January 2, 2009

2008, A Year to Remember Forget

Jonathan Golub, CFA Chief Investment Strategist Justin Gordon Research 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 current investor has ever seen. Anyone predicting the events of 2008 at this time last year would have been thought insane. Summary of Market Activity Stocks Volatility Oil Rates Credit 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) VIX peaked at 81 (11/20/08), 5 times the average over the prior 5 years 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) 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 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 injection into 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 flirtation with or avoidance of apocalyptic events. As the chart below illustrates, it was the fallout from the Lehman bankruptcy that did the majority of the damage to markets, driving volatility and risk premiums through the roof.

Jonathan@GolubMarketInsights.com (917) 796-2987

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S&P 500
(38.5%) 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 (13.1%) 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 (6.6%) 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 (36.9%) 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 (51.9%)

20.0%

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

2008

12/31/07 - 03/17/08
Fall of Bear Stearns

03/17/08 - 09/15/08

09/15/08 - 11/20/08
Lehman Bankruptcy

11/20/08 - 12/31/08

10/09/07 - 11/20/08
Peak - Trough

Source: Standard & Poors Corporation

While we generally applaud the efforts of the Fed and Treasury, it is clear that allowing Lehman to fail was 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 functioning economy 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. The question 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 might lose 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 to over-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 very comfortable missing the initial bounce should markets rebound.

Jonathan@GolubMarketInsights.com (917) 796-2987

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Market Barometer In October, we established a subjective barometer to indicate the level of risk that we saw to our economic 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.

SEVERE HIGH ELEVATED GUARDED LOW

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 to redirect 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 for declaring a recession finally pulled the trigger. Whats interesting is that as bad as it feels, the economy actually edged out a positive gain over the twelve months ending September (the most recent data available). GDP
12% 10% 8% 6% 4% 2% 0% (2)% (4)% 50 55 60 65 70 75 80 85 90 95 00 05
0.7% YoY GDP is -0.5% when quoted on quarterly change annualized

Source: Bureau of Economic Analysis

NBER 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 it appears 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 the rate didnt jump more in November was because disillusioned workers dropped out of the labor pool.
Jonathan@GolubMarketInsights.com (917) 796-2987

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Non-Farm Payrolls Monthly

600 400 200 0 (200) (400) 90 92 94 96 98 00 02 04 06
(000s) 3 mo avg

(533) Most recent

08

Source: US Department of Labor

While the first official reading of fourth quarter GDP arrives in late January, monthly data from industrial activity to retail sales clearly indicates a precipitous drop in economic vigor. ISM (Manufacturing)
Expansionary (>50)

60 55 50 45 40 35 30 90 92 94 96 98 00 02 04 06 08
Contractionary (<50) 32.4

Source: Institute for Supply Management (ISM)

ISMS most recent reading of 32.4 (01/02/09) indicates a rather severe fall in manufacturing. (Scores below 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 is consistent 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 is this 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. As expected, this has been the weakest Christmas season in years. Retailers have been discounting heavily to lure customers. Can you say deflation?
Jonathan@GolubMarketInsights.com (917) 796-2987

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Retail Sales ex-Autos

10% 8% 6% 4% 2% 0% (2)% 94 96 98 00 02 04 06
(2.9%) Most recent 3 mo avg

08

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 some time. This negative news flow only tells what we already know that things are pretty lousy. For this reason we have identified those indicators that should lead us out of (or deeper into) this mess a renormalization of credit, fall in volatility, and stability in real estate values. Indicators

Leading Indicators Interest Rates Treasuries Credit Spreads Inter-bank Lending Volatility Real Estate Values

Coincident Indicators Employment Corporate Profits Economic Activity GDP Manufacturing Retail Sales

When we came up with this list in October, it was our belief that credit would slowly thaw allowing economic 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 is still quite strained.

Jonathan@GolubMarketInsights.com (917) 796-2987

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Dislocation in Credit Markets Continues There are two huge problems in the credit markets first, investors are so uncomfortable with the current 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
8%

6%

4%

2%
8 bps

0%

90

92

94

96

98

00

02

04

06

08

Source: Reuters

Just as consumers have flocked to Wal-Mart to purchase safes for their homes, the security of US 3month 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)
6.0% 5.0% 4.0% 3.0% 2.0% 1.0%

5.8%

90

92

94

96

98

00

02

04

06

08

Source: Moodys; Reuters; Federal Reserve

Jonathan@GolubMarketInsights.com (917) 796-2987

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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 at 17.3% over Treasuries, down from a peak of 20.1% on December 16. High Yield Spreads
20%

(ML HY Index Yield 10 Year Treasury Yield) 17%

15%

10%

5%

0%

96

98

00

02

04

06

08

Source: Merrill Lynch; Reuters

Inter-bank lending is an essential part of the global banking system. Over the past twenty years, the Ted 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 substantial decline but still meaningfully above long-term levels. TED Spread
Ted Spread measures the willingness of banks to lend to each other.

