"Only that historian will have the gift of fanning the spark of hope in the past who is firmly convinced that even the dead will not be safe from the enemy if he wins. And the enemy has not ceased to be victorious."

Bye Bye Dow 5000

On November 15, 2008, HCM warned that the Dow Jones Industrial Average could sink as low as 5000, and the S&P 500 could drop as low as 475, by the middle of 2009. At the time, the Dow was trading at 8497 and the S&P 500 at 873. We warned of the possibility of a further decline of 40 to 50 percent in equity prices based on our view that the economy was experiencing a deflationary shock that was more characteristic of a depression than a normal recession.

At its nadir on March 9, 2009, the Dow hit 6547 and the S&P 500 dropped to 676.53 (closing not intraday prices), drops of approximately 23 percent each from their November 15, 2008 prices. Since then, the Dow has rallied about 25 percent and the S&P 500 about 29 percent. Moreover, these indices seem hell-bent on rising further in the face of economic news that can only be characterized as the worst the U.S. has seen in decades. The fact that the market is rallying in the face of such negative news tells us that the market is not prepared to retest its lows anytime soon. Accordingly, while HCM views the equity market as currently valued at unsustainable multiples of earnings (by our count, the S&P 500 is trading at better than 20x 2009 operating earnings excluding charges), Dow 5000 and S&P 500 are no longer in the cards. It was a good directional call but, as is our wont, overly negative. At some point this rally will end, but we don't expect the market to drop to depression trading levels once it does. Mea culpa.

Clearly the equity rally has been news rather than earnings driven. In order to remain at current levels, equity prices will have to gain earnings support in the coming months. Many companies are reporting significantly lower revenues due to the depth of the global economic slowdown. Those companies that are beating estimates, such as Dow Chemical, are doing so by cutting enormous amounts out of their cost structures, which over the long-term should reset their production costs at a lower run-rate. This should prepare these companies for high levels of profitability as the global economy heals. But draconian cost cuts exact a toll on other sectors of the economy, as well as on employment and the supply chain, so they are far from a zero sum game for the overall economy. Just as some companies are benefiting from these drastic measures, their suppliers and employees are suffering. This dynamic is what renders this a market in which investors are best served by active management and fundamental research, not by macroeconomic or sector-wide bets. Those types of broad bets may be profitable in the short-run but risk sharp reversals in the not-too-distant future as the effects of cost cutting and debt reduction reverberate through the economy.

The world remains captive to the dynamics of a depression rather than a garden variety recession. The economy is responding to extraordinary government actions and traditional monetary and fiscal remedies remain ineffective. Accordingly, the economy is far from out of the woods, and investors should remain cautious. While our initial judgment was that the rally would run out of steam at Dow 8000 and S&P 800, it is now apparent that those targets should be lifted to Dow 8500 and S&P 925. If the markets were to reach those levels, they would be trading at ridiculously high multiples of any reasonable earnings forecasts (something we have seen before that always ends in tears). Today, the markets are trading more on hope than facts and investors would be well-served to carefully monitor their exposure to stocks trading at higher price/earnings ratios. Investors are apt to regain their optimism faster than companies regain their profitability.

The last time the world experienced a depression dynamic, between 1929 and 1932, the Dow rallied by more than 20 percent four times, only to drop below previous lows. Thus far, the current crisis has seen five rallies of 10 percent or more that have failed to hold. HCM would not be surprised to see the market pull back from current levels at any time since there does not appear to be either earnings or economic support for current levels. HCM remains cautious about the economic outlook both domestically and abroad. As we were writing this, the first quarter GDP estimate for the U.S. was released at a -6.1 percent annual rate, pretty much as we expected (although we thought it could be as low a -7.0 percent and it could still be revised upward or downward). This figure should not be a surprise to anybody who has been paying attention to the economy. Nonetheless, we can say with some confidence that the last two quarters will represent the trough of this economic cycle. At this point, it is apparent that the rate of economic decline is beginning to slow meaningfully. The problem is that as of yet there are scant signs of economic growth emerging anywhere around the globe.

