The Kitchen Sink Stock Market
Kurt Brouwer July 16th, 2008
On Wall Street there is a phrase called the ‘kitchen sink’ earnings report. It works like this. A given publicly-traded company is struggling, they know a really bad quarterly earnings report is inevitable, and so they toss in everything negative they can find — up to, and including, the proverbial kitchen sink. That way, they get all the bad news out at once. Over the past few months, as investors, we have been living through a kitchen sink period in the financial markets as almost everything imaginable has been thrown at us:- Stocks have tumbled - both here and abroad.
- The dollar has fallen to new lows versus the Euro.
- Oil prices have doubled in the past year.
- Inflation has moved higher.
- Falling U.S. home prices have caused a widening array of problems.
- Subprime loans have collapsed.
- Banks, mortgage companies and hedge funds have suffered huge losses due to subprime lending excesses.
- Lending activity at banks has shrunk.
- Tax exempt municipal bonds had their worst performance in many years due to liquidity problems at banks, insurers, and hedge funds.
- The economy has slowed or even contracted.
- Job losses are mounting.
As you can imagine, all of these factors have contributed to widespread unease and a feeling of doubt about the future. A recent article from the Washington Post [emphasis added] points out how bleak the current mood is, but also tries to put our present economic environment in a historic context:
Why We’re Gloomier Than The Economy (Washington Post, June 18, 2008, Neil Irwin)
“Ask Americans how the economy is doing, and their answer is stark: It is not just bad, it is run-for-the-hills terrible. Consumer confidence is at its lowest level in almost 30 years. Only 12 percent of Americans think the economy is in good shape. On the Internet, comparisons to the Great Depression are widespread.
But the reality is different. According to most broad measures of how the economy is doing, it’s not all that grim.
Soft? You betcha. In recession? Quite possibly. And a crisis in the financial markets has rattled nerves for months now. But so far, the economy is holding up better than it did during the last two recessions in 1990 and 2001. Employers haven’t shed as many jobs, the unemployment rate is still relatively low, and gross domestic product has kept rising. Things are nowhere near as bad as they were in the Great Depression, or even during the severe recession of 1982-83. The last time consumers were this miserable, in May 1980, the jobless rate was 7.5 percent and inflation was 14.4 percent. Now those numbers are 5.5 percent and 4.2 percent respectively…”
Objectively, conditions are not bad compared to 1980, so why is the mood so dark? We believe that there are two factors at work today. The first factor is that the economy and the financial markets are definitely struggling. Coupled with that is the sharp decline in home prices - something we have not seen since 1991. In addition, we are reminded daily of higher prices for food and fuel when we stop for gas or go to the grocery store. All of these factors hurt our confidence.
We also believe that Americans are in doubt about major institutions in our country. We know that President Bush’s approval rating is around 23%, which means that only 23% believe he is doing a good job. However, Congress’s ratings are far worse and only 12% of Americans believe Congress is doing a good job. In short, we are facing a crisis of confidence in our government as well as our economy. Over the past 30 years, consumer sentiment slumps the most when we lose confidence in both the economy and in our government. And, that may be why consumer confidence is almost as low now as it was in 1980.
Index of Consumer Sentiment Nears 30-Year Low
Source: St. Louis Federal Reserve Bank
This chart from the St. Louis Federal Reserve Bank shows the Index of Consumer Sentiment going back in time to January 1978. It is hard to believe, but consumers are now gloomier than they have been in the past 30 years, with one exception - 1980. That year we faced very difficult economic conditions during a contentious presidential campaign (Carter vs. Reagan).
We certainly have problems these days, but having lived through the early 1980s, I have a difficult time equating the difficulties we have now with the horrendous economic environment we had in 1980-82:
Double Digits in 1980-82: Inflation, Unemployment & Mortgage Rates
In the late 1970s and early 1980s we had sky-high inflation, unemployment and mortgages rates. At that time, the Federal Reserve’s Chairman, Paul Volcker, had to raise interest rates to unheard-of levels. These rate hikes led to a prolonged economic contraction that was the worst since the Great Depression of the 1930s. This description from Wikipedia gives a sense of how severe the reaction was [emphasis added]:
“…However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker’s Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street and blockading the Eccles Building…”
The image of farmers blockading Washington D.C. with tractors is hard to imagine now, but those were tough times. The reason Volcker raised interest rates so aggressively was that inflation went wild in the late 1970s. For example, inflation hit 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981 before Volcker’s harsh medicine began to kick in and inflation moderated to 6.2% in 1982.
