Economic Review and Market Perspective*
July 20, 2009
Economic Review Despite the U.S. Government taking extraordinary measures to revive the financial system, the economy, as measured by gross domestic product (GDP), continued to show signs of weakness in the second quarter, after contracting at an annualized rate of 5.5% in the first quarter of 2009 and 6.6% in the fourth quarter of 2008. The smaller decrease in GDP in the first quarter was partially due to an improvement in personal consumption expenditures for both durable goods and nondurable goods. The Federal Reserve’s Beige Book provided a mixed picture suggesting that U.S. economic conditions generally remained weak or deteriorated further from mid-April through May. Apparently, the Fed does not see a substantial increase in economic activity through the end of the year. Notwithstanding, some regions of the country showed signs of moderation. The Federal Reserve’s report is consistent with the data from other economic indicators. The weak economy continued to have a negative impact on the U.S. job market, with 539,000 and 345,000 positions lost in April and May, respectively. Although the 345,000 job losses in May was about half of the 643,000 average monthly job loss for the prior 6 months, employers cut an additional 467,000 jobs in June, much higher than expected. For perspective, over a full economic cycle, employment averages a gain of 200,000-300,000 jobs per month. Job losses were generally widespread, with manufacturing continuing to be especially weak. Other industries, such as construction, professional and business services, and retail trade, experienced some moderation in the latest month. Since the beginning of the recession in December 2007, a total of 7.2 million jobs have been lost, with the unemployment rate rising to 9.5% as of June and approaching levels not seen since the deep recession of 1982 when unemployment peaked at 10.8%. The Conference Board Consumer Confidence Index, which had improved from February through May, retreated in June. Notwithstanding the overall increase in consumer confidence since February, U.S. consumers continued to increase savings, limit spending, and reduce debt. The personal savings rate reached a 15-year high of 6.9% in June compared to a zero percent savings rate as recently as April 2008. U.S. retailers reported their 10th consecutive month of weakening year-over-year sales, the longest decline on record. Consumers reduced their debt for the fourth consecutive month as of May 2009, and credit has fallen in eight of the last ten months. This is the longest string of declines since 1991, and represents the lowest level since early 2008. Meanwhile, the continued weakness in employment has, at least in the short term, reduced the likelihood of inflation because wage pressures, which are typically a critical component of rising inflation scenarios, are not an issue at the moment. Nonetheless, inflation remains at the forefront of economic discussions as the U.S. Government has pursued very aggressive monetary and fiscal remedies over the course of the past 18 months that many believe could result in much higher prices down the road. For now, evidence that inflation should be a concern has not materialized. With the latest CPI data, inflation is still negative on a year-over-year basis for the first time since 1955. While it is true that the most recent months have shown an up-tick in the data, the advances have been relatively modest. The Federal Reserve also does not consider inflation to be an imminent concern as evidenced by its statement on June 24; “The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.” On the real estate front, the U.S. housing market continued to show signs of improvement with existing home sales posting monthly increases of 2.9% and 2.4% in April and May, respectively. May’s increase marked the first back-to-back monthly gain since 2005. With that said, the total number of units sold of 4.77 million on an annualized basis was 3.6% below the 4.9 million-unit pace of May of last year. As far as new construction is concerned, April housing starts showed a modest rebound in single family home construction, which was more than offset by a substantial decline in multi-family homes. Overall, construction of new homes and apartments fell 12.8% for the month, representing an annualized rate of 458,000 units, marking the lowest pace in a half century. Financials received a boost when the long awaited stress test results for the largest U.S. banks revealed that $75 billion in capital needed to be raised, but that 9 out of the 19 institutions did not require additional funds to shore up balance sheets. On the heels of the better than expected results, several financial institutions