4.0%

3.0%

2.0%

1.0%

1.3%

0.0% 90 92 94 96 98 00 02 04 06 08

Source: Reuters

Volatility 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.

Jonathan@GolubMarketInsights.com (917) 796-2987

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Worst/Best Days Since 1929

Year Period 6 Worst Days 10/19/87 1987 Crash 10/29/29 Great Depression 05/14/40 World War II 10/15/08 Current Crisis 07/20/33 Great Depression 09/29/08 Current Crisis
Source: Standard & Poors Corporation

Return (20.4) (16.1) (10.3) (9.0) (8.9) (8.8)

Year 6 Best Days 10/30/29 09/21/32 10/13/08 10/28/08 04/20/33 10/21/87

Period Great Depression Great Depression Current Crisis Current Crisis Great Depression 1987 Crash

Return 12.5 11.8 11.6 10.8 9.5 9.1

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 after each market incident volatility subsides. That has been the case over the past several weeks with the VIX retreating to only 40. VIX
80 70 60 50 40 30 20 10 0 99 00 01 02 03 04 05 06 07 08
Bear Stearns Collapse Average 12/31/07 11/20/08 12/31/08 = 21.4 = 22.5 = 80.9 = 40.0 Lehman Collapse Citigroup Capital Injection

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 as volatility rises. Throughout 2008 a four percent change in the VIX has generally been accompanied by a one percent change in stock prices. This simple math helps explains the markets run since November 20.

Jonathan@GolubMarketInsights.com (917) 796-2987

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Changes In The VIX And S&P 500

Daily Pct Change 15.0% in S&P 500

10.0% 5.0% 0.0% 0.0% (5.0%) (10.0%) (15.0%)

Daily Pct Change in VIX

30.0%

20.0%

10.0%

(10.0%)

(20.0%)

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 our banking 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 government capital infusions rather than lend. Real Estate Values
($000)

$225 $200 $175 $150 $125 $100 90

$181

92

94

96

98

00

02

04

06

08

Source: National Association of Realtors

To date, real estate values have declined by 21% nationwide with greater losses in hot markets like California, Florida, and other sunshine states. At current levels, it will take nearly a year to work through 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 to values.

Jonathan@GolubMarketInsights.com (917) 796-2987

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Real Estate Inventories

12
months Existing Homes (latest: 11.2)

10 8

New Homes (latest 11.5)

6 4 2 90 92 94 96 98 00 02 04 06 08

Source: US Census Bureau

A Silver Lining There are two key arguments for a better outcome in 2009 valuation and stimulus. Most every asset class appears extremely undervalued using historical measures. This is true for everything from stocks to municipal bonds and distressed mortgage paper. However, those who have invested on this basis over the past 12 months have been severely punished. Equity Valuations Versus Treasury Yields (Fed Model)
18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 65 70 75 80 85 90 95 00 05
Similar to P/E of 11.6 2.2

Earnings Yield (solid = forward dotted = trailing) US Treasury Yield (10 year)
8.6

Source: Standard & Poors Corporation; First Call

The chart above shows that the historical relationship between stock valuation and bond yields has entirely broken down. Interestingly, stocks now sport a higher dividend yield than Treasuries, something not seen in fifty years. Similar comparisons can be made for most asset classes, but this argument alone should not be the sole basis of an investment strategy.

Jonathan@GolubMarketInsights.com (917) 796-2987

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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 Obama administration. Chairman Bernankes Open Market Committee recently promised near-zero interest rates 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 next iceberg. Fed Funds Target and Effective Rates
4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% Jan-08 Apr-08 Jul-08 Oct-08
Effective Rate Target Rate

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? You betcha. However, with credit markets holding the jugular vein of the economy in its hand, we believe the 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 style financial meltdown, but the odds of an adverse outcome are too high and its implications are too painful for comfort. Weve never hoped to be wrong more than now. Good luck to all of us in 2009.

Jonathan@GolubMarketInsights.com (917) 796-2987

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DISCLAIMER The views expressed are those of Jonathan Golub d/b/a Golub Market Insights. Opinions and estimates offered constitute 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 is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. Each investor must make his own determination of the appropriateness of any investment. This material has been prepared for informational purposes only and on the condition that it will not form the sole basis for any investment decision. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. CIR 230 Disclaimer Jonathan Golub does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. Jonathan Golub d/b/a Golub Market Insights, January 2009.

Jonathan@GolubMarketInsights.com (917) 796-2987

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