“For this relief much thanks; ’tis bitter cold, and I am sick at heart”

– Shakespeare, “Hamlet”

Shakespeare could write the same line today, but as it applies to the members of the Federal Reserve Board regarding their decision last week to provide liquidity to the financial markets. Not only did they cut interest rates another 1%, two other measures were implemented to inject massive liquidity to the credit markets: 1) they opened the primary discount window (borrowing from the Federal Reserve at significantly lower rates) to a broader array of financial institutions, to include, for example, large security firms; and 2) provided $100 billion for collateralized loans. The main purpose of the Federal Reserve, which was established in 1913, is to ensure the integrity of the financial system. Despite the fact that Bear Stearns went under last week, we believe the Federal Reserve has acted prudently. Their actions have served to calm the financial markets.

To say that the past 5 months have been volatile for the market is a huge understatement. The stock market has fallen by more than 20% and bonds (excluding Treasuries) have suffered as many investors have run for shelter into US Treasuries. This has driven the yield down on Treasuries to unsustainable levels (i.e., 1.78% on 2 year T-notes, 2.61% on 5 year T-notes). With yields at current levels, swapping stocks for the safety of US Treasuries is becoming less prudent by the day. It would take more than 7 years to recoup the losses of the past 5 months. Moreover, stock market valuations are very compelling right now. This is one of several factors that make us believe the recent upturn in the market is sustainable:

1. The stock market is not expensive (in our opinion, it is cheap) when compared to interest rates and the intrinsic value of companies. There are pockets of the stock market that we are concerned about. In particular, financial stocks and emerging market stocks. History tells us that the sector that led the market higher just prior to a downturn, does not lead the market higher during the ensuing recovery. Technology stocks led the market higher in 1998-1999, but financials led the rebound beginning in July of 2002. Fundamentally, in order for banks to grow profits, they need credit expansion (i.e., lend more money). We do not see this happening as credit standards have tightened dramatically.
2. Why own a Treasury bond when stocks have a better current dividend yield. Take, for example, General Electric (GE). GE currently has a dividend yield of 3.32% compared to a 5 year T-note yield of 2.61%. Also, if one is in the highest tax bracket, the 2.61% T-note yield is taxed at a rate of 35% for an after-tax yield of 1.70%. The dividend from GE is currently taxed at 15% for an after-tax yield of 2.82%. GE’s higher current yield with the added benefit of capital appreciation over the next 5 years makes GE a much better investment.
3. Companies are in significantly better financial shape than during other recessionary times, especially large, growth companies. Balance sheets have improved dramatically since the collapse of MCI and Enron in 2002. Companies are better able to weather this economic storm because they are not debt ridden.
4. There is a huge amount of cash in money markets. The amount of money in money markets has risen over 56% during the past 12 months to a record $3.45 trillion. A record 10 months of outflows from equity funds has contributed to this largess of cash. The previous high was 8 months after the stock-market crash in 1987. We believe investors will be looking to move this money out of cash in the near future as interest rates of 3% or less make cash an unappealing investment alternative.
5. The US economy is still robust, regardless of what the news media tells you. Below is a graph that shows the distribution of the entire world’s GDP in 1995 and in 2006. Over the past eleven years (which includes the 2000-2002 bear market), the US percentage of the world’s GDP has risen from 25.1% to 27.7%! Japan, Germany, France and Italy all declined as developing market (i.e., China, India) economies expanded. Not only is the US holding its ground, we are capturing more of the world’s economy!