As inflation ratcheted higher, so did home mortgages rates. Thirty-year fixed rate mortgages went up to nearly 13% in November 1979 and did not fall under 12% again until November 1985. The peak rate for mortgages was 18.45% in October 1981. 18.45%!
But, even though high interest rates began knocking down inflation, soaring rates also led to sharply higher unemployment. The unemployment rate peaked at 10.8% in December 1982. However, it had been soaring for years and it remained at 8% or higher until January of 1984. Given all this, it is not surprising that investors and consumers were very negative in that time period 1980-82.
A Decade of Above-Average Returns Followed a Decade of Below-Average Returns
As you can see from the chart below, when consumer sentiment hit bottom in 1980, we had just been through a terrible decade for stocks. In fact, the decade of the 1970s had negative real (adjusted for inflation) returns for stocks. However, the decade of the 1980s was excellent for stocks.
Source: Brouwer & Janachowski, LLC
As you saw in the first chart above, in 1990, consumers again turned very negative due to a difficult real estate market, the onset of the first Gulf War in August 1990 and a slowing economy and impending recession in 1991. Yet, again, the plunge in consumer confidence in 1990 came just before an excellent decade for the stock market.
Now, we are going through another difficult time for stocks, very similar to what happened in the 1970s. In fact, stock market returns since 2000 have also been negative, adjusted for inflation.
As we saw in the chart above, returns from the stock market are cyclical. Good times follow bad times. Now, I cannot tell you that this plunge in consumer sentiment unquestionably presages a turning point for investments. However, I can state with confidence that such extreme negativity in consumer sentiment is rare. In fact, the index has only been lower once in 30 years. I believe the current level of pessimism is overdone and that, ultimately, the country’s bleak mood will change.
As the Washington Post article referenced above concluded:
“…But now, coming off two decades of prosperity and low inflation, Americans have come to treat low unemployment and inflation as givens. We have gotten so used to things being good, in other words, that even when conditions become somewhat bad, it feels terrible.”
When you hear politicians and pundits opine that this is the worst crisis since the Depression, just mentally compare current conditions to those of the late 1970s and early 1980s. Back then, we had double digit inflation, unemployment and home mortgage rates. Today, inflation is around 4%, unemployment is 5.5% and 30-year fixed mortgages are about 6.25%. In other words, we are not remotely close to anything like double digits on any one of these factors, much less all three.
Summing It All Up
I believe that as the bad news gets absorbed and financial conditions moderate, the most likely outcome is that consumer sentiment - and the financial markets - will turn more positive. Several developments are now helping create the underpinnings for revitalized economic and market conditions.
- The dollar is trying to strengthen. The Federal Reserve and the U.S. Treasury are now taking steps to shore up the dollar and this should have important positive effects throughout the economy and the financial markets. We are beginning to see signs of strength in the exchange rate of the dollar versus the Euro and other foreign currencies. A stronger dollar should lead to a retreat in oil prices and should also reduce inflationary pressures in food, gas and other necessities (See Gross Likes Dollar vs. Euro For First Time).
- The credit markets are beginning to stabilize. Increasing lending activity will also pave the way toward renewed economic growth.
- The real estate market has experienced a significant correction and is now going through a bottoming process.
- Underlying values in the stock markets have improved dramatically as many companies continue to perform well and increase shareholder value even while their stock prices have fallen.
At this point, I do not know if “everything, but the kitchen sink” has been thrown at us. Nonetheless, I believe the U.S. economy and our financial markets are fundamentally strong and resilient and that they will survive this downturn and begin growing again.
In the early 1980s, the stock market took time to regain positive momentum in the face of the many negatives, but patient investors were rewarded with a strong and prolonged turnaround in the markets. I believe the same is true now. Patient investors will again be rewarded as conditions improve. And, when it does come, the turnaround in the stock market could be dramatic - on the upside.
