The fourth quarter of 2008 witnessed sustained volatility in financial markets not seen since the Great Depression. Underlying the dramatic moves were a loss of confidence in the global financial system along with fears of a sustained recession in the world’s economies. The US stock market as represented by the S&P 500 index, fell 22% to 903. The yield on the benchmark Ten-year Treasury note fell to 2.24% from 3.83% on record demand from buyers seeking a safe haven from the storm. (For the year, the S&P 500 declined 38% and the yield on the Ten-year note declined 181 basis points from a starting value of 4.03%.) To address the financial crisis, governments and central banks across the globe have taken unprecedented actions to reinforce the credit system. In America, this has taken the form of the Federal Reserve lowering overnight interest rates to practically zero, enhanced lending against almost all forms of collateral, and the open market purchase of mortgage backed securities and agency debt, to possibly include long-term Treasury securities as well. The Treasury, meanwhile, through the Troubled Asset Relief Program (TARP), has injected hundreds of billions of dollars into the credit system by taking passive equity stakes in national and regional banks and other large financial institutions, and extending loans to automotive firms. Failure to support the latter would have likely resulted in a further major leg down in the market.
While it seems as though these measures have succeeded in stabilizing financial markets for the time being, with what we believe to be at the least an intermediate market bottom of 752 on the S&P 500 reached on November 20th, the uncertainty surrounding the extent and duration of the global economic recession remains a massive weight on world stock markets. To combat the recession, the incoming Obama administration has pledged to put together an economic recovery program approaching one trillion dollars in stimulus spending. We also expect the administration to address the home mortgage foreclosure debacle using the second $350 billion installment of the TARP. Governments around the world are putting into place similar plans to confront a problem of truly global proportions.
The question facing investors is whether or not these programs will succeed in bringing the recession to a timely end and limit the extent of the damage it visits upon the economy. While we think the recession will be the worst seen since the Great Depression, we in no way think it will approach the economic severity of the Great Depression given all of the government programs discussed above. We have confidence that remaining committed to firms that have a proven record of paying cash dividends to shareholders is the best strategy for a market that we feel will move largely sideways for at least the next few years.
Given the economic difficulties we will face in the years to come and the “bad taste in the mouth” many investors have from recent heavy losses, we do not see large price appreciation in the intermediate future. At the same time, we believe that stocks have moved into the “strong hands” of committed investors, as less stable shareholders bailed out during this year’s extreme volatility. We believe that the current shareholder base, in combination with the continued efforts of the world’s governments and central banks, provides somewhat of a floor under the stock market.
Longer-term, we have no doubt in our judgment that we will emerge from the current economic malaise. At that point, we believe the issue facing the market and the economy will be whether or not the governments and central banks of the world have the discipline to remove the substantial stimulus needed to pull ourselves out of this recession and financial crisis. Failure to do so at the proper time could reignite inflation. The people who are buying Thirty-year Treasury bonds at 2.69% may think they are locking in a “risk-free” return, but given the strong possibility of an eventual inflation, they are in reality taking on enormous risks. As such, we are extremely bearish on long-term US Government bonds and hold none in our portfolios. On the flipside, we are bullish on gold as a hedge against inflation. Traditionally, stocks have also done fairly well in inflationary environments, particularly from today’s suppressed valuations. So regardless of the eventual outcome, we feel our portfolios are well positioned.
For 2009, we see declining market volatility relative to that in 2008 as investor passions cool and the reality of a long slog out of recession settles in. Based on the attractive valuation the stock market has been pushed down to, however, we think gains in share prices are more likely than not as the market moves back to some sort of equilibrium after last year’s trauma. We predict a range of 700 to 1200 on the S&P 500 for 2009.
As always, our focus continues to be on developing a diversified portfolio of shares in high quality companies at a reasonable price. We may contract and expand your overall equity exposure based on our general market forecast. Please feel free to contact us at anytime to discuss your individual investment position. Patrick Mauro Investment Advisor, Inc. is regulated by the Securities and Exchange Commission (SEC). Federal regulations require that you be offered a disclosure document (ADV-Part II). This form is on file with the SEC and is available to you by merely writing a request to this firm. We appreciate the confidence you have shown in us, and will endeavor to continue to earn that confidence.
Patrick Mauro, Daniel Mauro, Henry Criz