ELF
Capital Management, LLC
(Endowment
Like Fund Management)
This is the ELF Capital Management,
LLC Market Letter for the month ended November 2008. If you do not wish to be included in our
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the letter.
Economic and Market Predictions for 2009
Should auld
acquaintance be forgot
And never
brought to mind?
Should auld
acquaintance be forgot
And days of
auld lang syne?
For auld
lang syne, my dear,
For auld
lang syne
We’ll take
a cup o’ kindness yet
For auld
lang syne.
Its
interesting that this is most commonly sung song each New Year’s Eve and most people
don’t have the foggiest notion what it means?
Of course, many have already had quite a few beverages beforehand and may
not really care what it means. It turns
out that “Auld Lang Syne” came from
For a
better part of this year, many have experienced fear and that fear has manifested
great pain. It has been self-fulfilling. Many businesses are facing difficult times
and job losses are mounting. The stock
market has reached lows not seen in 80 years and most people with any form of
savings have seen their net worth decline dramatically. Even when it seemed that the stock markets were
well over-sold, they continued to fade lower.
However, despite all of this doom and gloom, I’m becoming more
optimistic that there is light at the end of this tunnel. So, with the hopes of spreading some holiday
cheer, this month’s letter will provide a glimpse of why I think 2009 will be
more prosperous. With this being my
first attempt at offering predictions for the New Year, I hope it brings good
tidings and renewed spirit.
So, for
auld lang syne, join me in taking a cup o’ kindness yet, for auld lang
syne. And, with it, my predictions for the
New Year:
Unemployment
Rate
While my
prediction might sound like it was arrived at it by using a consensus of
forecasts, instead I took to crunching some numbers. The process involved researching the US
Department of Labor’s web site, downloading monthly unemployment data and charting
the data against some other economic indicators. To find a reasonable set of comparable data
to work with, I could only go back as far as January 1948. The exercise produced results that were quite
fascinating.
Since
January 1948, the
Job losses
are currently accelerating and the consensus of economists is forecasting that
nominal GDP, in the 4thQ of 2008, will be -3.0% to -3.5%. If it does, and I suspect it will, it will go
on record as the worst single quarter nominal GDP figure reported since the
1930’s. However, because deflation will
likely add 1% or more to this low nominal GDP figure, I’m not as concerned about
the magnitude of the number. And, real
GDP seems a more accurate guide as to measuring the pace with which our economy
is contracting. Nevertheless, I do
expect that businesses will react to the data and unemployment will accelerate faster
in the 1stQ of 2009.
For the
record, GDP (Gross Domestic Product) represents the monetary value of all
finished goods and services produced within a country’s borders; and nominal
GDP includes the impact of inflation, or deflation as the case may be, while
real GDP excludes the impact of inflation or deflation.
Since 1948,
the average unemployment trough to peak cycle was approximately 3% and the most
severe were those that peaked in October 1949 and May 1975. In those cycles, unemployment rose by
approximately 4.4%. The next most severe
were in July 1958 and November 1982, when the unemployment rate rose by 3.8%
and 3.6%, respectively. To give you an
idea of how business has reacted to prior real GDP contractions, consider this:
When
looking over the 1975 and 1982 recessions, it is important to know that these
recessions were orchestrated by the Federal Reserve Bank to thwart periods of
extremely high inflation at the time. In
1974, Fed Chairman Arthur Burns raised the Fed Funds target rate to 13%; and in
1980 through 1981, Fed Chairman Paul Volker raised the Fed Funds target rate to
20%. So, if you think the crisis we are
experiencing now is bad, it was not nearly as bad as the recessions in 1975 and
1982.
So, with
this information in hand and from the current cycle lows of 4.4% in March 2007,
a severe rise of 4.4% would take us to 8.8% unemployment. While 8.9% unemployment does not seem very
prosperous, after each unemployment peak, 90% of the time real GDP turned
positive and began the next expansion.
This confirms for me that unemployment is perhaps the most lagging
indicator. What should also ease fears
is that 70% of the time, the unemployment rate declined as fast as it rose. This reinforces the belief that layoffs are
always overdone. Another positive to
consider is that 80% of the time, unemployment declined and settled at or below
5% afterwards.
The Dow
Jones Industrials, the S&P 500 and the Russell 2000
Now, why do
I think that the market will begin it’s recovery by the time unemployment
reaches its peak? Well, when charting
the data, I saw a relationship that really stood out in the data. Yes, this is all about me expecting history
to repeat itself. It often does.
By the time
unemployment peaked, the Dow Jones Industrial Average had begun its next
expansion and recouped 50% or better from the lows – 9 out of 10 times. I don’t mean after it peaked; I mean when it peaked. And, 100% of the time the Dow recouped 40% or
more. This was rather eye-popping and I’ve
checked the data more than twice.
While this
is no guaranty that the same will happen this time, the probability of it
coming to fruition is more likely than not.
Naysayers may argue that “this time it is different” because we are in
uncharted territory and there is no comparison.
And I would agree that it is uncharted from the perspective of never
seeing the market losses this deep since the 1929 Crash. However, I would argue back that this
recession is fairly similar to the 1974 and 1982 recessions and this time, the government
response is significantly more positive than it was then. As for the market dropping more now than
then, I also believe that the media and hedge funds may have had more to do
with the depth of this market collapse than any time before.
