2008 a year to forget

7/31/2019 2008 a Year to Forget

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January 2, 2009

2008, A Year to Remember ForgetJonathan Golub, CFA

Chief Investment Strategist

Justin GordonResearch Associate

I think I speak for all of us when I say Goodbye and Good Riddance to 2008. While the past year

may not have been unprecedented (the 1930s come to mind), its been far worse than any currentinvestor has ever seen. Anyone predicting the events of 2008 at this time last year would have been

thought insane.

Summary of Market Activity

Stocks S&P 500 declined by 38.5% in 2008 (37.0% including dividends);Down 51.9% from peak to trough (10/09/07-11/20/08)

Volatility VIX peaked at 81 (11/20/08), 5 times the average over the prior 5 years

Oil Peaked at $147 (07/14/08) then plummeted to $35 (12/24/08)Gasoline began at $3.05, ended at $1.65, and peaked at $4.18 (07/11/08)

Rates 10-year US Treasury yields fell to 2.2% (12/31/08) from 4.0% (06/30/08)3-month T-bill yields fell into negative territory in December

Credit High yield spreads peaked at 20% over Treasuries (12/16/08) from 5.6% (12/31/07)

Source: Standard & Poors Corporation; CBOE; New York Mercantile Exchange, Reuters; US Dept of Energy; Federal Reserve; Bloomberg; Merrill Lynch

and then theres Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers, AIG, Merrill Lynch,

Washington Mutual, Iceland, the devastating Madoff scandal, a bailout of the auto industry, and more.

On the bright side, thanks to an aggressive statement by the Fed on December 16, a capital injectioninto Citigroup, a lifeline to Detroit, and welcomed cabinet appointments by Barack Obama, the market

rallied 20% from its November lows, finishing the year down only 38.5%.

2008 Market Returns

While the market has been in decline for the past twelve months, breaking the years movements into

smaller time periods is always useful. 2008s market gyrations are best explained by their flirtationwith or avoidance of apocalyptic events. As the chart below illustrates, it was the fallout from theLehman bankruptcy that did the majority of the damage to markets, driving volatility and risk premiums

through the roof.


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S&P 500

2008 12/31/07 - 03/17/08 03/17/08 - 09/15/08 09/15/08 - 11/20/08 11/20/08 - 12/31/08 10/09/07 - 11/20/08Fall of Bear Stearns Lehman Bankruptcy Peak - Trough

(38.5%) (13.1%) (6.6%) (36.9%)

20.0%

(51.9%)

Source: Standard & Poors Corporation

While we generally applaud the efforts of the Fed and Treasury, it is clear that allowing Lehman to failwas a colossal mistake. Yes, the stock market bounced back a bit from its nine-week, 37% fall, but

credit markets have only begun to thaw. So, where do we go from here?

Outlook For 2009

Were often asked whether the worst is behind us. Have we yet seen capitulation? Unfortunately, we

think the bigger question is whether or not the economy can avoid a 1930s style economic malaise. If

it can, then things are oversold. If not, were in the early innings.

Cutting to the chase, we would be underweight equities at this time for three reasons.

First, we believe that the current level of stress in credit markets is incompatible with a functioningeconomy and that future flashpoints will arise. The environment reminds us of the following anecdote.A patient walks into the emergency room with a 107o temperature. He asks the doctor how long the

fever will last. The doctor reassures him that by this time tomorrow the fever will be down. Thequestion is whether he will be cured or dead. 107o fevers are incompatible with life.

Second, we believe that the economy is more likely to recover than not (our unscientific odds are 3:1);

however, we are uncomfortable with the risk/return trade-off given the potential downside. In addition,

we think its important to look at an investment decision in context. If things head south, you mightlose your job or watch your business fail, the value of your home will fall, your annuity contract or

pension plan might not payoff as expected, and your local municipality might be insolvent. Not toover-emphasize the negative but if things turnout poorly, your stock portfolio might not be your biggest

worry.

Third, upside opportunities play out over time. Market trends tend to be long lived consider the run

between 1982-2000. If the economy recover there will be plenty of time to invest. Were verycomfortable missing the initial bounce should markets rebound.


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Market Barometer

In October, we established a subjective barometer to indicate the level of risk that we saw to oureconomic system. If the worst case outcome was a dramatic, self-reinforcing downward spiral, then

the scale would be a measure of its likelihood. Low might represent a 1/10,000 chance. Severe

would indicate that we were on the precipice.

We believe that we were on the edge twice in the past year first, when

Lehman was left to fail; and second, when Treasury made the decision toredirect TARP funds away from troubled assets, causing a near-failure of

Citigroup.

We put the current rating at High but believe that we will be back to

Severe sometime in 2009.

Economic Indicators All Point South

On December 1, the poobahs at NBER (National Bureau of Economic Research) responsible fordeclaring a recession finally pulled the trigger. Whats interesting is that as bad as it feels, theeconomy actually edged out a positive gain over the twelve months ending September (the most

recent data available).

