Oak Library

Economic Update: February, 2009

By Mark Oelschlager, CFA
February 24, 2009

It has been a harrowing few weeks for the market, as the Dow and S&P 500 have both pierced the November lows. One can never know for sure what is driving the market, but the latest downdraft is being chalked up to some combination of economic weakness, dissatisfaction with the stimulus package, and fears of bank nationalization.

Everyone knows the economy is weak, so it isn’t news when there are weak data points reported. While there had been signs of strength (higher retail sales, a jump in the Baltic Dry Index, and higher existing home sales, to name a few), when some of the recent data did not confirm those signs, it spooked the market. It does appear that the rate of economic contraction is slowing, which is good, since before we grow we have to slow the rate of deterioration.

Dissatisfaction with the stimulus package is not surprising, as it smacks of exploitation of a situation for political gain and may very well have little impact on the economy. We do like the tax cuts, but question the wisdom behind some of the giveaways. What may end up happening is that the economy recovers on its own, for other reasons, yet Washington is able to say it saved the day.

With things so dire, what reason is there to expect economic recovery? A couple things. First, the amount of stimulus in the pipeline is huge. With the dramatic interest rate cuts and the Fed pumping so much liquidity into the system, we have the fuel to get the economy going again. But this doesn’t work immediately; it works with a lag. Speaking of fuel, the decline in gas prices is another tailwind that, while it takes time to work its way through the system, should eventually help.

Another sign that the economy may turn around is the slope of the yield curve. The yield curve historically has been an incredibly prescient forecaster of the economy. When it is upward sloping, it is forecasting economic strength. When it is flat or inverted, it is telling the market that economic weakness is on the horizon. Two to three years ago the curve was flat or slightly inverted, so it was forecasting an economic downturn. But the economy was strong at the time, and few people could see anything that could derail it. Various experts declared that the slope of the yield curve didn’t matter anymore – that it had lost its predictive ability. In hindsight, it was dead on, and it was the majority of experts who were wrong.

Today, gloom prevails, yet the upward sloping yield curve is telling us that things are going to get better. Of course, it could always be “different this time” (which is the most dangerous phrase in investing), but it doesn’t appear to be a bet worth making, especially given the prevailing valuations of stocks.

It might be irresponsible to leave it at that and not mention the unusual nature of today’s economic situation. This isn’t a garden variety recession; it’s a severe global economic downturn accompanied by asset deleveraging and at least a partial breakdown of the financial system. Consumers are acting rationally by increasing their rate of savings. The problem is that this hurts the economy – the paradox of thrift. The deleterious effect on the economy then causes even more thrift, and so on. What the Federal Reserve recognizes is the importance of breaking that spiral, and thus it has flooded the economy with liquidity. This could create an inflation problem in the future, but for now the more pressing issue is breaking the deflationary spiral.

Clearly, confidence in the financial system is key. We don’t think nationalization is the best solution, but capital injections by the government seem sensible. Perhaps most importantly, there needs to be progress on recognizing the true value of financial companies’ assets. Treasury has yet to figure out how to do this, which is not surprising given the competing interests of taxpayers and the companies. Once transparency is increased and uncertainty is reduced, capital should flow more freely.

Getting back to stocks, sentiment this week reached extremely low levels, which of course is usually good for future returns, at least in the short term. On Tuesday Fed Chairman Bernanke’s comments that the banks need not be nationalized sparked a market rally of 4%.

While the seas have been rough, we are pleased with our funds’ year-to-date performance. Through Monday (2/24/09) the S&P 500 was down about 17%, with our diversified funds all outperforming the market. Of course, past performance is not an indication of future results. Please refer to the performance area of the website for the most recent performance information on all of our Oak Funds. That said, we recognize that, as with farming, our efforts today are what determine the yield we realize in the future.

This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.

The Baltic Dry Index is a number issued by the London-based Baltic Exchange. The index provides an assessment of the price of moving raw materials by sea. The S&P 500 Index is a market-value weighted index consisting of 500 stocks chosen for market size, liquidity, and industry group representation, with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.