Moreover, the glimmers of hope that the stock market and its boosters would like to believe justifies a sustainable rally are wholly attributable to the most dramatic and unconventional series of governmental interventions in the markets in history. It is not surprising that trillions of dollars of liquidity infusions and government guarantees have introduced a degree of stability into the system, but that hardly equates to a sustainable recovery. In order for that to occur, government demand will have to be replaced by sustainable sources of organic growth that are financed by equity, not debt, and productive activity, not speculation. If the U.S. economy and the rest of the world cannot begin to grow on their own, the markets will remain under pressure for years to come because the companies that comprise those markets will find profitability difficult to attain and maintain. Right now, it is questionable whether the conditions for such organic growth are being put in place or not. The only thing that can be said with certainty is that the size of government is exploding and the volume of government debt in the U.S. and elsewhere is swelling to dangerous levels.

For the moment, markets feel calmer. Measures of liquidity and volatility have settled down considerably. Short term credit spreads have all but normalized, although normal credit growth has yet to resume. Long term credit spreads are lower than their highest levels but remain extremely elevated by historical standards. But to a meaningful extent, central bank actions have had their intended effect. Nonetheless, the first quarter GDP report is strong evidence that economic healing has a long way to go. Conditions in the labor markets remain very troubling. Bridgewater Associates points out that while labor markets are normally a lagging indicator in a debt-driven economy, they tend to be a leading indicator in a deleveraging economy. When credit is unavailable, spending and debt payments are dependent on income, and income is generated by employment. When companies are deleveraging, job growth becomes a leading indicator of demand. Bridgewater believes that recent data suggests that unemployment is likely to rise by nearly 0.7 percent a month, and we agree that further job losses are inevitable.

Comparisons are often made between the U.S. and Japan, which remains mired in an economic slough of despond twenty years after its stock market peaked. If there is reason for optimism that the U.S. will not be consigned to decades of sluggish economic growth, it is that the Federal Reserve and U.S. Treasury have moved much more rapidly than did Japanese authorities to address the current crisis. But the U.S. is going to remain dependent on its government for growth for the foreseeable future. Joblessness, as just noted, is still increasing, and capacity utilization is going to take a long time to rebuild as many industries remain in downsizing mode. Debt destruction is still the order of the day, as a flood of troubled debt exchanges continues to hit the credit markets. HCM remains convinced that while there are many opportunities in individual stocks, bonds and loans, many traps lie waiting in the broader indices. Active management and individual stock picking and credit selection will be required to successfully navigate this environment. Passive strategies and indexing will be recipes for underperformance or worse in a world that is still replete with black swans and fat tails. Risk assets are far from out of the woods.

Unfortunately, HCM is already seeing too many signs that the financial world is focused on returning to business-as-usual rather than learning from its mistakes. It is abundantly and depressingly clear from the noises eructating from the canyons of Wall Street and The City that business leaders are far more focused on figuring out how to continue to extract their personal pound of flesh from the system than preventing their own short-term greed from placing the system at risk again. The whining about compensation and the unseemly rush to repay TARP money while continuing to benefit from government-subsidized FDIC-backed financing is just more evidence that most financial leaders really don't "get it" or don't care to "get it" and would sooner return to their previous practices than move the system to a more stable operating and capital base. Bankers appear to be spending far more effort trying to circumvent limits on compensation than working with regulators and lawmakers to institute a new regime based on what is best for the long-run stability of the financial system. HCM points this out not because this is surprising; actually, it is predictable and depressing (it reminds us of the talk that 9-11 would change the aggressive temperament of New Yorkers, something that lasted about a week-and-a-half). One can only hope that the Obama Administration can withstand the political pressures to back off the radical reforms that are needed to prevent this crisis from being treated as just another run-of-the-mill market correction, which is every Wall Street banker's deepest desire.

