Things Seem to be Getting Less Bad…

Stocks are up today after comments from Federal Reserve chairman Bernanke that the economy is on the verge of recovery.  We believe that the recession has either ended, or is in the process of ending, although the official date will likely not be known until sometime in 2010.  By the time the end date is officially proclaimed, the recession will be long over, although there are some that believe there is still a risk of a “double-dip” or that a second recession may occur.

 There are a number of factors that contribute to our optimism:

 –Existing home sales reported today were better than expected at +7.2%;

 –The four-week moving average of unemployment claims has been declining from the peak in early April;

 –Investor cash levels, although down from their record high in March (at the recent market bottom), are still equivalent to about 40% of the value of the entire U.S. stock market.  Even a small percentage of this cash entering the market would be a significant positive for stock prices;

 –The level of housing starts is below that needed to absorb the formation of new households, and the level of auto manufacturing is currently below scrappage levels, indicating future improvement in these industries;

However, there is still negative news.  The delinquency rate on home mortgages was reported at 9.2% for the second quarter, 4.3% of which were already in the process of foreclosure. About half of these foreclosures were “prime” borrowers. While future inflation is a risk due to the extraordinary recent fiscal and monetary stimulus measures, we do not see an immediate threat given the current unemployment rate of over 9%.

While the economy is not without its challenges, fear indicators such as the CBOE VIX index (of implied volatility in options contracts) and TED spread (difference between U.S. Treasury bills and interbank interest rates) have returned to more normal levels similar to those before the failure of Lehman Brothers.  We have seen a significant improvement in the overall mood, both in the media and among people we talk to. 

With the stock market up over 50% from the recent bottom on March 9, many are wondering whether the current rally can continue and for how long.  It is important to remember that the S&P 500 index is still 35% below the peak reached in October 2007, which coincidentally is about the peak reached in March 2000.  The current decade is on pace to be one of only three 10-year periods in modern history with negative stock market returns.  Because this decade has been so terrible for investors, we believe that better times lie ahead and that stock market returns will revert upward toward their historical average of 9-10% annually.  Nobody knows for sure when this might happen.  While it is possible that we may retest the recent lows, the improvement in the mood and slowly improving economic news makes us believe that there is significantly more upside than downside from here.

Bill Hansen, CFA

August 21, 2009

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