Where Do We Go From Here?
by Lyn Hutton, Chief Investment Officer, Commonfund

Summary

• October 2008 will likely be remembered as one of the worst months in the history of the capital markets as all sectors experienced dramatic sell-offs.
• The global economic impact of the credit crisis is expanding and we are likely to experience worsening economic conditions for many months to come.
• Despite the abundance of bad news and likelihood of the deepest U.S. recession since 1980-1983, we do not believe in the “doomsday” scenarios posited by some forecasters and instead expect improving U.S. economic growth later in 2009, and investment opportunities in advance of that turn.

October 2008 will likely be remembered as one of the worst months ever in the history of the capital markets: the Dow dropped 14 percent, the S&P 500 lost nearly 17 percent, and the NASDAQ fell more than 17 percent. Over the last twelve months these same indexes are down 31, 36, and 40 percent respectively. It was even worse outside the U.S. as October saw the MSCI EAFE index fall 21 percent, bringing the total twelve month decline to 47 percent; the MSCI EMF index dropped more than 27 percent in October and is down more than 56 percent over the last 12 months. Worldwide, it is estimated that equity values have been reduced by nearly $10 trillion in October alone. By the numbers, this is the worst equity bear market to date since 1973 – 74 with the September – October 2008 sell-off eerily similar to that in August - September of 1974.

It hasn’t been any better in the fixed income markets. After more than a year of widening spreads across the board, October saw high quality investment grade credit spreads spike to levels not seen since the 1930s and, at the same time, even Treasury bonds had to fight a steepening yield curve. High yield bonds sold at near 18 percent yields and at prices that imply a 17 percent default rate. Similarly, leveraged loans, if they traded at all, were sold at distressed prices never seen since index tracking began in January 1998.

Commodities took their worst single month plunge in 50 years as the DJ-AIG index was down more than 21 percent in October and is off nearly 27 percent over the last twelve months. The prospect of a global recession and the attendant demand destruction was magnified by the continued de-leveraging in the capital markets as many leveraged investors were forced to unwind their short yen or USD positions (boosting both) and long commodities holdings.

Measures of market volatility hit their highest readings ever during October: the VIX reached a level north of 80 on intraday trading and measures of fixed income and commodity market volatility hit record levels. The Bloomberg Financial Conditions Index (“BFCI”), which incorporates historical yields and spreads in money markets, fixed income and equity markets, and measures current financial market conditions in terms of standard deviations away from the long term average, hit a record -10.02 – a 10 standard deviation event! To give this reading some context, the BFCI measured the financial crisis that led to the fall of Long Term Capital Management and Russian debt default in 1998 at -2.65 standard deviations. A “six sigma event,” or six standard deviations away from the average, is one that statistically would occur once every 2.5 million times. In terms of trading days, that’s once every 9,920 years assuming a normal distribution and means that we experienced the equivalent of the “10,000 year flood” in the capital markets during October.

The private capital markets are not immune from the financial market crisis. Early reports lead us to expect private equity, natural resources and real estate valuations will follow the public market trends and show mark downs in asset values – some steep – for the September 30 and December 31 quarterly reports.

Between the steep market declines – impacting everything from 401Ks and personal investment accounts – and the drop in home values, the damage to consumer balance sheets is great; some estimate as much as $8 trillion in NET worth has been lost in the U.S. over the last 12 months. So, it should not have come as a surprise that consumer spending dropped by 3.1 percent in third calendar quarter of 2008 – the most since the 1980 recession – and is likely to fall further.

Has All of the Bad News Been Priced In?

In short, the old adage that “in times of stress, the correlations go to one” has been proven. There has been no place to hide during the capital market melt-down and diversification has been of little benefit over the past few months. While there are signs that the inter-bank funding markets are responding to central bank actions and a strong case can be made that the equity markets are deeply over-sold and could stage a sharp rally – after all, the last week in October was the best week for the S&P 500 in 34 years – the near-term outlook isn’t rosy for long term investors.

The capital markets are pricing a deep recession in the U.S. and in much of the other developed economies along with rapidly slowing growth in the emerging world. Our view is that the worst of the economic data is likely ahead of us – falling industrial production, shrinking corporate profits with the attendant drop in business spending and rising unemployment numbers that could rise above 8 percent in 2009. The U.S. economy could well be in the most severe recession since the 1973-75 or the 1980-83 periods and, after all the revisions are in, we might see as many as four quarters of negative real GDP growth.

With the S&P 500 currently selling at a forward multiple of around 13.7 (assuming earnings of $70 per share with the index at 960), or an earnings yield of 7 percent when the 10 year Treasury is yielding 4 percent, investors have begun to ask: at current levels, have stock prices sufficiently discounted the slowing or even shrinking of top line revenue growth (some owing to the strength in the USD), possibly shrinking profit margins (despite falling material and commodity prices and, with rising unemployment, reduced labor cost pressures)? In our discussions with managers and strategists, one resounding theme we keep hearing is that the price actions in the equity and credit markets over the past several months are not based on underlying company fundamentals, but rather on macro level concerns and liquidity.