The article that appeared in The New York Times on April 27, 2009 ("Geithner, Member and Overseer of the Finance Club," p. A1) describing the incestuous relationship between Treasury Secretary Timothy Geithner and those he regulated previously as head of the New York Fed and today in his new, far more powerful post is a distressing reminder of how deep the lines of complicity run in our system. HCM does not believe that Mr. Geithner is dishonest or ill-intentioned, simply that he is a product of his environment, as his predecessor Hank Paulson was shaped by his years on Wall Street. At this point, we can be fairly certain that what is good for Wall Street is unlikely to be good for Main Street unless the types of reforms that have been outlined in this publication are adopted (see The HCM Market Letter, April 1, 2008, "How to Fix It"). In speaking about the continuing travails of the banks, CLSA bank analyst Michael Mayo writes: "Accomplices include managements, directors, shareholders, analysts, regulators, and financial companies other than banks such as government-sponsored entities, mortgage lenders, mortgage brokers, insurers, and other nonbanks that helped to drag down good banks along with the bad." There are still too many accomplices and too few true reformers working to insure that the system won't repeat the mistakes of the past. If the crisis is really over, as our business and political leaders would have us believe, then now is the time to man up and implement real changes rather than cave in to the demands of those who put the system at risk in the first place.

The Banks

The Obama Administration appears to be sinking into a pattern in which it makes bold public promises and is then forced to backtrack in the face of the realities of governing. Such is the transition from campaigning to governing, and for the most part our new president is doing relatively well. In the case of the so-called bank "stress tests," however, the Obama Administration is not being particularly forthcoming, although different stories are flying around about the need for various institutions to raise additional capital. Far more forthcoming (and perhaps alarmist) was the International Monetary Fund, which recently predicted banks will need to raise $875 billion in equity by 2010 to return their capital bases to pre-crisis levels. Overall, the IMF estimates that total losses for the U.S., European and Japanese financial sectors will eventually reach $4.1 trillion between 2007 and 2010. Banks will absorb $2.5 billion of these losses, insurers $300 billion (this number seems overly optimistic in view of AIG's losses), and other financial institutions $1.3 trillion. And we thought Nouriel Roubini was a worry wart!

HCM suspects that several banks are in need of significant amounts of additional capital, although government guarantees and the return to non-mark-to-market accounting have provided them with some breathing room. We are a far cry from the situation of last September, when systemically important institutions were on the verge of failing and had to be rescued by the government or merged into stronger institutions to avoid disaster. Nonetheless, there is little doubt in our minds that the banking system remains fragile, which explains why lending remains sluggish. In fact, despite the Herculean efforts of the government to stimulate lending and prop up the banks, banks are lending less than they were before. Part of this funding gap is being filled by the capital markets, which are supplying capital for worthy corporations. But this does little for small businesses and individuals who desperately need but cannot obtain financing.

The focus in bank results is shifting from capital markets-related losses to non-performing loans. Bank of America saw a 45 percent quarter-over-quarter increase in commercial real estate non-performing loans and a 48 percent increase in commercial and industrial non-performing loans in the first quarter of 2009. Michael Mayo, one of the most outspoken bank analysts on Wall Street who has resurfaced at CLSA Securities, one of the strongest research firms around, predicts that loan losses as a percentage of total loans will exceed those of the Great Depression before this crisis ends. Mr. Mayo expects loan losses to increase from 2 percent of loans to 3.5 percent of loans in 2010, higher than the 3.4 percent of loans that were reported in the Depression, and 5.5 percent of loans in his worst-case scenario. His outlook is based on the fact that banks made riskier loans to a much more leveraged borrowers during this cycle. This is illustrated by the fact that consumer debt to GDP is currently 100 percent compared to only 37 percent in 1929. Moreover, there were no home equity or credit card loans in the 1930s. Mr. Mayo foresees a rolling recession by asset class from mortgages to construction loans to credit cards, commercial real estate, corporate loans and other areas. If he is correct, the economy has yet to experience much of the damage from the downturn and the equity markets have gotten ahead of themselves.