sought funds in the capital markets in deals that were generally oversubscribed, which provided some evidence of thawing in the credit markets. Also during the quarter, several prominent financial institutions expressed their interest in returning the money received from the Troubled Asset Relief Program, suggesting that the industry is stabilizing to some extent. Outside the U.S., economic conditions also remained difficult but, unlike in the U.S., the broad data suggested a further deepening of the weakness with the exception of China. In June, Eurostat, which is the statistical arm of the European commission, reported that GDP fell by 2.5% in the Euro Area (EA16) and by 2.4% in the broader EU27 in the first quarter compared with the fourth quarter of 2008. The deterioration in economic activity was broad based, with Germany leading the way, as its GDP decreased by 3.8% versus the previous quarter. On a year over year basis, Germany’s economy declined by 6.9%. Similar to the United States, however, certain segments of the Eurozone experienced moderation and an improvement in sentiment. For example, the Eurozone manufacturing and service sectors purchasing managers’ surveys pointed to slowing contraction for a third successive month in May, causing the composite index to reach an eight-month high of 44.0 from 41.1 in April and a record low of 36.2 in February (over 50 indicated expansion). Similar to the U.S., Eurozone economic sentiment rose for a second successive month in May to reach a six-month high, reflecting an improvement in both consumer and business confidence. Nonetheless, conditions remain extremely challenging. China's economy gathered momentum in the second quarter thanks to massive fiscal and monetary stimulus. GDP growth accelerated in the second quarter to 7.9% annualized, up from 6.1% annualized in the first quarter compared to a year earlier, making China the best-performing major economy in the world. Additional data for June from China’s National Bureau of Statistics depicted an economy successfully making up for a slump in exports through domestic demand, both investment and consumption, generated by a $585 billion pump-priming package and record bank lending. As the world’s third largest economy, it is hoped that China, as well as other developing countries, will lead the global economy out of recession. However, if Japan, the U.S., and other major Western developed economies are experiencing tepid recoveries, it remains to be seen if China can be weaned off the massive stimulus without an unacceptable deceleration of growth. China also faces the risks of another bubble in its housing market and unacceptable levels of inflation. Market Perspective As indicated in the table below, since March 2000 U.S. financial markets have experienced two market tops, two bottoms, and a possible third top (namely, as of June 12, 2009). The table characterizes the October 2007 to March 9, 2009 period as an unusually deep bear market, the worst since the 1929 Crash. From the peak of household net worth in early 2007 to March of 2009 U.S. households lost almost 21% of their net worth, representing $14 trillion, and consumer spending declined precipitously.
Time Period |
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Market Cycle Description |
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March 2000 – End of 2002 |
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Deep Bear |
Early 2003 – October 2007 |
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Long, Steady Bull |
October 2007 – March 9, 2009 |
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Very Deep Bear |
March 10, 2009 – June 12, 2009 |
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Sharply Upward, Short (So Far) “Bull” |
The impact on asset class returns of the two deep bear markets has been dramatic. Large capitalization U.S. stocks were particularly impacted by the bursting of the technology/Internet bubble in 2000 and the vaporization of large financial and auto industry company stock prices in 2008; annualized returns were quite negative over the entire 9.25-year period covered by the text table above. Foreign stocks benefited from currency gains; nonetheless, annualized returns were also negative, but only a little. Small cap U.S. stocks were barely in the black but outperformed large caps consistent with the seminal Fama-French research. Over the 9.25-year period, global bonds provided annualized returns somewhat over 6% and also were fairly consistent performers (except the second half of 2008). Finally, U.S. equity REIT’s were the surprising winners over the period, providing total returns of almost 7% annually. The table below shows the data and also one-year and five-year returns as of June 30, 2009.
