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Markets Gone Wild :Surviving Sub Prime, Black Swans and Market Turmoil
John Cassady, CFA
Senior Portfolio Manager
Fifth Third Asset Management, Inc. (FTAM)
2
Homes Now Equal to 2000 Stock Levels
Source: Bianco Research
The "New" American DreamEquity in Household Real Estate Versus Direct Stock Ownership
0
1
2
3
4
5
6
7
8
9
10
11
12
1952 1956 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008
Tri
llio
ns
of D
olla
rs
0
1
2
3
4
5
6
7
8
9
10
11
12
Tri
llio
ns
of D
olla
rs
Equity in Household Real Estate(Fine Line)
Direct Stock Ownership (Heavy Line)
3Source: Bianco Research
Sub Prime Contagion
ABX Indices: 06-02 Series - Price
2/27/0790.17%
2/27/0763.16%
2/20/07
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
105%
8/1/
06
8/15
/06
8/29
/06
9/13
/06
9/27
/06
10/1
2/06
10/2
6/06
11/9
/06
11/2
4/06
12/8
/06
12/2
2/06
1/9/
07
1/24
/07
2/7/
07
2/22
/07
3/8/
07
3/22
/07
4/5/
07
4/19
/07
5/3/
07
5/17
/07
6/1/
07
6/15
/07
6/29
/07
7/16
/07
7/30
/07
8/13
/07
Per
cent
of
Par
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
105%
Per
cent
of
Par
ABX-HE- BBB- Index
ABX-HE- A Index
ABX-HE- AAA Index
BBB
Current Loss Outlook
(62.5%)
BBB
Historical Worst Case
1999 = (5.25%)
Crisis I
2/27/07
4
Jumbo 30-Year Fixed Mortgage Rates vs.Conforming 30-Year Fixed Mortgage Rates
5.00%
5.50%
6.00%
6.50%
7.00%
7.50%
8.00%
8.50%
9.00%7/
17/1
997
1/1/
1998
6/18
/199
8
12/1
0/19
98
5/27
/199
9
11/1
1/19
99
4/27
/200
0
10/2
6/20
00
4/12
/200
1
10/4
/200
1
3/21
/200
2
9/5/
2002
2/20
/200
3
8/7/
2003
2/12
/200
4
7/29
/200
4
1/13
/200
5
6/30
/200
5
12/1
5/20
05
6/1/
2006
11/1
6/20
06
5/3/
2007
10/1
8/20
07
Rat
es
5.00%
5.50%
6.00%
6.50%
7.00%
7.50%
8.00%
8.50%
9.00%
Rat
es
Jumbo Mortgage Rates(More Than $417,000)
Conforming Mortgage Rates(Less than $417,000)
Source: BanqQuote
Source: Bianco Research Updated 8/31/07
Contagion – Part 1
5
Honey, I NUKED the Hedge Fund
$
$ $
$ $
$ $
Hedgie raises $1,000,000.
There are 10,000 Hedge Funds today.
1) 2)
Wall Street Bankers lend Hedgie
$5,000,000 more, @ 6% interest.
3) Hedgie invests $6,000,000 @ 8% interest.
$6,000,000 x 8%
$480,000(300,000)$180,000
$1,000,000
ReturnGross ReturnInterest Expense (Wall Street loves Hedgie)
18% return, Collect big fees
4) Uh oh, here comes the black swan…
$6,000,000 x (.20)
($1,200,000)$1,000,000
Bond prices decline 20% 100 80.
Busted, margin call’s incinerate principal.
