By any measure, 2008 will go down in the record books as one of the most economically challenging years in the history of our country. The pain from, and on Wall Street, will not soon be forgotten, as the stock market is poised to end the year with its worst performance since 1931. The magnitude of the fallout from the well documented debacle in the financial sector remains a subject of intense debate as well as the heart of our worst economic fears.
Meanwhile, trust has been shattered at every level, from CEOs and their corporate cronies in the boardroom, to an unpopular congress and an ineffective current administration. Based on a study from progressive think tank, Third Way, only 17% of Americans trust the federal government, the lowest level in nearly 50 years.
So we approach the New Year with critical questions yet to be answered. Perhaps most importantly, can government intervention solve the credit crisis and turn the economy around? It puzzles me to think we are placing so much hope in an entity that so few of us really trust, yet the immensity of the problem gives us little choice. Like it or not, the government is going play an integral role in the recovery process. It is difficult to fathom the magnitude and complexity of the financial challenge. For example, The Bank for International Settlements estimates the notional amount, or the total value of all derivative’s underlying assets, is approximately $500 trillion. While that value is debatable, it is undoubtedly a very big number. In comparison, $500 trillion is roughly 10x the GDP of the entire world.
Be careful what you ask for… So, yes the US government has to get involved. The amount of legislation, reform, new policies, oversight boards, and the like that will be enacted over the next few years will be staggering. The cost of all this, and the smothering effect on creativity, innovation, and economic growth is another tough question.
I think there are two potential catalysts that would make 2009 a recovery year. The first would be a turn in the woeful employment situation. While the economy did lose an alarming 500,000 jobs in November, which may not be the worst we’ll see over the next several months, the sea change toward government intervention could result in a massive increase in government employment. President Elect Obama’s transition team has reported that over 300,000 people have used its website to apply for federal jobs. The CIA alone has seen a record level of job applicants, over 130,000. That’s comforting, right? At some point the employment situation will turn, and that would be an important catalyst for the market.
The second potential catalyst is corporate earnings. The current estimate for 2009 earnings for the S&P 500 has fallen around 15% to approximately $90/share. My sense is that earnings estimates are likely to continue to fall, perhaps another 10-15%. At some point, an industry-leading company will buck this negative trend and deliver earnings above expectations. The market would likely advance sharply in response to a positive earnings report from a bellwether company. I think such an event is likely some time in 2009.
Against this backdrop, stocks look statistically cheap… By virtually any valuation measure, stocks look relatively inexpensive. The market is selling at a 20-year low based on Price/Earnings, Price/Cash flow, Price/Book Value, and Dividend Yield. My sense is that most of the decline in earnings expectations has already been discounted by the market. Again, any fundamental improvement in employment or earnings could lead to a powerful rally in the market.
Financial Armageddon… There is no lack of pundits who believe we are on the slippery slope toward financial Armageddon. Thankfully, I believe congress and Team Obama get it. I do think they will do whatever is necessary to avoid the dire predictions of an economic depression. The result, over the next several years, is more likely to be relatively slower economic growth reflecting tighter credit conditions and increased government regulation. At the same time, stock price volatility is likely to remain intense and unpredictable as the deleveraging cycle unfolds. Learning to live within our means, as individuals, families, corporations, and in the public sector, will be a painful process. But the process has begun and it is unlikely to be reversed.
In this context, the importance of a disciplined approach to investing can not be overstated. Systematic, analytical decisions must carry the day in order to avoid the emotional pressures to sell at the wrong time or to chase unsustainable rallies. And there will be plenty of opportunities in 2009 to succumb to either emotional extreme. Nevertheless, within our process we will continue to search for high quality companies with low debt, solid cash flow, innovative new products, and disciplined management. We then hope to utilize our time-tested valuation techniques to take advantage of periodic valuation extremes resulting from continued market volatility.
We wish all of you a blessed holiday season.