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One-Year |
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Annualized Returns |
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Index |
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Return |
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Five Years Ending |
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April 2000 - |
Barclay’s Aggregate U.S. Bond |
|
6.05% |
|
5.01% |
|
6.16% |
Citigroup Non-U.S. Bonds |
|
3.53% |
|
6.24% |
|
6.72% |
S&P 500 |
|
<26.21%> |
|
<2.24%> |
|
<3.42%> |
Russell 2000 |
|
<25.01%> |
|
<1.71%> |
|
0.68% |
MSCI-EAFE |
|
<31.35%> |
|
2.31% |
|
<0.88%> |
Equity REIT’s |
|
<43.29%> |
|
<2.73%> |
|
6.81% |
A recent Wall street Journal article implied investors should reconsider their asset allocation strategies because long-term U.S. Treasuries outperformed U.S. stocks over the latest five, ten, fifteen, twenty, and twenty-five year periods ending June 30, 2009. Since Caves & Associates, along with the vast majority of financial professionals and academic researchers, base our investment philosophy and portfolio designs on the supposed superiority of stock returns versus those of bonds, we thought some additional perspective would illuminate this controversial and potentially “revolutionary” result.
The period returns (not annualized) for the Barclays Capital Long-Term Treasury Index and the S&P 500 Index for various periods as of June 30, 2009 and June 30, 2007 are shown in the table below. The table also reports the relative performance of the Treasury long bond versus stocks by indicating a “B” for Treasury better than stocks and “W” for Treasury worse than stocks.
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Period Returns as of June 30, 2009 |
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Period Returns as of June 30, 2007 |
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Period |
|
L-T Treas. |
|
S&P 500 |
|
B/W |
|
L-T Treas. |
|
S&P 500 |
|
B/W |
|
5-Year |
|
40.26% |
|
<10.72%> |
B |
|
32.96% |
|
66.31% |
|
W |
||
10-Year |
|
105.34% |
|
<20.14%> |
|
B |
|
102.66% |
|
99.07% |
|
B |
|
15-Year |
|
228.20% |
|
173.03% |
|
B |
|
212.46% |
|
390.81% |
|
W |
|
20-Year |
|
400.20% |
|
346.37% |
|
B |
|
418.62% |
|
681.57% |
|
W |
|
25-Year |
|
1,115.89% |
|
1,015.31% |
|
B |
|
1,170.66% |
|
2,574.15% |
|
W |
|
Memo: 25 Years |
|
9.71% |
|
B |
|
10.34% |
|
13.87% |
|
W |
|||
As reported by the Wall Street Journal, and shown above, the U.S. long bond did outperform stocks for each of the cumulative periods as of June 30, 2009. However, using an ending point two years earlier, as of June 30, 2007, stocks outperformed the long bond over ever period except one. In other words, these two sets of data provide very different “evidence” about the superior returns of stocks in an investment portfolio. What causes these contrasting results?
Statisticians and analysts explain the seeming disparity as an “end-period effect.” The primary reason the long bond outperformed stocks in each of the cumulative reporting periods as of June 30, 2009 is that each period includes the devastating performance of the extraordinarily deep bear market of October 2007 to March 9, 2009. U.S. equities declined approximately 50% over this period while long-term U.S. Treasuries provided a total return of about 18.5%. In contrast, the returns for each of the reporting periods as of June 30, 2007 do not include the results of the latest bear market. As a result, as noted above, stocks outperformed the long bond in four of the five cumulative periods. Only over the ten-year period ending June 30, 2007 did stocks underperform and then only modestly.
Respecting 25-year returns shown at the bottom of the table, the impact of omitting the two years from 7/1/07-6/30/09 and substituting the two years from 7/1/82-6/30/84 borders on the amazing. Looking at 25-year annualized returns, the long bond goes from being a modestly superior performer (about 10.1% versus 9.7% per year) to a “not even close” loser (about 10.3% versus 13.9% per year).
To conclude, we see the “truth” of two longstanding adages: (1) there are lies, damn lies, and statistics! (2) You can’t believe everything you read in the paper, in this case meaning the media like to needlessly stir up emotions and controversy.
* Thanks and credit must go to the many sources for this writing, including Managers and PIMCO mutual fund families, the Wall Street Journal, and the Los Angeles Times.