Yes, Bruce the Bull will Return

As reported by the mainstream media, the stock market has witnessed its worst performance, percentage wise, since 1937.  Yes, this has been a disappointing year with the S&P 500 index shedding almost 37 percent of its value.  But we are not, as some of the talking heads seen on television are saying, on the edge of a precipice about to see the market suffer another 30 percent loss in 2009.Over the past 50 years, this writer has been an eyewitness to nine major market corrections of over 20%.  In each case, investors’ pessimism has been so ingrained that they couldn’t believe that a new bull market could rise from the ashes of the Bear, even when they are told that bear markets come about to correct the excesses created during bull markets.  Yet, over that 50 year period, even taking those nine corrective periods into consideration, the stock market has advanced, through year-end 2008, by 1,362%.  Not a bad return for the patient long-term investor.One factor that is often overlooked by shareholders are the dividends generated by their portfolios.  Much more emphasis is placed on capital appreciation or in the case of this year’s performance, capital losses, than is ever placed on the portfolio’s yield. Yet history has proven that close to 50% of the annual total rate of return (appreciation/losses plus dividends) comes from the dividend side of the equation.  Fact,  the total rate of return (TR) for the S&P 500 for the last ten years has been minus 1.381% (-1.381).  Case-in-point; the TR for the S&P 500 for 2008 was minus 36.998% (-36.998).  Had the S&P 500 not paid a small dividend, the loss would have been minus 38.49% (-38.49).Looking at an individual’s portfolio of dividend paying stocks paints a far different picture than just looking at the capital losses for 2008 or, for that matter, any period of years.  As bad as business was for most companies during 2008, few companies, outside of the financial arena cut or eliminated their dividend.  So for investors depending on those dividends for their livelihood, little was changed.  Their income stayed the same even though their portfolio value had decreased.  For long term investors, reinvesting their dividends builds cash for future investments.  Yes, their portfolio also decreased in value but they have cash to invest when the market regains its forward momentum.So where are we in this Bull/Bear cycle?  No one can say with any assurance; we can only guess.  In the past, especially last year, the majority of analysts were dead wrong in their predictions on the economy, the market and everything else.

To try and grasp a handle of the above question, its best to review what has gone on over the past few years leading up to what caused our economy to shipwreck during 2008.  Over the last several years we have seen bubbles in stocks, bonds, housing and commodities.  Investors had been the unwilling witnesses to the deleveraging of the financial sector. The investment banking industry has been obliterated.  AIG is now under the tutelage of the Federal Government as is Fannie Mae, the largest mortgage buyer in the United States.  IndyMac, Bear Stearns and Lehman Brothers are a few of the financial service companies that are now just memories.  All were victims of investments in arcane financial transactions such as sub-prime montages and other forms of derivatives.  Over the past three months, additional institutional investors plus many of the Hedge Funds, have been forced to liquidate  everything they could, irregardless of  fundamentals.  By September 15th 2008, the announcement date of the filing of Lehman’s bankruptcy, the financial world had become chaotic and normalcy was a thing of the past.

Investment performance in the 4th quarter was one of the worst on record.  Looking back over this past year, we can see that two separate negative events were recognized by the investing public.  First, was the depth of the financial crisis and, second was the fear of a recession.  Armageddon fears prevail today.  Nearly all asset classes, equities, corporate bonds, municipal bonds, real estate, oil and industrial commodities were off anywhere from 40 to 50%.  Only Gold (+5.2%) and U.S. Treasury bonds were up at year-end 2008.  But all of that is in the past.  The question now is –  has the selling stopped?  Have institutional investors and the hedge funds deleveraged enough?  Maybe – maybe not.

In light of all of the above, our government has come to the rescue with bailout and stimulus packages to restart the economy.  To justify their actions, the Fed’s Federal Open Market Committee minutes of December 15-16 2008, stated the following, “Although told real GDP was expected to fall much more sharply in the first half of 2009 than previously anticipated and projected to decline for 2009 as a whole.”  What the Fed is saying is that our economy is in one hell of a mess and not about to get better for quite some time.  This seems to give them the green light to spend at will.

In just a few weeks, Mr. Obama will become President Obama and, with a Democratic Congress, may have an easy path implementing his American Recovery and Reinvestment Plan.  These enormous spending plans are relief on a Rooseveltian scale.  The only problem is that all of the bailouts and the stimulus packages, plus Obama’s Recovery Plan are being financed by the sale of U. S. Treasury securities and, in some cases by creating money out of thin air or as the economists put it, monetizing the debt.  The reason –  the U. S. is just plain out of money.

It has been estimated that before our financial crises (or as some would put it, credit crises) is over, Federal Government intervention will have raised our outstanding debt by an additional two trillion dollars.  And the question remains, is this enough money to halt the recession and to reliquify our financial system?  The answer to that question may be months away, but for now,  we know that through the Fed’s debt monetization, the world has become afloat in dollars.

Does any of this tell us where we are in the Bull/Bear cycle?  It may. Here are several facts which we are sure.  The market, as measured by the S&P 500, corrected from its October 2007 high of 1,576 to a low on November 20, 2008 of 752.45.  This amounted to a correction of a little over 52%.  As of the close on January 7, 2009, the market had gained 22% from that low.  That has been a very strong move under any stretch of the imagination for such a short period of time.  At this point in time, valuations are beginning to be moderately attractive.  After over a 50% correction, certain sectors of the market are beginning to show attractive P/E ratios and tempting yields.  We are also seeing a little less fear of a deflating economy and the realization that the Fed’s pump priming is going to cause momentary inflation which may lead to price inflation in the months ahead.

On the other hand, we realize that a safe haven for the majority of the assets we manage must be maintained until the deleveraging process has concluded and some semblance of order has returned to the financial sector.  This will come about when we see the banks begin to loosen the bands securing  their vaults and start lending.

Housing is an important ingredient in the foundation of our economy.  Deflating home values were a key cause for our economic downturn.  One clue to the health of the housing industry is the Homebuilders Exchange Traded Fund (XHB).  This ETF had traded in a very narrow range over the last month, which may be evidence that home prices and the inventory of houses is nearing a bottom.

We will be watching for the transition from deflationary fears to the well-founded dread of inflation.  Here the bond market will signal this change as bond prices slide and yields advance.

Above all we will stay flexible.  Present economic weakness is acknowledged and the results of our Government’s intervention programs are yet to be proven successful.

We wait with our BUY pads at the ready.  A market bottom may have been reached last November but the better part of valor is to be patient.  The time to reinvest our cash holdings may be near; no need to force our reserves into a bear market.

Areas of Interest

As more and more people around the world migrate from poverty, i.e. India, China, Russia and South America, move to the lower middle class, an  increased demand for goods such as nutrient-rich foods and consumer goods will cause a long-term demand for commodities.  The current credit crisis and the economic downturn has caused many commodity producers to tighten their belts and canceled capital-intensive projects.  As global economies improve, commodities, energy, water and green technology companies will be in the forefront and in great demand.  In this country, baby boomers will call for increased demand for health care and pharmaceutical.  These companies will be high on our buy list.

In conclusion, we are ready for both short bull and bear moves during 2009. The time to invest our cash reserves will be when the odds shift back in our favor. That may be soon, so Bruce, hold your horses, the bull is just around the corner.

Gordon B. Lamb
8 January 2009
DJIA 8742.46