$ $ $ $ $ $X X X X X X
6
30 Day AA-Rated Commercial Paper Rates
8/2/2007, 5.32
5.00
5.10
5.20
5.30
5.40
5.50
5.60
5.70
5.80
5.90
6.00
6.10
6.20
4/2
7/2
00
7
5/7
/20
07
5/1
4/2
00
7
5/2
1/2
00
7
5/2
9/2
00
7
6/5
/20
07
6/1
3/2
00
7
6/2
0/2
00
7
6/2
7/2
00
7
7/5
/20
07
7/1
2/2
00
7
7/1
9/2
00
7
7/2
6/2
00
7
8/2
/20
07
8/9
/20
07
8/1
6/2
00
7
8/2
3/2
00
7
8/3
0/2
00
7
5.00
5.10
5.20
5.30
5.40
5.50
5.60
5.70
5.80
5.90
6.00
6.10
6.20
Financial Non-Financial
Asset Backed
Source: Bianco Research
Outstanding Levels of Asset-Backed Commercial Paper
9/5/2007, 966.70
8/8/2007, 1,182.85
900
950
1,000
1,050
1,100
1,150
1,200
5/3/
2006
6/28
/200
6
8/23
/200
6
10/1
8/20
06
12/1
3/20
06
2/7/
2007
4/4/
2007
5/30
/200
7
7/25
/200
7
9/19
/200
7
Bill
ion
s o
f D
olla
rs900
950
1,000
1,050
1,100
1,150
1,200
Bill
ion
s o
f D
olla
rs
Money Market Meltdown - Liquidity Seizure
7
-6%
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
Jul-0
0Oct-
00Ja
n-01
Apr-0
1Ju
l-01
Oct-01
Jan-
02Apr
-02
Jul-0
2Oct-
02Ja
n-03
Apr-0
3Ju
l-03
Oct-03
Jan-
04Apr
-04
Jul-0
4Oct-
04Ja
n-05
Apr-0
5Ju
l-05
Oct-05
Jan-
06Apr
-06
Jul-0
6Oct-
06Ja
n-07
Apr-0
7Ju
l-07
% Change
90
100
110
120
130
140
150
Jan-
00
Apr-0
0
Jul-0
0
Oct-00
Jan-
01
Apr-0
1
Jul-0
1
Oct-01
Jan-
02
Apr-0
2
Jul-0
2
Oct-02
Jan-
03
Apr-0
3
Jul-0
3
Oct-03
Jan-
04
Apr-0
4
Jul-0
4
Oct-04
Jan-
05
Apr-0
5
Jul-0
5
Oct-05
Jan-
06
Apr-0
6
Jul-0
6
Oct-06
Jan-
07
Apr-0
7
Jul-0
7
(MM) Units
4
5
6
7
8
(MM) Units
Home Sales Price
Existing Home SalesMonthly Supply
Housing Affordability
Real Estate Story – Looking for a Bottom…
Source: FTAM Updated 7/31/07 Year-Over-Year
8.4Months
4.9Months
2
4
6
8
1/31
/00
4/30
/00
7/31
/00
10/3
1/00
1/31
/01
4/30
/01
7/31
/01
10/3
1/01
1/31
/02
4/30
/02
7/31
/02
10/3
1/02
1/31
/03
4/30
/03
7/31
/03
10/3
1/03
1/31
/04
4/30
/04
7/31
/04
10/3
1/04
1/31
/05
4/30
/05
7/31
/05
10/3
1/05
1/31
/06
4/30
/06
7/31
/06
10/3
1/06
1/31
/07
4/30
/07
7/31
/07
Month Supply
-0.6%
8
Will Housing Prices Collapse?
Since 1985, the 4 worst quarters for average U.S. home prices are:
Q4 1990 -0.47%
Q2 1992
Q4 1994
Q2 2007
-0.23%
-0.25%
-0.60%
But there have been long and more severe local bear markets:
Area Period % Change
New York 4Q 1989 – 2Q 1995 -6.5%
Houston 3Q 1988 – 3Q 1996 -21.4%
Flint, MI
Grand Rapids, MI
Kalamazoo, MI
Detroit, MI
7/06 – 7/07
7/06 – 7/07
7/06 – 7/07
7/06 – 7/07
-8.4%
-3.5%
-5.6%
-30.4%Source: ISI Group
9
Consumer Spending – How Much of a Decline?
'83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06-4-4
-2-2
00
22
44
66
88
1010
(% 1Q Ann) Real Private Consumption (saar) - United StatesRecession Periods - United States
?
10
What will the Fed do? Rate cuts normally Good for stocks.
Source = FactSet/Ned Davis Research
'83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '070
2
4
6
8
10
12
14
Policy Rates Fed Funds Target Rate, Percent - United StatesRecession Periods - United States
1) S&P 500 up
31.6% in 1985. 2) S&P 500
up 31.3% in 1989. 3) S&P
500 up 37.4% in
1995.
4) S&P 500 down 11.8% in
2001.
