On Friday, the first day of 2009, the equity market rallied broadly, with the Dow up 2.9% or 258 points, while Treasury yields rose sharply (the 10-year yield surged to 2.42% from 2.25% the day before, and 2.07% just a few days prior). This seeming cyclical turn-around in equity prices and Treasury yields is mistakenly seen by many observers as potentially setting the stage for far more of the same over coming weeks and possibly even months. But as I warned in the report before last, just like the inevitable additional bouts of misguided optimism to come, this turn-of-the year market euphoria will prove to be only temporary. For those nimble enough, it may be possible to shift investment horses back and forth in midstream without getting trampled, But that may take extraordinary investment attention, acumen and dexterity.
A reversal of the primary market trends of 2008 is virtually certain to prove unsustainable in the midst of the still rapidly deepening and extremely severe and prolonged recession that is still to come. There is far more pronounced economic and financial pain ahead that will spur a reinvigorated panic flight to the safety of Treasuries and a renewed selloff in equities. Look for S&P 500 profits to weaken to between $50 to at most $60 a share, well under market expectations. That will mandate significant cuts in dividends. A realistic and quite likely optimistic 10 times price-earnings ratio implies a price index low in at least the area of 600, well under the Friday 931.80 level. In order to put this forecast in proper perspective, it is worth noting that under similar circumstances in comparable cycles the S&P 500 price-earnings ratio hit cyclical lows well within the single digit area.
A plunge in the latest Institute for Supply Management gauge of manufacturing activity ahead portends perhaps the worst slide in this still key sector in the last sixty years, which is as far back as the data go and a much deeper recession. The overall ISM index fell to a level not seen since June 1980, when the economy was plummeting into the worst and most prolonged double-barreled recession of the post World War Two era. But, new manufacturing orders, an advance indicater of future manufacturing activity, seems to be forcasting an even worse recession than 1980-82, perhaps in some respects reminicent of that of the late 1930's. The December employment report, to be released next Friday, is likely to be the worst thus far this recession, reinforcing expectations of a double-digit high in the unemployment rate.
The flare-up of hostilities in the middle-east raises far-fetched concerns over a new oil embargo and a consequent new spike in oil prices and other commodity prices. The potential inflationary consequences of that exagerated prospect, especially in light of the Fed's massive expansion of credit is seen by some as another potentially inflationary factor seemingly justifying a rise in Treasury yields. My response to these concerns is that they are utter "nonsense".
While it is true that a rise in inflation expectations and Treasury yields go hand in hand, a spike in inflation any time soon is as likely as a snowstorm in midsummer. Iran is the primary backer of Hamas. Thus, a defeat of Hamas in Gaza by Israel would weaken Iran's clout in the region. That would be privately welcomed by the Arab oil producers, who see Iran as a major threat to their stability and possibly the survival of their regimes. Moreover, the Arab oil producers recognize that a defeat of Hamas is a necessary precondition and perhaps the only viable avenue to the establishment of a separate Palestinian state. Under these circumstances there is little or no reasonable basis for an Arab oil producer embargo. Inflation is dead for this cycle even with Fed efforts to resserect it.
The Fed is attempting to engineer a low Federal funds rate and Treasury yield environment in an attempt to move institutions to lend and invest in riskier investments. The Fed has indicated an intention to buy Treasuries if necessary to achieve their objectives. The Fed is also attempting to use its low interest rate policy to weaken the dollar, which will both spur exports and encourage other central banks to defensively adopt an equally agressive easing policy. Since those initial-step objectives have not yet been achieved, let alone as yet borne fruit, it is clearly premature to expect a sustained market sell-off in Treasuries. If necessary, the Fed will prevent it. But it should not even require Fed intervention considering that as the global recession worsens, deflation will take a firmer grip in reality and expectations. And with that development more clearly recognized, the drive to lower Treasury yields wil be reinforced.
The unsustainability of a rally in equities and sell-off in Treasuries at this time seems all the more likely the given that these developments are typical in recessions, especially prolonged ones. This time, hopes of an early economic recovery were born of merely the turn of the calendar into a new year, a new President and major stimulative initiatives already in place, with more promised. There were other premature speculations, intended to ride a snap-back reversal of the downtrend in equity prices and Treasury yields, both earlier this recession and in earlier recessions. Like each of those, this bout of misplaced enthusiasm will also run its course, and be completely reversed. That, for example was the classic experience in 1933. In anticipation of the inauguration of President elect Franklin Roosevelt, the Treasury bond market sold off sharply at the beginning of the year, only to subsequently completely reverse itself and reach new yield lows.
Though it would not matter if I were alone in my view for this year, I would still hold to them because past experience amply supports them. But, there are others who share my views. Nevertheless, these views are contrary to consensus expectations (including some forecasters I normally hold in high regard), that the Treasury rally is just another bubble ready to immediately burst, if it is not already doing so, that equity prices are still dramatically oversold (though they are up from their lows), and inflation is about to reasert itself in the form of sharply rising commodity prices.
There are some forecasters who go so far as to recommend shorting Treasuries. The latest issue of Barron's includes a major, cover-featured, article on Treasuries by Andrew Bary, headlined "Get out now". It cites Mohamed El-Erian, chief investment officer of Pimco, the largest bond fund manager, who recommends immediately selling Treasuries. Of course he and his firm have been arguing against buying Treasuries almost all the way down in yield. In sharp contrast, Lacy Hunt, of the highly successful Van Hoisington Treasury bond fund which was up some 40% last year, holds to his expectations (and mine) of new lows in Treasury bond yields ahead and another outstanding gain for his fund this year. Similarly, David Rosenberg, the noted Merrill Lynch economist, expects the 10-year yield to hit a cyclical low of 1.5% this year, down from 2.42% on Friday, a view I share. In Japan, which preceded us on the road to deflation and a protracted on-again off-again recession, the yields on JGB's, their Treasuries, fell to 0.75% lows. Thus, a forecast of a 1.5% US Treasury 10-year yield should be seen as merely a cautious forecast.
As I have indicated previously, it is also appropriate to invest in high-grade corporates (with perhaps the best risk reward trade off in bonds of banks and others partnered with the US Treasury) and municipals that offer exceptionally high yields because of an exagerated default risk. When the economy eventually recovers, that default risk will evaporate, while inflation concerns will remain tame for an extended period. There are already signs of improvement in those debt sectors. But, there is far more price improvement to come. Perhaps one third of hedge funds will go out of business this year, with pronounced financial strains also showing in credit card issuers, insurance companies, and other mortgage paper holders. That outlook forshadows renewed panic sales of assets to stave off bankruptcy and meet claims and withdrawls. That suggests even better investment opportunities may lie ahead.
Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731
Email address:philipbraverman@gmail.com
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