I’m old
enough to remember that the recessions in the 1970’s and 1980’s were similar in
that the banks were going through a capital crisis and the consumer confidence
and spending fell off the cliff then also.
And while the
GDP, Housing and New Bank Formations
While my
predictions for unemployment and a market rebound came to me by performing
quantitative research, my predictions for GDP, housing and bank formations are
more qualitative in nature.
As a
primer, quantitative research involves classifying features, counting them, and
constructing more complex statistical models or charts in an attempt to explain
what is observed; while qualitative analysis draws upon the need to develop
fine distinctions about the subject matter as opposed to organizing data into a
finite number of classifications. When
we talk about economics, both play a role.
And, as quantitative analysis tends to sideline rare occurrences or
emerging trends that can signal an opportunity in the making, qualitative
reasoning may just be more apt for this discussion.
In this 4th
quarter of 2008, fear became so great that consumers cut back on spending –
dramatically. So much so that commodity
prices, like oil for example, have also dropped significantly. This is causing deflation. At the same time, consumer spending is said
to be responsible for 70% of GDP and as a result, we can expect nominal GDP to
be quite negative in this 4th quarter.
What seemed
to create the most impact was the fear of job losses. Consumers cut back on their spending,
businesses felt the impact and job losses began to accelerate. It all became self fulfilling. Call this a negative feedback loop. But, this loop does come to an end and it
often ends quickly after one or two iterations.
Let me explain.
When people
fear job losses, everyone cuts back on their spending. Then business managers, or owners, will
usually lay off enough people to weather the downturn. In fact, they often lay off more people than
needed in order to avoid having to go through a second round of layoffs. If they have to do it a second time, they
will make sure to not have to repeat the process. Lying off employees is not only disruptive to
the entire business; every manager I have ever met never looked forward to
having to go through it. Well, maybe I
can remember one. A large lay off can be
considered to be 15% to 20% of personnel; 5% to 10% is more likely. Once completed, the remaining employees learn
that they have to pick up the slack and begin to feel safe. When they see that they have survived, they
begin comfortable to spend again and are eager to begin shopping for deals
while the rest of the world remains in fear.
So, in a worst case scenario, this means that 80% of consumers now begin
to rekindle their pent-up spending desires and start to shop again. And, this begins a positive feedback loop.
We should
not disregard the impact of pent-up demand.
Households do not significantly downsize their quality of life
overnight, unless they have no choice in the matter. Those few that action to downsize their
lifestyles, generally do so over time.
When these
80% to 90% of consumers begin to open their wallets again, even if they spend
less than they did before, a positive feedback loop will begin. This will boost real GDP. As the stock market stages its recovery, it
will create a positive wealth effect for those people who remained invested or
bought into the lows. This will also
reinforce consumption as people take some of these gains to satisfy their
pent-up demand.
Early on,
the fixed income markets will react to this phenomenon, as a rising GDP will
signal that the bottom has been reached with business and households becoming
less of a credit risk. This will also
motivate home buyers, who have been sitting on the sidelines and waiting to buy
at the bottom.
As the
credit risk abates, banks who have taken large write-downs will see a good
portion of those loans become more valuable and we will see mark ups. This is one of the most telling reasons that
financials often lead in economic recoveries.
Financials didn’t become the most hated because they offer no promise;
they got killed because of the magnifying effect of the leverage they use. But using leverage is how they traditionally
serve their function and make money. It
is only when they over do it that causes the vulnerability to economic
downturns – whether fear induced or not.
New banks
will form to fill the void of what has been called, the “shadow banking
system”. In the past two decades, rather
than make loans and retain them as investments, banks originated loans,
packaged them into securities and sold them to investors. Because banks sold them off, they no longer
retained responsibility for making high risk or “bad” loans. Instead, banks got paid for originating
loans, and after the loans were sold, they got paid to collect the payments and
forward the proceeds to the investors.
The system would have worked well if buyers of these loans were more
discriminating before the shadow banking system grew so large. It didn’t and here we are.
Those
existing banks who participated heavily in the shadow banking system will be
behind the “eight-ball” until they work-out the bad loans now held on their
books. This will be to the advantage of
those banks that remained traditional through this recent period. They will benefit greatly. However, the shadow banking system created
more lending capacity than the current banking system can handle traditionally. Even when we weed out unqualified borrowers,
lending capacity will be limited and that will create opportunity. As it has been said for generations that
“necessity is the mother of invention”, I expect to see a number of new bank
formations to fill this void. And these
new banks will be buying for their own portfolio and be more prudent as a
result.
Well,
that’s it. I’m eager to see how my
predictions pan out and even more eager to ring in the New Year. I want to wish you all Happy Holidays and
thank you for your past business. And,
if you’re not a current client, please look over our web site www.hwkfs.com and please consider booking your
business or holiday travel with our online travel agency www.marketlettertravel.com.
Our
Investment Strategy Going Forward
While we’ve
been sitting on our hands for the last month, we haven’t abandoned our desire
to buy into dips. We think that December
will offer us some opportunities and expect to do some light buying at each opportunity. With approximately 40% cash across our
accounts, we will likely put up to 10% more to work in US equities and may put up
to 10% into investment grade corporate bonds before the end of the year. Kind regards