SPENCE Asset Management

Noise Versus Signal February 2009

One of the most crucial aspects of our job is deciphering signals of something significant from noise that is merely distracting. Unfortunately, we live in an age where politics can generate the loudest of noise and greatly confuse the signals while having a widespread impact on markets.

In all of the research pieces we have examined in recent months, we found the best description that characterized the noise of the leaders in both parties selling the TARP program back in the fall was “fear mongering.” We have concluded that if there is one policy that both Democrats and Republicans agreed on that has actually worked; it has been the TARP sales pitch which was intended to scare the heck out of the American people so that bailout legislation could be passed. Mission accomplished.

What in reality was an uncoordinated campaign by money center banks and investment banks to put out a leverage fire they themselves started became noise from our political leaders convincing financially sound and responsible citizens to completely reign in all economic activity that represented a belief in the future. What we have now is a concerted effort by government to curb the fear and replace it with confidence.

While this new mission of restoring confidence could take some time we think it is important to put the latest crisis into historical context. To do so we have evaluated data from the last five great stock market declines going all the way back to 1902. When looking at the data associated with the confidence crises of 1902, 1906, 1919, 1929, and 1974 we find remarkable similarities. Only the 1929 decline led to a depression. The other four debacles all led to remarkable resurgences in national confidence within a relatively short period of time.

Let’s survey some of the signals at the height of the “fear mongering” during 2008’s crisis and see where we stand today.

Libor Spreads:

In simple terms the LIBOR rate and LIBOR spreads reflect banks confidence in each other. When LIBOR spreads are wide it reflects a lack of confidence in the system. Since their unrealistic peaks last fall, LIBOR spreads have experienced one of the most remarkable contractions on record. In doing so, they demonstrate a renewed calm in the attitudes of bankers in terms of the overall trustworthiness of the system.

Commercial Paper Issuance:

Commercial paper is short term instruments issued by large companies for immediate liquidity and funding needs. Last fall the issuance of commercial paper fell off a proverbial cliff. However, by the end of November the trough ended and the market’s willingness to absorb the issuance of commercial paper has rebounded significantly.

Mortgage Bond Yields:

With the backdrop of Fannie Mae and Freddie Mac going into government receivership fresh on the minds of investors, yields on these bonds soared back in the fall. Since then, as the government has demonstrated a tangible commitment to the support of these entities and particularly their missions, yields on these mortgage bonds have been falling steadily for many weeks now. Accordingly mortgage rates have been falling as have yields on high grade corporate bonds.

The drop in the Volatility (VIX) Index:

The VIX Index attempts to measure the “perceived risk” of the stock market. Once again last fall during the peak of the fear mongering campaign, the VIX reached unbelievable levels. In recent months the VIX has begun to fall substantially.

Trade-Weighted Dollar Index:

During times of crisis, readings on the Trade-Weighted Dollar Index will soar due to perceived safe haven nature of dollar denominated assets. Once again last fall during the initial sales pitch for the bailout program, the Trade Weighted Dollar Index soared. And like so many of the other indicators we have mentioned, since November this index has slowly retreated.

Treasury Yields:

In recent weeks we have noted that Treasury bond yields are beginning to creep back up. We also see this as a positive sign. It was also during the height of fear that yields on government backed securities reached their lows.

We all know that financial markets are fickle and can throw off mixed, confusing, or outright false signals. Let’s move from Wall Street to Main Street. Average people who do their jobs, pay their bills, put their kids through school, and pay their taxes without the assistance and relief of some congressional committee; where do they stand in the wake of all of this turmoil?

We are encouraged to see that mortgage refinancing activity is exploding. For the creditworthy individuals, lower payment arrangements are being established. If you are making mortgage payments we encourage you to pay a visit to your local banker and see if the new low rates can help you reduce your financing costs.

We are reminded each time we fill up our gas tanks how much the dive in crude oil prices has increased our own disposable income. The vast majority of Americans benefit when prices fall at the pumps. Just as a tripling of gas prices crippled many consumers, a seventy percent drop in gasoline prices has to make things easier on family finances.

Like oil, other commodity prices have also dropped since last summer. The impact of this shift is beginning to work its way through the system and into the grocery stores. In effect, refinancing activity and the drop in fuel and other commodities is driving up the inflation adjusted wages of Americans.

And for those corporations on Main Street who pay those American wages, there is no doubt that the automobile industry has been severely jolted. Sales have returned to levels not seen since 1982 and 1991. Strangely enough these periods marked the bottom of economic cycles.

Besides the automobile slump, other big ticket spending items are also in troughs. We note that we have now reached levels in this area not seen since the year of 1982; ironically this juncture marked the dawn of a remarkable new beginning of prosperity for investors.

After bashing the fear mongering campaigns orchestrated by the political leadership of both parties in the fall, perhaps it might be time to give leadership a little credit as well. When looking at this recession it is important to take note of both monetary and fiscal policy. The bottom line is in both of these areas, government actions are increasing the money supply; an increase in the money supply will be crucial to shake the U.S. out of the downturn. Fortunately these measures have also been rising fairly steadily for many months. And despite what you might think about an economic stimulus package, we have been convinced by noted economists like Richard Koo of the Nomura Research Institute and others we admire that a stimulus package is necessary and will be forthcoming.

Now that we have reviewed the signals, what does it all mean and how do we tune out the noise? When we review the stock market troughs in 1902, 1906, 1919, and 1974 we are amazed at how breath-taking the falls were before remarkable rebounds. When we look at the decline in 1929 we shudder and take comfort in the safety nets and systems implemented since the depression which we feel make a repeat scenario very unlikely.

We feel that most of the moving parts are in place for a great investment opportunity. Price to earnings ratios on stocks reflects the incredible contraction in confidence. Will there be another depression? Not only do we hope not, we think not. Are there any guarantees? Unfortunately no. How long will it take for the economy and the markets to recover? This will regrettably depend on the political noise generated and the resulting ability to restore confidence. The signals that we mentioned above suggest that this process has begun.

Finally, the historical data we have reviewed suggests that those who are the first to regain their confidence or retain their confidence will benefit most from the depressed prices that this crisis has created. We must quiet the noise and heed the signals- financial signals and those signals apparent in our every day lives.

—Jim Spence, Registered Principal, Spence Asset Management

Spence Asset Management, Inc.
2455 E. Missouri Ave. Suite A Las Cruces, NM 88001 575-556-8500

Securities offered through: Cambridge Investment Research, Inc. • Member NASD/SIPC

Investment Advisory Services offered through Spence Asset Management, Inc., a Registered Investment Adviser Cambridge Investment Research and Spence Asset Management are not affiliated The views expressed here are those of Spence Asset Management and are subject to change with market conditions. The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes investment advice or a solicitation for the purchase or sale of any security. Market forecasts cannot be guaranteed. Past performance does not guarantee future results.