May 2009 Monthly Market Review

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This month’s letter will be short as everyone at AFG is preparing for our Annual Research Summit, and launching our international research products. This is a very busy time at AFG, and for those attending our conference, it will be another great event with actionable research ideas, as well as a very stimulating group of outside speakers. If you have not yet decided to attend, please contact us and learn more about the event.
 
This year, April showers brought happy portfolios along with May flowers. Despite a few nay-believers stressing their belief that this is a bear market rally and February was A Bottom not The Bottom, the US equity market continued the momentum started in March, sending S&P500 up by 9.4% in April. Those impressive results materialized in spite of the fact that the month’s economic data was mixed.
 
April brought plenty of negative news to keep rational people wondering if things will indeed improve later this year, or at least make them question the sustainability of the current market rally. The big headline statistic was unemployment, which reached 8.5% and is expected to continue climbing well into 2010. The Service sector continued to shrink for the 6th straight month in March according to the Institute for Supply Management, with its index showing the contraction accelerating to 40.8 from 41.6 in February, much worse than the 42 Economists expected.The U.S. federal budget deficit rose to a record $956.8 billion in the first six months of the fiscal year by March, and is well on its way to the $1.75 trillion -- or 12.3% of GDP -- for the full fiscal year, which ends in September 2009. US foreclosure filings rose to a record in the first quarter with a total of 803,489 properties receiving a default or auction notice or were seized, 24% more than a year earlier. The Conference Board's Leading Economic Index declined 0.3% in March, steeper than the 0.2% analysts were expecting.
 
On a positive note, home prices in 20 cities were down 18.6% in the 12 months ending in February, compared with a 19% drop in the 12 months ending in January, the first time in 16 months that the decline in prices did not set an annual decline record. The US economy shrank 6.1% in Q1, much bigger than what Wall Street expected and hardly different from the 6.3% plunge in the fourth quarter. However, investors liked the components of the GDP decline, which suggested that the decline was driven by plunging business investment as firms drew down inventories at the fastest pace since the start of the decade. Excluding the drop in inventories, ultimate demand in the economy fell at a 3.4% annual rate, compared with 6.2% in the fourth quarter. Investors are now hopeful the depressed inventory level could lead manufacturers to ramp up production later in the year. In addition, U.S. factory orders increased more than expected in February, the first time in seven months that the indicator turned positive. Retail sales showed signs of hope as well. February sales were revised up to increase 0.3% instead of dipping 0.1% as originally reported. January sales were revised up to an increase of 1.9% from an increase of 1.8%. On the credit side, about $70 billion of corporate bonds were issued in February, up from $21.4 billion in October, and while still only about half the level of last May, it shows debt markets are starting the journey towards normality. Lastly, April showed an uptick in M&A activity indicating some corporate buyers see bargins out there and are in the mood of seeking non-organic growth again. Operationally, the market is in a difficult spot to handicap. While we felt it was undervalued when the Dow was trading in the 6,000’s, (see our Then and Now report), its current levels have clearly priced in a more normal economic environment. Over the next year, we believe the trend will continue to be towards an improving economy and likely with it a rising equity market. Primarily this view is premised on the inordinate government spending and incredibly accommodative Federal Reserve. It is hard to believe with the amount of money entering the economy that business indicators will not continue to improve in the short term. The question, however, is at what cost?
 
Our longer term view is much more cautious as a result of an exploding budget deficit, a rising tax environment on personal and business income, as well as business activities through a proposed carbon tax scheme. In addition, the massive growth in the Fed’s balance sheet has laid the foundation for significantly higher inflation in the years ahead. Further, there are big question marks regarding how this administration will treat the businesses it interacts with to achieve its policy goals. We have already seen how financial firms that accepted TARP funds have started to regret their decision, as agreements with the government seem to last as long as public opinion polls. Further, the government’s treatment of Chrysler’s senior debt holders is concerning. Despite having a very well established bankruptcy law in America, the public bullying and favoritism of one group of pensioners versus those represented by the senior debt holders is very troubling. This does not bode well for private firms that cross paths with the administration. As a group, these are troubling indicators about the economy in the future.
 
While we believe the short run will be dictated by a “missing the run” versus “protecting for downside” mentality, it will be important to think about these issues in the months to come and properly position portfolios to minimize the damage from what may be a “double dip” recession. We will reprint a chart and a discussion from last month, as we think its implications are not fully absorbed in today’s “miss the rally” mentality.
 
"Just for fun, we did a quick exercise. We consolidated the current S&P500 companies excluding Financials and Utilities, and calculated their leverage. To be conservative, we included every piece of liability and debt for those firms including operating leases. The S&P500 industrials generated revenues approximating $7.5 trillion in 2008 vs. total debt of $3 trillion, suggesting a debt/revenue ratio of 40%, comparable to our current national debt to GDP ratio. As equity investors we know excessive leverage is a dangerous thing as we will be the first one in line to see our investment wiped out. As a nation, exorbitant leverage will be devastating to the economy as it will devalue our currency, allow foreign debtors to dictate our agenda, and we the tax payers will be the first in line to be hurt, seeing our assets worth less, our income taxes rising, and our future shaky. We do not suspect corporate America will ever consider increasing its leverage to 82%, and we don’t understand why the Federal government thinks it is a great idea.” 

With the switch from the Republican Party to the Democratic Party, Alan Specter has essentially given the current administration the ability to carry out its agenda with little opposition, as the Democrats possess a filibuster proof Senate when Al Franken is likely seated. Whenever one party has such absolute control, our instinct says trouble lies ahead. Hopefully that will not be the case, but politicians generally cannot but over-reach when presented with the opportunity. We have seen that with both Democrats and Republicans, and we do not expect this time to be any different.
 
Lastly, here are the returns for April 2009 (Mar 31 – Apr 30), a good month for the equity market:

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