of many small biotech companies. I can’t recall the precise numbers but I believe the stated number was that of 370 publicly traded biotechs, 120 are expected to burn through their cash balances in the coming six months. This may sound like a sector to short but the dynamic of the industry presents a possible attractive long opportunity.
Many small biotechs with cash and liquidity issues could have promising drugs in mid-stage development but lack the financial resources to carry out the testing to the final stages. In contrast, mature pharmaceutical companies have liquidity but patents facing expiration. To bridge that gap, pharmaceuticals need to bolster their drug pipelines which would lead them to considering biotechs with promising ideas. Even mature biotechs like Amgen (“AMGN”) can gain from purchasing some of these smaller biotechs. For investors that don’t have the competency to select individual biotechs or are not invested with biotech fund managers, ETFs like XBI and IBB can allow them to participate in a possible uptrend in the industry.
Parting Thoughts
While I’m not optimistic on broader equity markets, it appears that they now present a more tradable environment than in previous months. However, the euphoria tied to stimulus programs and the initial inclination for many fund managers to not want to miss out on an upswing in the early part of 2009 and lag the market may subside by Q2 09. It’s important to note that disappointing earnings are what drives bear markets and while the general consensus is that markets will recover in H2 09, this could prove optimistic. Couple this with the fact that the more seasoned investment professionals came of age during the strongest bull market in history from 1982-2000 and suffered just a mild recession in 2001, there’s little real experience or tangible “feel” to what a serious downturn is like.
Nonetheless, there are some securities with sound capital structures, solid cash flows, and most importantly attractive valuations that can offer investors some upside. Stocks that offer these characteristics along with attractive dividend yields could be a good addition to investor portfolios but investors would also benefit from seeking out some sort of equity hedge component to insure against market reversals.
Amit Chokshi
amit.chokshi@kinnaras.com
(203) 252-7654 phone
(860) 529-7167 fax
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