We May Have Been Too Optimistic

For many months we have been saying the recession will be longer and deeper than most economists and analysts anticipate. How many times have we repeated the term "It's All About The Economy"? We have been right about those predictions. However, we have been talking about a bottoming process for awhile and it looks to us that the bottom may not have come yet and the process of the stock market gaging the extent of the current crisis and discounting such results may take many more months.

We have suggested that the credit markets will lead the way and loans and bonds are the place to benefit from the unfreezing of the credit crisis. In the past month those markets have rallied about 10% and a number of high yield companies have been able to access the new issue market to raise fresh capital. This bodes well for the financial crisis but the economy remains extremely weak and we anticipate the news to continue to be bleak throughout 2009 and possibly into a good part of 2010. Unemployment could reach 11 or 12% as businesses pare their work forces while trimming many expenses. Very few industries have been spared from the impact of the financial crisis. Health care, for-profit education, and some consumer durable (but not all) companies have maintained some growth in this sour economy.

The credit market remains the best opportunity to garner decent returns but excessive profits may not come in these markets until 2010. In December ,we recommended two closed-end bond funds which were trading at a discount to net asset value. They were PTY and PCN both of which are managed by PIMCO. With the recent rally, the prices of these funds have skyrocketed such that they are now trading for around a 30% premium to net asset value. Too many investors are looking to migrate into fixed income securities and they have elevated the prices of these funds to levels that are too high and they should be sold as the downside risk is greater than any upside gains.

We were at the JP Morgan Credit Conference this week and the investors were optimistic about the opportunity in the credit markets over the next few years. However, nobody seemed to be anxious to deploy too much capital too quickly. Most companies expected weak results for this year and into next year. A few lectures by professionals who have contact with numerous corporate clients also indicated the economic picture is clearly in for worse times ahead.

The government is desperately trying to figure out what to do with the toxic assets on the balance sheets of banks on one hand while negotiating with Congress over a comprehensive stimulus plan. We contend that whatever the plans are they won't be enough. In fact, it is likely the government will likely need to deploy trillions more before the financial crisis is over and the economy is lifted out of the doldrums. Many banks are going to fail and others will need additional capital infusions. Investors will sit on the sidelines until the magnitude of the toxic assets is known and it becomes apparent that the mess is close to being cleaned up. This will take a long time and as a result the economy may remain weak for at least another year.

As Republicans, we generally like the concept of cutting taxes to accelerate the economy but it is not the correct medicine for the stimulus plan. This country needs new jobs and an improvement in the housing market. We do not need a plan to appease each Senator and Congressman in office. A new tax cut will give the consumer fresh cash to put under his mattress. We need consumers to spend money to increase the velocity of the money supply. The consumer is in savings mode so a tax rebate will not lead to new jobs nor will it stimulate economic growth. The government would be better off giving consumers gift cards to the local retailer if it wants to help the consumer and stimulate the economy. We believe the stimulus plan needs to focus on jobs and infrastructure projects are definitely the way to go. The spending should be on projects that have been in the planning stage but can be accelerated. Our roads and bridges clearly need improvement and so does the power grid. Let's improve America now and spend the taxpayers dollars wisely as we try to pull our country out of this economic slump.

Unfortunately, for the stock market none of the above is encouraging. The markets expect a resumption of growth in the second half of 2009 and unemployment to peak at 8-9%. It looks like those numbers are optimistic. We haven't even begun to see the effects of the impending commercial real estate crisis nor have we factored in the impending escalating corporate defaults and consumer defaults on credit cards, auto loans, student loans, and home equity loans. Volatility will certainly remain high and some rallies may ensue with hopeful Obama plans but for investors, cash will remain king and we would suggest caution over the next few months as investors start to realize that 2009 will not be the year the economy hits bottom.