To Our Valued Friends of Silver Oak,
This is an edited version of our Client Letter, sent recently with our Quarter 2 Portfolio
Performance Reports. This letter is intended to supplement that data and provide
continuing insight into our thinking about the markets and the economy.
Are the stock market and the economy no longer correlated?
In our June letter we provided a graph showing the roller coaster ride that was the stock
market in the first half of the year. Since then, the U.S. stock market has continued to
increase and has risen above the 9000 level on the Dow Jones Industrial Average. Many
in the national news have proclaimed the end of the recession is in sight. Therefore,
they argue, there is sufficient precedent to justify an interpretation that we are in the
beginning of the next bull market. These sources point to the slowing rate of decline in
our various economic indicators along with selective anecdotes such as home sales
rising as their justification.
We certainly agree the rate of decline has slowed. The massive government
intervention should get credit for avoiding a greater economic decline. Yet we are not
convinced that the next bull market has begun. On the surface, it certainly looks like
Pamplona and the running of the bulls with the bears scurrying out of the way!
However, numerous factors could portend another goring of the economy over the next
While we hope that the charts on the next two pages will help illustrate our points and
simplify the statistical references, for those readers who prefer just the executive
Summary – please see the last page.
Waving the Red Flag
Prior Recessions – What We Learned
The tendency of most economists (and even those of us in the advisory world) is to talk
about recessions in statistical terms. We are not going to use statistics other than to
define a term which you may have heard in the news. Gross Domestic Product (or GDP),
which is the total dollar volume of the goods and services produced, is frequently cited
in determining if our economy is shrinking or growing. It is also directly correlated to
the growth or decline in longer term stock prices.
To grasp the essential information, pictures or graphs are often better tools for
conveying information. Chart 1, below, is based on the recession of 2000‐2001. Several
trends can be spotted very quickly that are important lessons as we ponder what might
happen today. That recession ended officially in November 2001. Unemployment
claims, the green line, improved a little in early 2002 but then trailed off a bit until the
economy improved halfway through 2003.
The stock market (top grey line) also improved for a few months after the declared end
of the recession. The euphoria drove the market from its low (point C) to a high in
March (point P) which represented about a 33% gain. However, as you can see,
statistically knowing the recession had ended did not keep the market from creating
new lows and then stagnating for another several months.
One of the questions that we all would like to answer is whether this pattern is
repeating itself again today. Are we truly coming out of recession and will the market
upswing be sustainable?
Consumer spending is one of the factors that typically has been important in ending
recessions and in identifying growth cycles. The red line at the bottom of Chart 1
signifies consumer spending. Note that it grew slightly after the recession ended,
although contributing only about 1% to GDP.
Dow Jones Trend Line
Unemployment & Consumer Spending
Consumer spending remained steady coming out of the last recession. Unemployment
was at its worst a few months before the recession ended. Today, however, we clearly
are able to make a case for a different fact pattern in both of those factors.
Chart 2 will help us get a better visual sense of what our job losses today look like
compared to the last two recessions. Not only have we not stabilized, but we continue
to lose a substantial number of jobs every month. From many resources we read, it is
thought likely that the jobless rate will increase into early 2010.
But as bad as that thought is, it does not tell the whole story. In order to cut their
losses, many employers have reduced their payrolls by forcing employees to work fewer
hours. When the underemployed are tabulated, the number of people looking for full‐
time work adds at least 7% to the current rate of unemployment. When things do start
to turn around, employers are more likely to give current employees more hours before
expanding the hours of part‐time workers, and before adding new workers.
This does not bode well for consumer spending, which has always been a critically
important element of a recovery after recessions. Historically, consumer spending has
added 3.5% to GDP growth in the first year of an economic renewal. At the end of the
last recession that number was only 1%. With today’s unemployment level perhaps
three times worse than during previous recessions, it is extremely unlikely that we will
see enough consumer spending to pull us out of recession. As one newsletter put it:
“The difference is that this 2007‐2009 cycle was double the asset deflation and triple the
job loss coupled with a credit collapse, which means that it is going to take even longer
for the consumer to come back this time around.“ This is of particular concern since
consumer spending typically makes up 70% of our GDP.
During Q2 2009, consumer spending declined at an annual rate of 1.2%. We suspect
that there will be some pent up demand for goods that might lead to some
improvement, yet it is difficult to expect sustainable consumer spending until there is
significant new job growth.
Stocks & Bonds
The Wall Street Journal recently ran an article that we felt persuasively made the case
for investing in bonds rather than stocks. The take‐away was that bonds still offer
better risk‐adjusted return potential. While high yield bonds, for example, are not
without risk the article points out, returns in the next year could “reach the mid‐teens
over the next year”.
As David A. Rosenberg, former Chief Economist of Merrill Lynch, recently wrote, “Unlike
the stock market, which has de facto priced in a 40‐50% earnings surge in 2010, there is
no such hurdle or high‐hope in the corporate bond market, which is still largely priced
for a deep recession – a GDP contraction of 1‐2% going forward and the unemployment
rate heading towards 11‐12%.” “Insofar as the economy does not relapse to such an
extent, there is significant cushion embedded in the pricing of the corporate bond
market this time…”
Given the potential for the stock market to give up its gains as it did in the last recession,
we continue to focus on the steady returns that our fixed income‐oriented portfolios
provide. To supplement that focus, we have added a fair amount of risk in areas of the
investment markets that we feel present good opportunities. The level of the risk we
have added is directly proportionate to the conversations we have held with each
In our prior communications we have referred to the term which PIMCO coined, “The
New Normal”, as being expressive of the notion that stock returns going forward will
not be at the same level as we have been accustomed to earning over the past decade
or two. We will continue to monitor such factors as bank lending levels, the availability
of credit, inflation, unemployment, and corporate earnings for signs that sustainable
growth in the stock market has returned. Until that time, we will remain focused on our
current strategies that are working well. As we observe changes in the economic
fundamentals, we will continue to share our thoughts with you and to solicit your
As always, we are available and eager to speak with you in detail about any of the points
covered in this letter. We also continue to accumulate research articles on these topics
that we are happy to provide you if you are interested.
Best personal regards,
Joel H. Framson, CFP®, CPA/PFS, MBT Eric D. Bruck, CFP®