GDP

50 55 60 65 70 75 80 85 90 95 00 05

(4)%

(2)%

0%

2%

4%

6%

8%

10%

12%

Source:Bureau of Economic AnalysisNBER takes a variety of indicators into account when declaring a recession including growth and jobs.On the labor front, the US economy lost almost 2 million jobs in the first eleven months of 2008, and itappears that things are only beginning to get ugly. At 6.7% the unemployment rate is still rather

benign, only slightly worse than the long-run average of 5.6%. Dont be fooled, the only reason therate didnt jump more in November was because disillusioned workers dropped out of the labor pool.

GDP is -0.5% whenquoted on quarterlychange annualized

0.7%YoY

GUARDED

ELEVATED

SEVERE

LOW

HIGH

GUARDED

ELEVATED

SEVERE

LOW

HIGH


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Non-Farm Payrolls Monthly

90 92 94 96 98 00 02 04 06 08

(400)

(200)

0

200

400

600

Source:US Department of LaborWhile the first official reading of fourth quarter GDP arrives in late January, monthly data fromindustrial activity to retail sales clearly indicates a precipitous drop in economic vigor.

ISM (Manufacturing)

90 92 94 96 98 00 02 04 06 0830

35

40

45

50

55

60

Source: Institute for Supply Management (ISM)

ISMS most recent reading of 32.4 (01/02/09) indicates a rather severe fall in manufacturing. (Scoresbelow 50 indicate a contraction.) While we live in a service-based economy, the ISM Manufacturing

Index provides a excellent read on turning points in the economy. The rapid deterioration in ISM isconsistent with anecdotal evidence that everything froze up in October and November.

In addition, the great American consumer appears to have been humbled recently. The bottom-line isthis when you lose your job (or are in danger of losing it), watch your home value decline by 20%

and your 401(k) by 40%, your inclination to go to the mall as a leisure activity is likely to shrink. Asexpected, this has been the weakest Christmas season in years. Retailers have been discounting

heavily to lure customers. Can you say deflation?

Expansionary (>50)

Contractionary (


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Retail Sales ex-Autos

94 96 98 00 02 04 06 08

(2)%

0%

2%

4%

6%

8%

10%

Source: US Census Bureau

Its Not The Indicators That Scare Us

Given all of this weakness, it might surprise you that the economic data is not what keeps us up at

night. We expect economic releases and profit announcements to continue to be weak for quite sometime. This negative news flow only tells what we already know that things are pretty lousy. For thisreason we have identified those indicators that should lead us out of (or deeper into) this mess arenormalization of credit, fall in volatility, and stability in real estate values.

Indicators

Interest Rates Employment

Treasuries Corporate Profits

Credit Spreads Economic Activity

Inter-bank Lending GDP

Volatility Manufacturing

Real Estate Values Retail Sales

Leading Indicators Coincident Indicators

When we came up with this list in October, it was our belief that credit would slowly thaw allowingeconomic activity to gradually improve. On a positive note, the inter-bank market has become more

fluid and stock market volatility has fallen meaningfully from peak levels. However, credit availability isstill quite strained.

(2.9%)Most recent

3 mo avg


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Dislocation in Credit Markets Continues

There are two huge problems in the credit markets first, investors are so uncomfortable with thecurrent environment that they are willing to accept a near-zero yield from the US government for the

promise of a return of capital; and second, credit spreads for anyone other than the US government

are outrageously high.

T-Bill Yields

90 92 94 96 98 00 02 04 06 080%

2%

4%

6%

8%

Source:ReutersJust as consumers have flocked to Wal-Mart to purchase safes for their homes, the security of US 3-

month T-bills has driven yields to near-zero. At the same time, credit has been harder to come by for

even the most credit-worthy borrowers. In many cases, the availability of credit has been non-existent.For example, on December 3, the Wall Street Journal reported that the Port Authority of New

York/New Jersey auctioned off $300 million in bonds without a single bid.

Corporate Spreads (Baa)

90 92 94 96 98 00 02 04 06 08

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Source: Moodys; Reuters; Federal Reserve

5.8%

8 bps


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More risky segments of the credit market have virtually seized. To put this into perspective, high yield

bonds traded at a yield of 275 basis points over Treasuries in June 2006. The spread now stands at17.3% over Treasuries, down from a peak of 20.1% on December 16.

High Yield Spreads

96 98 00 02 04 06 080%

5%

10%

15%

20%

Source:Merrill Lynch; ReutersInter-bank lending is an essential part of the global banking system. Over the past twenty years, theTed Spread (3-month USD Libor minus 3-month T-bills) has averaged 55 bps. This rate jumped to

464 bps on October 10. A coordinated global effort has pushed this back to 135 bps, a substantialdecline but still meaningfully above long-term levels.

TED Spread

90 92 94 96 98 00 02 04 06 08

0.0%

1.0%

2.0%

3.0%

4.0%

Source:ReutersVolatility High But Declining

It would be logical to think that the best days in the stock market would occur in the best years. Oddly,they occur in the worst because these periods are punctuated by wild swings, the definition of high

volatility.

(ML HY Index Yield 10 Year Treasury Yield)

17%

Ted Spread measures thewillingness of banks to

lend to each other.