11
Above Average Global Growth
Source: World Bank/IMF
World GDP Growth
2.7%
4.8%
2.4%
3.0%
4.0%
5.2%4.9%
5.5%5.2% 5.2%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
12
4.8%
7.3%
1.0%
6.4%
-0.5%
6.4%
-0.5%
1.2%
-1.4%
1.6%
2.7%
2.2%2.4%
0.2%
1.2%
3.5%
7.5%
2.7%3.0%
3.5%3.6%
2.5%
3.1%2.8%
4.5%
1.2%
4.8%
2.4%
1.1%
2.1%
0.6%
4.0%
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
7%
8%
3Q 1
999
4Q 1
999
1Q 2
000
2Q 2
000
3Q 2
000
4Q 2
000
1Q 2
001
2Q 2
001
3Q 2
001
4Q 2
001
1Q 2
002
2Q 2
002
3Q 2
002
4Q 2
002
1Q 2
003
2Q 2
003
3Q 2
003
4Q 2
003
1Q 2
004
2Q 2
004
3Q 2
004
4Q 2
004
1Q 2
005
2Q 2
005
3Q 2
005
4Q 2
005
1Q 2
006
2Q 2
006
3Q 2
006
4Q 2
006
1Q 2
007
2Q 2
007
0%
1%
2%
3%
4%
5%
6%
7%
Unemployment Rate
Average Growth Rate for GDP
3.1%
Unemployment Rate & Real GDP
Source: FTAM (Q2, Advance)
13
0.50%
0.75%
1.00%
1.25%
1.50%
1.75%
2.00%
2.25%
2.50%
2.75%
3.00%
3.25%
3.50%1
99
4
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
An
nu
al r
ate
of c
ha
ng
e
0.50%
0.75%
1.00%
1.25%
1.50%
1.75%
2.00%
2.25%
2.50%
2.75%
3.00%
3.25%
3.50%
An
nu
al r
ate
of c
ha
ng
e
Core CPI
Core PCE
Core CPI vs. Core PCE
Fed Focus – Core Inflation Measures
Source: Bianco Research
14
Percent Change in Real GDP by State 2005-2006
Source: U.S. Bureau of Economic Analysis
15
0
200,000
400,000
600,000
800,000
1,000,000
1,200,000
1999 2000 2001 2002 2003 2004 2005 2006 2007
U.S. Michigan
Motor Vehicle & Parts Manufacturing Employment
1999 – 2007 April
April
Source: BLS
1,128,400
189,000
316,300
846,900
U.S.: -281,500 or –25%
Michigan: -127,300 or –40%
16
23.0%
9.5%
6.5%
35.5%
15.3%
23.9%
13.1%12.2%
16.3%
7.6%
6.2%
4.5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
FORD
HONDA
Source: Autodata, Updated 7/31//07
Detroit Drops; Asia GainsU.S. Market Share of Major Automakers:
TOYOTA
NISSAN
CHRYSLER
GM
17
-5
0
5
10
15
20
25
92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07
(%)
-200
0
200
400
600
800
1000
Source: ISI Group
U.S. Mtg. Equity Withdrawal
House Price Index
(000)
millions
MEW Declines – Bad News for Detroit
18
-15-27
7.6
-11-29
13.5
-12
-32
17.4
-11
-33
13.4
-8
-26
-3.7
-90
-80
-70
-60
-50
-40
-30
-20
-10
0
10
20
30
40
2002 2003 2004 2005 2006
Ford Funding Shortfall
Pension OPEB Shareholder Equity
-25
-51
7
-8
-57
25.2
-9
-61
27.8
-5
-65
14.7
5
-51
-5.4
-90
-80
-70
-60
-50
-40
-30
-20
-10
0
10
20
30
40
2002 2003 2004 2005 2006
GM Funding Shortfall
Pension OPEB Shareholder Equity
Post-Employment Healthcare Costs
Source: Bank of America, Bloomberg, 10-Ks
$ billion $ billion
Book Value/Share
-9.62
Book Value/Share
-2.58
19
2007 – A Turning Point for the Big 3
Master Contract Negotiations – September 2007
• Wage Rates – Need to come down
• Productivity Enhancement – More flexible work rules
• Healthcare Costs
• Legacy and existing workers
• Need to erase a $1,500 per vehicle cost disadvantage
• Can a VEBA cure the healthcare crisis for the Big 3?
Chrysler – What can Cerberus do that Daimler couldn’t?
A seminal moment for the UAW and the domestic auto industry…
20
4.91%
2.13%
4.55%
13.54%
15.79%
10.39%
18.44%
26.34%
5.20%
8.06%
1.42%
9.11%
Standard & Poors 500Index
NASDAQ CompositeIndex
Russell 2000 Index
MSCI EAFE
12/31/2005 12/31/2006 8/31/07 YTD
Common Stock Total Returns
Source: FTAM
21
43.00%
15.20% 15.50%
30.80%
83.00%
5.80%
19.60%
34.90%30.40%
13.70%
-5.94%
1.20%
15.60%
34.87%31.38%
5.08%5.68%
19.89%
8.63%
-0.99%
18.09% 18.89%
-20.00%
0.00%
20.00%
40.00%
60.00%
80.00%
100.00%
iSharesBrazil EWZ
MS E.Europe
Fund RNE
India FundIFN
iSharesCanadaEWC
iSharesAustralia
EWA
iSharesChina FXI
iSharesJapaneEWJ
iSharesSouth
Africa EZA
iSharesGermany
EWG
iShares UK EWU
US SpidersSPY
2006 2007 YTD
Source: Bloomberg Updated 8/31/07
Global ETF Returns US$
22
What stock traders are watching: Earnings
YoY Growth in S&P 500 Operating Earnings
7.4%
11.7%9.5%
21.3%
25.3%
16.8%
19.7%
13.9%11.7%
16.0%14.9%
16.3%
22.0%
11.4%
4.4%5.8%
11.5%
4.2%
14.4%
27.5%28.3%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
*NOTE: Current top-down estimate.