Corporate Credit

Mr. Mayo's grim outlook for banks is consistent with the fact that corporate credit markets are just starting to see default rates approach the levels where they are expected to peak. Despite the recent rally in high yield corporate credit, this sector of the market has started to experience a sharp increase in defaults. The 3-month moving average of high yield defaults is currently running at about 14 percent, well above the record 10 percent level seen in 2001-2002, when defaults exceeded 10 percent for two consecutive years, the worst showing since the Great Depression (until now). March 2009 was a horrendous month for corporate credit - defaults reached an annualized rate of 19.4 percent, among the worst months in the past 20 years.

Recovery rates on defaulted bonds have also been extremely low. The auctions to settle the credit default swap contracts for several defaulted credits proved to be virtual wipe-outs, paying out fly-speck recoveries of 3.25 percent for Abitibi-Consolidated Inc. (a newsprint and uncoated paper manufacturer), 2.375 percent for Charter Communications (a cable television provider), 2 percent for Lyondell Chemical Company (a commodity chemical producer) and 1.75 percent for Idearc Inc (an operator of telephone yellow pages). For our lay readers, these percentages represent the amount of capital recovered (out of 100 percent) on subordinated debt investments in some extremely large private equity transactions that were forced to declare bankruptcy. The dollar-weighted average recovery rate on unsecured bonds since December 2008 has been a mere 9 percent of par (100). Investors have experienced billions of dollars of losses, a situation that is unlikely to improve as other large leveraged credits default in the months ahead. It should be noted that the lion's share of these losses are occurring in the private equity sector, which suggests that the equity in many of these transactions has been or will be wiped out regardless of what private equity firms are telling their investors.

The combination of record high default rates and record low recovery rates suggests that the recent corporate credit rally was technical rather than fundamental in nature and has likely run its course. The rally never made sense to HCM, particularly to the extent it occurred among weaker names in the market. Such moves indicate that traders are simply returning to their speculative ways and haven't learned a thing from the losses they incurred just a few months ago. HCM never looks at the high yield credit markets for direction; if anything, credit investors are a contrary indicator of where investors should be putting their money because they are often basing their investment decisions on factors unrelated to the fundamental credit quality of companies (for example, they focus on technical factors such as spread, or fashion trades based on arbitrage strategies between securities without regard to credit quality). If we want to try to understand economic trends, we would better focus on the fact that China has doubled its gold reserves to become the fifth largest holder of the precious metal than to ponder the thinking of investors who have failed to learn the pitfalls of buying subordinated debt in overleveraged companies even after having been systematically wiped out cycle after cycle. The decision by the world's largest holder of foreign reserves to buy gold is of far more significance than the short-term thinking of investors whose benchmarks and perspectives lead them into one disaster after another. One investor with an extremely long-term view is purchasing gold while another with a short-term view is investing in highly risky junk bonds. I know which portfolio we would rather own for the long-term (and yes, we are well aware of the advantages a sovereign wealth fund has over other types of investors).

The miniscule recovery rates on defaulted bonds suggest that distressed investment strategies will be extremely treacherous in the current environment. Unless investors are coming in at the top of the capital structure through DIP financing, it is going to be very difficult to create value from the lower tiers of leveraged capital structures. Distressed assets are continuing to trade poorly based on the recognition that short-term recoveries will be paltry and long-term recoveries will be delayed and reduce rates of return. Moreover, despite reports that great sums of money are being raised for so-called distressed strategies, there is little evidence that this money is being put to work. Instead, money appears to be moving primarily into higher quality loans and bonds, leaving distressed names in the dust. HCM maintains its negative outlook on most subordinated corporate debt although we continue to find interesting opportunities in individual names. This remains a market that will reward fundamental research and active management, not broad-based bets on recoveries in asset classes.

(Part-II will be posted in a few days)

Michael E. Lewitt
mlewitt@harchcapital.com