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May 05, 2010
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Transcript of "©2009 Wilmington Trust Investment Management, LLC. All rights ..."
1. May 1, 2009 Adrian Cronje, Ph.D., CFA®, Chief Investment Strategist Wilmington Trust Investment Management Rex Macey, CFA, CIMA, CFP®, Chief Investment Officer Wilmington Trust Investment Management Clutching at Straws KEY POINTS: • The psychology of the market has changed. • Data suggesting that the economy is getting worse at a slower rate support confidence and stocks. • We remain guardedly optimistic and are not yet convinced that it is time to take more risk. The psychology of the market has changed. Cyclical stocks have been leading the market since its March low. Lower quality, low priced stocks have been outperforming. Value stocks slightly outperformed growth stocks in April, though growth stocks remain ahead year to date. Investors seem to be dismissing earnings results for 2009 and focusing on 2010, when cyclical growth seems more likely. Earnings estimates for 2010 have been stabilizing. Every day of late, economists have been pointing to data that suggest the worst of the recession may be behind us. On April 29, the Federal Open Market Committee said in a statement that the economy “has continued to contract, though the pace of contraction appears to be somewhat slower.” Investors clutching such straws have bid up equity prices nearly 30% since early March. Meanwhile, gross domestic product (GDP) fell at a real (inflation-adjusted) annual rate of 6.1% in the first quarter, bringing its streak of contraction to three consecutive quarters. Business investment and exports fell. The consensus forecast of economists was for a 4.7% decline in GDP. Nonetheless, the stock market surged 2% on the announcement date. The “positive news” was that inventories shrank, which bodes well for future production and consumer spending increases. Earnings: Less Weak Than Expected On the subject of squinting to find the silver lining, first-quarter corporate earnings have not been as bad as expected. Of the 271 S&P 500® Index companies that reported through April 30, 69% topped analysts’ forecasts. This is a function of weak forecasts. At the beginning of April, earnings were expected to fall 37%. There continues to be a wide gap between bottom-up and top-down earnings estimates (those derived, respectively, on a company-by-company basis and on the basis of macroeconomic conditions). According to Standard & Poor’s, bottom-up analysts are projecting $75 in collective operating earnings per share (EPS) for the S&P 500 companies next year—60% more than the $47 expected by top-down strategists. (To put both estimates in context, consider that the operating EPS of the S&P 500 companies totaled $82.54 in 2007 and $49.51 in 2008.) Historically, bottom-up analysts have been too bullish, and top-down analysts often have been too downbeat at recession turning points. ©2009 Wilmington Trust Investment Management, LLC. All rights reserved.
While this type of data may help the market move up from its overly pessimistic lows, it is not the basis for a sustained bull market. In typical recessionary periods, a deceleration in contraction quickly evolves into a sustained acceleration in improving conditions as analysts are caught flat-footed by extrapolating gloom and despair. This time, we think there are many reasons not to get too carried away just yet. Recessions characterized by deleveraging are rare events for which the play-book is thin. Speaking of rare events, the spread of the swine flu, correctly known as H1N1, has folks worried about a 1918-like pandemic. We pray that this flu does not become a pandemic. The point we want to make is any prognostication about where the markets are going, no matter how intelligent and experienced the source, is subject to events that are unpredictable in their timing and severity. We believe diversification is the best investment strategy for an uncertain future. And since the future is always uncertain, portfolios should always be diversified. The market may have a difficult summer if new data suggest the recovery may be slower than is currently thought. Sure, consumer confidence has ticked up, but to what extent was the first-quarter stabilization in consumption due to such one-time factors as plunging commodity prices? How effective will the fiscal stimulus be in capping the increase in the unemployment rate and smoothing the transition to a more sustainable, higher savings rate over the long run? While Treasury Secretary Geithner testified that the “vast majority” of banks have sufficient capital to withstand an even deeper recession, just how optimistic were the underlying assumptions in the “stress tests,” and were they applied objectively by independent judges? More importantly, where will the capital come from to support undercapitalized institutions and how soon will they resume lending? Deleveraging: Not Done Yet The recent downturn has been so sudden and so deep that it would not be surprising if the economy registered one or two quarters of strong GDP growth. But we think the trend may be more subdued than many hope, as the necessary deleveraging at the heart of last year’s crisis continues at a slower, more orderly rate. We do not see cause for concern about long-term capital market returns, but we think short- term performance may be vulnerable when investors become overly optimistic. To mitigate the risk to near-term performance, we continue to be more comfortable with what we hear and see from the hedge fund managers we monitor. As we have observed before, they were very responsive in reducing risk by the end of last year and held up relatively well during the first quarter. While generalities across such a heterogeneous industry are difficult to make, it seems that a popular way for hedge funds to reduce their market exposure today is to short the financial sector. While hedge funds have lagged the surge in the stock market since the beginning of March, we expect them to play a moderating role in our strategies by providing a hedge against renewed concerns about financial companies and a worse than expected economic outcome. On the other hand, the recent run-up in stock prices could turn out to be a real bull market if investors have reason to believe the economy really is getting better, not just declining at a slower rate. The current yield of the 10-year U.S. Treasury note has recently passed the 3% mark. Thirty-year yields have topped 4%. The spread between 2- and 10-year Treasuries has been widening—a classic tea leaf that many observers interpret as a sign that the economic outlook is improving in a sustained way. Unfortunately, the usual dynamics have been blurred by the fact that today the Federal Reserve is not only refereeing the ©2009 Wilmington Trust Investment Management, LLC. All rights reserved.
fixed income markets but has actually emerged as a player on the field of investment. Through its “quantitative easing” efforts, the Fed is buying long-term Treasuries and U.S. agency securities in an attempt to control long-term bond yields. The Fed’s announcement this week suggested that policymakers are not overly concerned about the 50 basis point (0.50%) increase in the yield of the 10- year note since it undertook quantitative easing. Our central bankers should—and probably will—bear in mind the mistake of Japanese policymakers, who quickly removed emergency stimulus at any faint sign of an economic pulse as they fought to escape their Great Recession of the 1990s and early 2000s. Sector Watch: Waiting for a Change in Leadership One of the key things we are watching is the composition of equity market sector returns. Our analysis of market cycles shows that it is extremely unusual for the hardest-hit sector in a bear market to also lead the next sustained new bull market. Yet that has been the pattern thus far: Financials were hardest hit between the market’s October 2007 peak and its March 2009 low. And they have led the market’s rise during the past six weeks. Going forward, any sector outside of financials leading the market up in a relatively consistent way would be a more promising sign for us that risky financial assets have decisively turned the corner. Disclosures The information in this Commentary has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for information purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination by Wilmington Trust that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will be successful. Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by Wilmington Trust or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested. Some investment products may be available only to certain “qualified investors”—that is, investors who meet certain income and/or investable assets thresholds. Investing involves risk and you may incur a profit or a loss. ©2009 Wilmington Trust Investment Management, LLC. All rights reserved.