Source: FirstCall
23
'79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '0755
1010
1515
2020
2525
3030
Standard & Poors 500 Index, 12 Month Forw ard P/E Ratio, Ratio - United States
Stock market valuation is still about average…
Source = FactSet
High inflation...
Internet euphoria…
24
Vice vs. Virtue
90%
100%
110%
120%
130%
140%
150%
160%
170%
180%
190%12
/31/
2003
3/15
/200
4
5/25
/200
4
8/6/
2004
10/1
8/20
04
12/2
9/20
04
3/11
/200
5
5/23
/200
5
8/3/
2005
10/1
3/20
05
12/2
7/20
05
3/10
/200
6
5/22
/200
6
8/16
/200
6
10/2
6/20
06
1/12
/200
7
3/27
/200
7
6/7/
2007
8/17
/200
7
10/2
9/20
07
90%
100%
110%
120%
130%
140%
150%
160%
170%
180%
190%
Vice: The Mutuals.com Vice Fund
Virtue:The Domini Social Equity Fund
Source: Bianco Research
More Profitable being Naughty not Nice
25
Fixed Income Total Returns
2.74%
1.58%
2.43%
1.77%
3.07%
11.85%
4.08%
4.33%
4.25%
4.85%
0.58%
3.64%
3.07%
3.94%
3.79%
LB High Yield
LB IntermediateGovt/Corp
LB Aggregate
LB 1-3 Year Govt/Corp
90-Day T-Bills
12/31/2005 12/31/2006 8/31/07 YTD
Source: FTAM
26
'98 '99 '00 '01 '02 '03 '04 '05 '06 '07
-60-60
-40-40
-20-20
00
2020
4040
6060
8080
100100
Stock Valuation Model
10-year Treasury Yield vs. SPX Earnings Yield
Bonds Attractive
Stocks Attractive
Fundamentally - Stocks Still Attractive Versus Bonds…
Source = FactSet
27
6.16
7.11
4.82
4.774.83
5.28
4.794.804.80
6.09
5.515.525.545.54 5.57
4.104.20
4.13 4.144.24
4.53
3.50
4.00
4.50
5.00
5.50
6.00
6.50
7.00
7.50
3 Month 6 Month 2 Year 3 Year 5 Year 10 Year 30 Year
(%)
YT
M
Treasury Yields vs. After Tax Muni YieldsLong Munis are Cheap
AAA Muni
35% Tax Bracket
U.S. Treasury
AAA Muni
25% Tax Bracket
Source: Bloomberg, Municipal Market Data Updated August 31, 2007
28
Investment Management Tactical Outcomes
Value add: +4.16% +0.14% +1.76% +1.17% +0.61%
Source = FactSet
'03 '04 '05 '06 '07700
800
900
1,000
1,100
1,200
1,300
1,400
1,500
1,600
Small & Midcap stock bias
Large cap bias
Remove largecap bias Started
incrementalgrowth
bias
Lengthenedbond maturity
Largecap&
internationalbias
Raised 3% cash
Reinvested cash
Lengthenedbond maturity
Shortened bondmaturity and
added tointernational.
Incrementaladd to Intl.
stocks.
Lower stockov erweight f rom
6% to 3%.
Last: 1451.70 (10-SEP-07)
Standard & Poors 500 Composite Index, Price Return, USD, Close - United States
29
Items of Consideration for Investors
1. The national economy will weather the sub-prime storm, but it will be a drag on growth for the next year. There is no reason to expect a quick turn around, so growth will be sub –3.0% into 2008.
2. The struggles of Ford and GM will overshadow the Midwest economy for at least the next 2 years. Economic fundamentals are much stronger today than they were in the past which will mitigate the economic impact on the Midwest economy, though we will still lag the national economy.
3. Remember the importance of diversification and re-balancing in your portfolios for long-term performance.
4. Volatility is to be expected in financial markets, what matters is earnings growth still supports stock valuations, keeping P/E multiples reasonable.
• At current levels S&P 500 is selling for 15.7x the 2007 estimates and 14.8x the 2008 earnings estimates. 25 year average is 20.4x, 50 year average is 17.5x, and 81 year average is 15.9x.
• This is not an expensive market.
5. International stocks represent near and long-term opportunity.
6. Current 2007 domestic biases include . . .
1. Stocks over bonds.
2. Large Cap stocks over Small Cap.
3. Higher quality over Lower quality (stocks & bonds).