As you would expect, we do a great deal of ongoing reading and research about the current state of the economy and capital markets.  We gather our information from a wide variety of sources, as our independent and objective approach to providing services allows us to utilize some of the best investment managers and research firms in the world.  Rather than rely on any one opinion, we prefer to read and digest a number of them, and then discern what we believe to be the most likely outcome given these varying views of the world. 

As we review the most recent data and research coming in, we have reasons for both pessimism and optimism.  Most of the pessimism comes from a short term view of “what else” might happen that could make volatility and fear continue in the market.  Economic data continues to “surprise” to the downside.  Many economists have been continually revising their forecasts, steadily ratcheting up their expectations for unemployment and ratcheting down their expectations for GDP growth.  Many are now adjusting their fourth quarter GDP expectations down to a projected annualized decline of four to five percent, with continued deterioration of the economy into at least the first two to three quarters of next year.  Credit spreads of high-quality corporate bonds are still at historically wide levels, despite the aggressive  actions of the Fed and Treasury, while the collective policy response continues to underwhelm the markets.  This month, the decision by the Treasury to cancel the purchase of mortgage securities has disappointed the market (although one could certainly argue that further capital injections are a far more effective way to utilize the allotted capital).  Additionally, the delay in shaping and passing an additional stimulus package and “bailout” for the automotive sector in the face of potential bankruptcy has further exacerbated investor concern.   

There is genuine anxiety that “deflation” is starting to take hold of the market, and that once a debt deflationary spiral starts, it is hard to stop.  For more on this “Paradox of De-Leveraging,” we invite you to read PIMCo’s Global Central Bank Focus, written by Paul McCulley last week (see link to the right).  While Paul is a bit wordy and, at times, academic, we think that he gets to the heart of the matter.  The fact that the monetary authorities are actively voicing concern about deflation, and that policy makers now appear to understand this risk to a greater degree (despite the political rhetoric), gives us comfort that they will do whatever it takes to stop such a process.  In fact, current Fed Chairman Ben Bernanke stated in a speech to the Economic Club of New York earlier this month that, "We will not stand down until we have achieved our goals of repairing and reforming our financial system and restoring prosperity.”  

Will we suffer a great depression like that of the 1930s, or a debt deflation spiral similar to the one in Japan in the 1990s?  The only thing of which we are certain is that we don’t know the answer to the outcome of this current crisis.  Much still rests on the collective ability of the Fed, the U.S. Government, and key foreign governments and central banks to craft an appropriately aggressive policy to reverse the current downward trajectory in the global economy and re-stabilize credit markets.   We do know that there were a multitude of policy mistakes that were made during those prior two crises that current policy makers can reflect on and avoid.  So far, the responses of the various governments and central banks around the world have been much quicker than in either of those two financial crises, and some of the policy errors that occurred in each have already been avoided.  However, each crisis presents its own unique set of problems, and no one can be certain that our current responses to this one will be enough to solve them.  There have been many disappointments along the way, and we expect that the market may be surprised by a few more.  However, given that there is a significant amount of information about this current crisis that is being digested by the fiscal and monetary authorities, in the end we believe we will eventually find the right combination of policy responses to work our way through the current issues. 

Yes, that is a long-term view – and that is the view with which we suggest individuals invest.  Many of the publications we read attempt to project where the market may be headed in the short run.  Interestingly, when we review these various research sources and their prognostications, we also review many of their economic projections for the earnings of the S&P 500 in 2009.  We have found that even those pundits that are relatively “gloomy” in their forecasts are suggesting a drop of approximately 30% to 40% from the S&P 500 peak earnings of approximately $83 (2007).  This would result in earnings of approximately $50 to $60.  At a level of 800, the S&P 500 would be priced at approximately 13 to 16 times earnings, which is fairly reasonable given the current interest rate on U.S. Treasuries.   

So, does that mean we have reached a bottom?  On that, we will not venture to guess.  We are honest when we say “We have no idea at what level this may end.”  Earnings could suffer from additional economic weakness, and consumer demand could fall even further than is anticipated.  Frankly, no one can truly estimate the short-term effect of the deleveraging that is currently rippling through the system.  If the bond market is correct in pricing in the highest credit spreads since the 1930s, then the stock market is overpriced and likely has further to fall.  If the stock market is correct, the upside in credit sensitive areas of the bond market looks particularly good as it would appear to be materially oversold.  Neither the stock market nor bond market is likely absolutely correct in its pricing levels at the current time. 

In the short run, continued fear and negative news flow could certainly make the stock markets around the world fall further.  If the stock markets continue to be “surprised” by economic growth numbers, then further downside is likely.  How much more?  That depends on the perceived severity of the “surprise.”  Conversely, some economic news or policy response may be viewed very positively by the market (see Friday’s reaction to the rumor of the naming of the new Treasury Secretary).  Volatility will remain high, and daily price movements appear likely to continue at levels that many of us have not seen during our lifetimes.   

However, in the long term, we feel there is a more likely outcome to be considered.  As illustrated in the attached chart, we have reviewed each of the time periods when the S&P 500 lost 40% of its value from peak to trough.  We then noted the point at which the loss exceeded 40% and calculated the subsequent five-year and ten-year returns for the S&P 500 from that level.  While this is obviously a limited data set, and each crisis is unique in some way, we believe that long-term investors that can withstand this volatility will ultimately be making investments in the credit and stock markets that will reward them handsomely in the future.  However, as we have stated in many past writings, the issue for all investors is whether or not they have sufficient cash reserves, liquidity, and intestinal fortitude to get through a period of significant volatility. 

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.  

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree. 

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.