Interesting:
Calculating the War Effect
Donald Coxe
Wednesday was my first flight since the war began. On the way to the airport, I thought back to the beginning. On Sept. 11, our head short-term trader suddenly called out: "What is going on? The front end of the Treasury curve just went crazy." Suddenly, somebody was bidding up the prices of U.S. Treasury bills, the world's most desirable haven in times of trouble. Yields on these highly liquid securities had plummeted, while yields on all other short-term paper were holding steady. A bond trader shouted: "I was talking to Cantor and heard a scream and the line just went dead." Moments later, the trader next to the TV called out: "Just coming over the screen -- a plane has hit the World Trade Center."
The market was the message before the media became the message.
On Wednesday, I was en route to Greenwich, Conn., for the annual asset allocation conference of the Greenwich Round Table. This is an invitation-only gathering of the Northeast financial elite, including major hedge funds, large pension funds and super-wealthy families. Although there were only 80 attendees, more than $1 trillion (U.S.) in actively managed money was represented by chief investment officers or managing partners. In addition, through private Web-casting, a roughly equivalent amount in global funds worldwide was tuned in. Every strategist, guru and mover and shaker worth his or her name has come to these closed meetings over the years. It would be the first high-end gathering of important money managers since Sept. 11.
The meeting organizer had been a senior executive at Cantor Fitzgerald before setting up his own shop in Greenwich. As he said to me of the firm that sustained the greatest murder rate: "I lost 700 friends."
The first speaker was Douglas Cliggott, portfolio strategist for J. P. Morgan Chase. He has been, in my opinion, Wall Street's best and brightest strategist for three years. He lacks the image or reputation of Abby Joseph Cohen (Goldman Sachs) or Tom Galvin (Credit Suisse First Boston). Unlike them, he has been right about the market -- and for the right reasons.
Doug is a low-key, scholarly sort of presenter. He gave a detailed historical analysis of the S&P 500 (the broad U.S. equity benchmark), which was trading at about 1,000 as the meeting began, down from its all-time high of 1,527. He argued that equity risk remains as high as ever, despite the big selloff. Doug said his peers were bullish because they still were using earnings numbers for next year close to $50 per S&P "share" -- a measure that pretends the S&P costs $1,000, then calculates its profit according to the precise weighting of each index company. This suggests a price-earnings ratio of merely 20, the lowest in many years. Doug said $34 was the kind of number we should expect in the light of the rapid deterioration of the economy in the weeks before the attacks, and the terrorists' huge hits to travel, durable goods purchases and other discretionary buying. He said corporate America had been hanging on to excess staff waiting for an economic upturn; now they will throw in the towel. That $34 number suggests the S&P's multiple is closer to 30 than 20, and bear markets have tended to end with the multiple at half that level -- or less.
Doug also pointed out that U.S. home mortgage debt had been climbing as fast as house prices for a year through the second quarter, but that debt binge (which had financed cars, SUVs, boats and vacations) had rolled over. Homeowners' percentage equity in their houses was at an all-time low as a result of the borrowing buildup. He noted that average levels of mortgage indebtedness had begun rising in the mid-1980s in response to tax law changes that eliminated a wide range of tax shelters, but left mortgage interest deductibility intact. It had been rising at roughly the same rate as the stock market from 1998 to 2000, which indicated that at least some of the refinancing went into the roaring stock market. His most optimistic comment was a hope for a drop in 10-year Treasury notes to the 4.25 per cent range (from around 4.75 per cent), which would lead to large-scale mortgage refinancing, easing the squeeze on over-indebted consumers.
He also cited a statistic from Fidelity, the largest provider of 401(k) plans (the U.S. equivalent of employer-sponsored RRSPs). As of year-end 2000, 81 per cent of the assets in those funds were invested in equities. With the market down so heavily since then, the 401(k) area could hardly be a source of buying strength for the stock market in coming months. He summed up by saying that if the market returned to 40-year average valuation levels, the S&P would fall to 662, down another 33 per cent. If it retained recent equity appraisals, it could bottom out between 800 and 900. For him, the right equity allocation was the minimum permitted by policy.
I was next. I gave them two asset allocation recommendations: one as of August and one as of now.
Then: Equities should be at the 51 per cent level, up from the 40 per cent range I had been recommending for two years. Tax cuts, Fed easing and the likelihood that Nasdasq would soon complete its Triple Waterfall crash back to 1,500 argued for higher equity exposure, once 10-year Treasury note yields got below 4.5 per cent, letting homeowners refinance.
Now: This is the latest war based on hatred of what we call the West. In the last century it came from the Nazis and Communists. When we won the second of those wars, we opened an era of peace. Peace has always been great for equity valuations: trade flows are easier, inflation is suppressed, research concentrates on civilian needs, consumers and businesspeople feel confident about the future and the military doesn't make heavy draws on the civilian economy on a cost-plus basis.
Now we are at war again, and the enemy is around and, frighteningly, among us, savaging the travel and services economy that boomed during the '90s. The recession could be deep, and we may not get a sense of victory for a long time. Earnings will be punished -- as in all wars. Ergo, stocks are worth probably 20 per cent less than under perpetual peace conditions.
The next speaker was from Tudor, probably the biggest U.S. hedge fund. He said the market could bottom within three weeks if the Bush administration continues to do the right things. He predicted a "tradable rally" within that time, but made no longer-range forecasts. The final speaker, from Commonfund, a provider of specialty equity funds, said he'd leave equity exposure intact at the organization's current levels. He was optimistic about victory and cited the rally the day after Desert Storm.
After those rather evenly divided presentations, the meeting ended with a minute of silence for the people of Cantor Fitzgerald. Then the Big Money left the room, remarkably quietly, to face another day of plunging markets.
Donald Coxe is chairman of Harris Investment Management in Chicago and Toronto-based Jones Heward Investments.
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