This tells us that bad news has been priced in unevenly with some, more recession-resilient sectors possibly oversold, and other sectors poised for further weakness. And we see this in how the market is responding: while October was one of the worst months in U.S. equity markets in history, the last week in October was among the best on record. Volatility of this magnitude is likely to continue for some time.

The Inflation v. Deflation Debate

The largest unknown is whether the significant asset deflation that we have already experienced will lead to outright CPI deflation next year; or, whether the tremendous monetary stimulus already applied will lead to re-inflation. This is one of the biggest challenges facing the Fed currently, and the impact if they get it “wrong” on either front could be severe.

Falling commodity prices and falling import prices – owing to a stronger USD – and rising unemployment numbers that are reducing input cost pressures suggest that the potential for lower prices or, at a minimum, an inability to raise prices, is high. Falling domestic demand can lead to price discounting and it is these twin pressures that make the case for future possible negative headline CPI readings and deflation. On the other side, inflation hawks are worried that the dramatic monetary policy stimulus deployed to rescue the financial system will, if monetized, lead to price inflation and, perhaps, another asset bubble. Still, current pricing in the TIPS market shows that inflation expectations are near zero. Our view is that we will see negative CPI reading but the risk of a “Japan-like” deflation scenario, or worse a 1930’s style deflationary spiral is low.

The Impact of Monetary and Fiscal Policy

The numerous policy responses to the credit crisis from central banks around the world have been significant. A massive amount of monetary easing in the form of very low real interest rates – by some measures, the lowest real rates in a generation – a recapitalization of the financial sector and a substantial increase in money supply has been applied in the U.S. and in most major economies around the globe. And, there is no doubt that additional fiscal policy stimulus in the form of increased government spending and/or tax cuts directed at incenting business spending and job creation is on the way in the U.S. Moreover, the rapid decline in energy costs to the consumer is a form of fiscal stimulus akin to tax relief.

Although low real interest rates incent consumption – both business and consumer spending – and punish savings / the hording of cash, there is little to no capacity in either the consumer or business spending sectors to finance such a turnaround over the near term. While the actions taken by the Fed, U.S. Treasury and other central banks will take time to work through the economy and it could be another six, nine or even twelve months before their effects are fully felt, we believe the actions taken will lead to a return to real GDP growth, at least in the U.S., sometime in the second half of calendar 2009. As noted above, the markets discount the future and are likely to anticipate the economic turn before the economy signals that it has bottomed.

Our Portfolio Positioning

At Commonfund, we are adhering to a back to basics philosophy by sticking with our fixed income and equity bias in favor of large market cap companies with earnings growth (albeit modest), and balance sheet strength because we believe it makes good fundamental sense in the current environment, and we believe these companies will emerge from this downturn stronger. We believe that this positioning should be rewarded assuming that investors again begin paying attention to fundamental company attributes and the markets recommence discerning strong companies and credits from weak ones. In the current market environment, there is little reward and still significant risk of stepping out in traffic.

The shift from negative, slow or below trend economic activity to recovery and accelerating growth has been, historically, bullish for small-cap stocks, momentum strategies, as well as for the early-cyclical, consumer discretionary and financial sectors – a size and sector/”value” bias that we have, heretofore, resisted. Mindful of Jon Templeton’s warning that the four most dangerous words in investing are: “this time it’s different”, we believe that at some point in the future – not too far off – smaller to mid-cap companies (some formerly large cap companies included among them) with good business models for a recovering domestic and global economy, yet with weaker balance sheets and selling at deeply discounted prices, will be compelling. Then, we will become more aggressive and rotate out of the defensive sectors and strategies in all asset classes. Recessions are a recurring part of business cycles, a pressure valve that is released when excesses build, bubbles develop and risk is mis-priced. For some, the dramatic magnitude of market sell-offs and decline in real estate values, has led them to expect a doomsday scenario akin to the deflation of the 1930’s or equity malaise of the 1970’s. While others draw parallels to these periods, we see great distinctions. And for the long-term investor that means that opportunities will emerge.

In the current environment, “capital preservation” remains our guiding principle so that our investors will have funds to re-deploy when the markets turn and they can once again be rewarded for taking risk. We, and our managers, are looking ahead to new opportunities – in the equity markets, in the credit and distressed markets, in commodities and natural resources, in the private equity markets and in the real estate markets – and we will proceed carefully and cautiously as this turning point could be a ways off. We are in “watchful-waiting mode” as the cost of “being early” is great; and so we will be patient, believing that our patience will be rewarded in the long term.

Statements concerning Commonfund Group’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund Group fund. Such statements are also not intended as recommendations by any Commonfund Group entity or employee to the recipient of the presentation. It is Commonfund Group’s policy that investment recommendations to investors must be based on the investment objectives and risk tolerances of each individual investor. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund Group. Commonfund Group disclaims any responsibility to provide the recipient of this presentation with updated or corrected information.