1.3%


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Worst/Best Days Since 1929

Year Period Return Year Period Return

6 Worst Days 6 Best Days

10/19/87 1987 Crash (20.4) 10/30/29 Great Depression 12.510/29/29 Great Depression (16.1) 09/21/32 Great Depression 11.8

05/14/40 World War II (10.3) 10/13/08 Current Crisis 11.6

10/15/08 Current Crisis (9.0) 10/28/08 Current Crisis 10.8

07/20/33 Great Depression (8.9) 04/20/33 Great Depression 9.5

09/29/08 Current Crisis (8.8) 10/21/87 1987 Crash 9.1

Source: Standard & Poors Corporation

2008s market gyrations have been accompanied by a spike in volatility. The VIX rose to 35 following

the fall of Bear Stearns and a staggering 81 following the collapse of Lehman. As time passes aftereach market incident volatility subsides. That has been the case over the past several weeks with the

VIX retreating to only 40.

VIX

99 00 01 02 03 04 05 06 07 080

10

20

30

40

50

60

70

80

Source: Standard & Poors Corporation; CBOE

Many of the markets day-to-day movements can best be explained by swings in volatility. Throughout

2008, the VIX and the S&P 500 have moved as almost perfect opposites the market falling asvolatility rises. Throughout 2008 a four percent change in the VIX has generally been accompanied bya one percent change in stock prices. This simple math helps explains the markets run since

November 20.

Average = 21.412/31/07 = 22.511/20/08 = 80.912/31/08 = 40.0

Lehman CollapseCitigroup Capital Injection

Bear Stearns Collapse


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Changes In The VIX And S&P 500

(15.0%)

(10.0%)

(5.0%)

0.0%

5.0%

10.0%

15.0%

(20.0%)(10.0%)0.0%10.0%20.0%30.0%

Source: Standard & Poors Corporation; CBOE; Bureau of Economic Analysis

Real Estate Holds The Key

Real estate played a huge role in getting us into the current crisis and will surely play a pivotal role in

leading us out. Residential and commercial property remain the predominant collateral backing ourbanking system. As such, the financial system will remain vulnerable until home values stabilize.

Concerned about additional declines, it is not surprising that banks have chosen to hoard governmentcapital infusions rather than lend.

Real Estate Values

90 92 94 96 98 00 02 04 06 08

$100

$125

$150

$175

$200

$225

Source: National Association of Realtors

To date, real estate values have declined by 21% nationwide with greater losses in hot markets likeCalifornia, Florida, and other sunshine states. At current levels, it will take nearly a year to workthrough the inventory of unsold new and existing homes. A combination of more readily available

credit and further price declines is necessary before inventories can be worked off, providing a floor tovalues.

Daily Pct Changein S&P 500

Daily Pct Changein VIX

($000)

$181


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We think the more compelling argument is that the flood of fiscal and monetary stimulus will eventually

have its desired effect. 2009 will surely start with a large gift from Congress and the Obamaadministration. Chairman Bernankes Open Market Committee recently promised near-zero interestrates for an extended period and a willingness to buy virtually any asset onto its balance sheet. We

believe that the ECB and other central banks will follow suit. Their arguments for not lowering rates, to

leave powder dry for the future, is like the argument for saving life jackets on the Titanic for the nexticeberg.

Fed Funds Target and Effective Rates

Jan-08 Apr-08 Jul-08 Oct-08

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

Source: Federal Reserve; Bloomberg

What the Fed failed to highlight in the official statement was that it has already been implementing a

near-zero rate policy, and buying up assets.

Hoping To Be Wrong

So is now the time to jump in the deep end in pursuit of undervalued assets? As tempting as it seems,were reluctant to say Yes. Do assets look cheap? Sure. Is the level of stimulus compelling? Youbetcha. However, with credit markets holding the jugular vein of the economy in its hand, we believethe next move on our risk barometer will be to Severe rather than simply Elevated.

We still believe that renormalization is the more likely outcome and that well avoid a 1930s stylefinancial meltdown, but the odds of an adverse outcome are too high and its implications are toopainful for comfort.

Weve never hoped to be wrong more than now.

Good luck to all of us in 2009.

Effective Rate

Target Rate


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DISCLAIMERThe views expressed are those of Jonathan Golub d/b/a Golub Market Insights. Opinions and estimates offeredconstitute our judgment. They are subject to change at any time without notice, as are statements of financial

market trends, which are based on current market conditions. We believe the information provided here isreliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitationfor the purchase or sale of any financial instrument. The views and strategies described may not be suitable forall investors. Each investor must make his own determination of the appropriateness of any investment. Thismaterial has been prepared for informational purposes only and on the condition that it will not form the solebasis for any investment decision. Any forecasts contained herein are for illustrative purposes only and are notto be relied upon as advice or interpreted as a recommendation.

CIR 230 DisclaimerJonathan Golub does not provide tax, legal or accounting advice. You should consult your own tax, legal andaccounting advisors before engaging in any transaction.

Jonathan Golub d/b/a Golub Market Insights, January 2009.

2008 a year to forget

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