Analysis and Strategy Overview

It seems to me the first question is "what do we think is coming". Naturallycrystal balls are most useful, but lacking that we all have to guess. My guess is that we will have a long and deep recession characterized by a dramatic drop in consumer spending across a wide variety of what I might call non-essential items (automobiles, durable goods, electronics, apparel, restaurants, and so forth). Since consumer spending is about 70% of the US economy, the effect will be dramatic. Profitability of many (perhaps most) businesses will be down substantially. Many companies will declare bankruptcy or otherwise seek protection from creditors. I think this will most likely include at least one of the major car companies, govt bailout notwithstanding.

Unemployment will rise but nothing like the levels of the 30s. There also will not be any major bank failures. Those important distinctions aside, I think this will be the most pervasive and significant recession since the 1930s. Those consumers that still have jobs will save more money and spend less (as noted above) and will start to improve their personal balances sheets. Perhaps they will rediscover the benefits of having money in the bank, which might lead to long term changes in consumer behavior (not necessarily good for a consumption based economy). Those people who can afford to will probably try to
pump more money into their retirement accounts to help replace the dramatic losses in DC plans over the past year. Retirees will be hit especially hard.

Banks will ultimately start lending again but with a much more intelligent basis, i.e. with real price differentiation between the more creditworthy borrowers and others. I think that eventually the marginally qualified will be able to get loans but the pricing will be so high that it may not be attractive or feasible to borrow. The flood of liquidity may mean that borrowing costs come down for the most creditworthy. Spreads for high quality bonds to Treasuries will diminish. Those for high yield will not. One analysis I read
today suggests the likelihood of 11-12% defaults in the high yield market (with below average recoveries) which would certainly eat up much of the current yield premium, not to mention its effect on high yield pricing.

For investing, I am concerned about the development of a "value trap" where things that are cheap because of perceived problems get cheaper. Fama et al (e.g, DFA) consistently make the argument that value stocks are riskier than growth stocks. Those companies that can continue to turn out solid earnings, albeit diminished, will be OK. Those that don't make much money but also don't need to raise capital will probably be OK.

Grant makes the point, which I have felt for a long time, that at current levels the US equity market is by no means cheap. Data I have found suggests that based on trailing 12 month GAAP earnings, the S&P is now trading about about 18 times earnings and a yield of about 3.2%. S&P's own numbers suggest a P/E in the 19-20x range and a yield just below 3%.

When I started working with investment companies in the mid 1980s, the market was considered cheap at an 8 P/E and expensive at a 16 P/E. It has only been during the prolonged equity bubble of 1995-2007 that these numbers in the high teens and 20s have been considered "normal".

Naturally this depends on what you expect for earnings going forward. Personally I do not expect any wonderful news out of any quarter (except, perhaps, for fewer enormous writeoffs from banks) so I don't expect much major improvement in 2009. In any case, the data supports the conclusion that with respect to current earnings, the market is not particularly cheap and could well be considered expensive to very expensive by historical standards.

Here are a couple of data sources.

http://www.decisionpoint.com/TAC/SWENLIN.html
http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

What actually happens to the market is partly a function of psychology. The Journal today had an article about the number of people pulling out of stock funds. Naturally as in 1998-1999 this is a self perpetuating cycle where stocks are considered unattractive, lots of sellers drive prices down, stocks look more unattractive causing more people to sell, and so forth. In the absence of any real good news on earnings or stock market prices I don't see a lot of people jumping in to the market...particularly those people who have been burned, or
are concerned about their jobs and conserving personal liquidity. So my guess is that the market either bumps along around current levels or if things don't go well, drops further...the data referred to above suggests it could drop 50% from current levels before it would be considered "cheap" (that's if earnings don't decline from current levels).

What happens with the bailout and the government is of course another unanswerable question. I don't think anyone disagrees that something dramatic needs to be done to prevent AIG, Citibank, GM et al from closing their doors with dramatic consequences. Of course we are uncharted territory here. It is not a particular criticism of the government to say that the bank bailout has had very little positive effect other than to keep the banks from actually failing (which could have been done with other, less expensive methods). Perhaps it will start working better in the future, but nobody knows. What the
actual cost of this, plus the industrial bailout which is sure to come, plus the stimulus package, is something nobody knows. What we do know is that there will be ton of liquidity in the system, the Fed is taking on enormous obligations in the form of low quality debt, and the deficit will go through the roof. Right now it costs basically nothing for the government to borrow (although of course the principal will need to be repaid) but that will not last forever. Grant is correct that once the recovery starts, whenever that is, a huge amount of liquidity will push up the price of scarce commodities. So, monetary policy will quickly have to shift 180 degrees to soak up the excess
liquidity and keep inflation from getting out of control...this tighter monetary policy will of course dampen down the recovery. It goes without saying that this orgy of government spending will also eventually have to be paid for, not to mention the excesses of the past 8 years, by a combination of much lower discretionary spending, a total revamp of entitlement programs (let's hope) and much higher tax rates than currently.

My conclusions: Things will not get better in a big hurry.
The stock market is expensive by historical standards and unless earnings improve considerably in 2009, which I don't expect, is unlikely to rebound and could go down significantly more. Spreads on corporate high grade bonds are very attractive if defaults don't get out of hand -- careful credit analysis will be key. High yield spreads may not compensate for much higher default rates and are risky. Treasuries are a losing proposition long term. Inflation is not an issue until the recovery starts, then watch out! It will take many, many years to undo the effects of the excesses of 1995-2007 and pay for the costs of this bailout. I still am a long-term dollar bear as non-US companies,
not being saddled with all of our problems, will probably recover more
quickly...indeed the dollar has given up much of its short-term gains.

Portfolio positioning? It suggest to me overweight positions in corporate bonds (mostly shorter duration) and non-US stocks, judiciously chosen. Neutral to negative on US stocks. Possibly investigate non-dollar bonds.