Interim Report - Light at the End of the Tunnel? 3/13/09

 

Recently we have been receiving client calls fearing a complete collapse of global stock markets.  Some of our clients have reached the point of “can’t take it any longer”.  We are very sympathetic to this view, especially in light of so many areas of the economy experiencing an accelerating downward spiral.  In this interim letter to our clients we thought it would be helpful to place our current economic situation into a broader global perspective, as the media tends to emphasize current trends with little regard to contrary or balancing observations and points of view.  We therefore conclude this essay with some of our own observations which will give a degree of balance to the current admittedly glum economic picture.

 

It is old news that the current leg of this bear market began with a financial crisis which morphed into a global economic recession.  In the new year to date however, US stock markets have experienced further sharp declines coinciding with tax increase proposals being debated in Congress and a lack of tangible evidence that new lifelines offered to the financial sector have yet to restore investor confidence or lead to new bank lending.

 

As if the generally unhealthy economic climate in developed and emerging markets around the world wasn’t enough to be concerned about, we also acknowledge that the technical condition of the US stock markets also appears quite negative at the present time. There has to date been no enthusiastic, broad-based buying exhibited by investors as markets fall to new lows.  Instead, each time the market begins to rebound, it is quickly overwhelmed by waves of new stock sales.  

 

Market analysts are fond of repeating the expression: “No one rings a bell when a bull or bear market ends”.  Instead, a trickle of events contrary to the prevailing trend begins to occur.  The hope, of course, in the present situation is that the trickle becomes a stream and then a river which ultimately overwhelms the economic and investment negativity we face today.  It is with this thought in mind that we present the following list of thoughts and observations for your consideration.

 

• A great number of countries located around the world are preparing for hundreds of billions, if not trillions of dollars of infrastructure expenditures which will continue for many years into the future – perhaps a decade or longer.  This developing global stimulus will dwarf any stimulus package that has ever been attempted with economic consequences possibly beyond comprehension.  Commodities shortages may quickly develop, especially in light of recent suspensions of many mining ventures around the world.  Today’s commodity surpluses may quickly become tomorrow’s global shortages.  Global shipping rates will be one of the first areas to reflect these anticipated expenditures as companies lease ships to move commodities between countries. Emerging markets around the world are the source of many of the commodities which will be used to jump start the global economy.

 

• China has the lead in its own massive infrastructure development program including railroads, highways, sea ports, housing, schools, office buildings and airports. All are now in various stages of early development.  The broad Chinese stock market has, since the November 20, 2020 US market low, generated a total return of 19% through March 10, 2020.  In similar fashion, EEM, the broad emerging market stock index fund, has generated a total return of 21% during this same period.  The S&P 500 Index has experienced a total return of -6%.

 

• The Wall Street Journal reports that iron ore prices have been increasing steadily since December, 2008.  Iron ore is the main ingredient in steel production.  Sale of iron ore involves transporting large quantities of dirt containing the ore over long distances utilizing railroads, seaports and dry bulk cargo ships.  China purchases 50% of the world’s iron ore exports, and is reportedly now rebuilding its inventories as part of its infrastructure development program.  When infrastructure spending kicks in globally, demand for steel will increase, perhaps dramatically, with spillover benefits into the transportation and energy sectors.

 

• The now well-known Baltic Dry Index of maritime dry bulk (ie, minerals, grains, etc.) shipping rates has increased from a low of 663 on December 5, 2020 to its present level of 2225, an increase of 236% in three months.  We consider this indicator to be a harbinger of global trade activity, analogous to Warren Buffet’s comments regarding the arrival of robins during the dead of winter. 

 

• Base-metal commodities prices have held steady or increased in price since late December, in the face of withering global stock market declines.  These metals, such as copper and iron ore are the building blocks upon which a global infrastructure boom will soon emerge.

 

• The investing public invariably gets it wrong at market inflection points.  Market revulsion continues to rise as stock prices become increasingly attractive.  According to Lowry’s technical advisory service, more than 70% of advisors are presently bearish on the stock market.  High bearish readings are a contra-market indicator.

 

• Most of us remember the wildly speculative tech boom of March, 2000 to September, 2002.  That orgy of bad decision making culminated in a peak-to-trough market decline of approximately 80% for the broad tech sector funds.  Out of fear of an economic collapse for the American economy, the Fed rapidly brought short-term interest rates down to 1% in the midst of the tech sector bust and held them there well into the subsequent economic recovery.  It has been argued that more than any other economic factor, the Fed’s prolonged aggressive monetary actions set the stage for the next, and considerably larger, speculative frenzy in the financial sector.  Cheap money leads to bad decision making.  From its peak in 2007 to its current trough, the broad financial sector index has now declined by approximately 85%, echoing the magnitude of the tech sector’s wipeout of its day.

 

• The Fed’s actions to end the tech-led recession of 2001 pale in comparison to the actions taken recently to pull the US economy out of its current recession and deflationary cycle.  Monetary and fiscal responses to the crises are being simultaneously matched by similar responses in many other countries around the world.  We are experiencing the largest global reflationary effort ever undertaken with the focus around the globe on infrastructure repair and development.  The seeds of the next government-orchestrated mega bubble are now being planted.  We believe the most likely beneficiaries of the coming infrastructure boom will include companies in the following sectors: raw materials, energy and mining related, as well as certain infrastructure industries including electric grid and water treatment related companies.

 

• According to a study completed by BCA Research, an economic consulting firm, US stock prices, inflation adjusted, are within 10-15% of their 1994-95 levels, which also match the market’s inflation-adjusted peak of the 1960’s.  The economic significance of the 1994-95 period is that it marks the beginning of the period when households began a leveraging-up spending binge that has only recently begun to reverse.  Thus, US stock markets averages are very close to coming full circle through a decade-plus period of consumer-fueled optimistic overspending.

 

• The Fed has now brought short term rates down to levels which deprive investors of any real returns on short term investments.  Revulsion towards the stock market (for now at least) has nevertheless resulted in investors accumulating cash in short term treasuries and money market funds in an aggregate amount which rivals today’s value of the entire US stock market.  When sentiment turns favorable once again, stock market gains could be explosive.

 

In conclusion, we are not predicting when the current bear market will end.  Rather, the purpose of our essay is to illustrate that an increasing number of below-the-radar factors are aligning themselves in a manner which illustrates a continuing reduction of risk in global equity markets.  Politicians however, will remain the wild card in all efforts to restore confidence in economies around the world. We welcome your phone calls to discuss our thoughts

 

Sincerely,

Sheffield Investment Management Inc.