Insights
Market Commentary - 3rd Quarter, 2008
During the third quarter, the dynamics of volatility, uncertainty and disbelief combined to send the equity markets to levels not seen in several years. While July and August posted relatively lackluster returns, the events that characterized the month of September led stocks to finish the quarter at considerably lower levels. The chart below reflects the market trend for the Dow Jones Industrial Average, the popular market barometer for the US equity market. For the quarter ended 9/30/08, the Dow posted a total return of -3.71% and a -16.59% return year-to-date. Equally disappointing performance for the corresponding periods were reported for the S&P 500 Index at -8.37 and -19.29%, while the NASDAQ wrapped up the quarter lower as well, with returns of -9.19% and -21.49%, respectively.
DOW JONES INDUSTRIAL AVERAGE
Year-to-date ending 9/30/08
Source: Yahoofinance
Though all style returns posted negative results year-to-date, value stocks, particularly in the small cap sector, held up best relative to growth stocks regardless of their capitalization structure. Consumer staples reported single digit losses, on average, while finance, utility and information technology stocks suffered year-to-date losses in excess of 20%.
The crisis of confidence wasn’t contained to the US markets, as all but 10 countries worldwide posted losses for the quarter. Interestingly, despite ties to the US, the stock market in Puerto Rico enjoyed a gain of 17.9%, while Iceland posted the largest loss for the quarter at - 22.43%! Year-to-date, the country of Ghana gained 64.72%, while the Ukraine all but collapsed with a whopping loss of 68%, followed very closely by devastating results from the stock markets of China, Romania and Bulgaria. (See the table below)
The credit crisis, fueled by the sub-prime debacle in the US, spread broadly across the globe and spilled over into the equity markets of nearly every country. Unlike crises in the past, the inter-connectiveness of the world markets has changed dramatically, where news can now be relayed instantaneously via the internet. Moreover, the widespread growth of the derivatives market over the past few decades, along with other complex product structures, created a complicated web which was further masked because of the effects of leverage! In the graphic below, note how $600 billion in sub-prime mortgages became a multi-trillion dollar mess, and contributed to the concern over counterparty risk after the mid September failure of Lehman Brothers. Only time will tell if the decision to allow Lehman to fail exacerbated the subsequent breakdown of the financial markets, as AIG and other industry giants collapsed in various measures like dominoes.
Source: Bespoke
In a mere two weeks, from mid-September through month end, Lehman filed for bankruptcy, Bank of America purchased Merrill Lynch, AIG was given an $85 billion loan from the Government and Citibank took over Wachovia Bank. Morgan Stanley and Goldman Sachs gave up their status as investment banks and became traditional Commercial Banks, while Washington Mutual was seized by regulators and then sold to JP Morgan.
Note also, that there were dozens of failures, takeovers, bailouts, market collapses and other similar events that occurred concurrently in Europe, Asia and the rest of the world! During a period of disbelief and astonishment, US Treasury Secretary Henry Paulson introduced a $700,000,000,000 ($700 BILLION) package to “bail-out” Wall Street and the banking system. This transpired amid stressed filled days of political opposition to the plan from the House of Representatives and heated debates in the media by nearly every economist and financial reporter that had an opinion. After the shocking “no” vote by the House, Wall Street reacted with disappointment and sent the Dow Jones Industrial Average plunging, by over 777 points, in it’s largest point loss ever!
Source: WallStreetJournel
Many of you recall the day the stock market crashed in 1987. This recent decline too, will go down in history. However, as we’ve become immune to enormous volatility, the entire September sequence of events, rather than that individual point loss on September 30th, will be what’s remembered. Looking ahead, it was not until shortly after the quarter ended that Congress finally passed the $700 Billion bailout bill….but that’s a story for the next quarterly commentary. The good news is that the Federal Reserve and other Central Banks around the world moved quickly, working together, to recapitalize the banking industry in an attempt to restore order and to keep the global banking system in tact as the crisis gained momentum.
We’re hopeful, however, that well documented mistakes of past crises, will not be repeated, including those that led to the Japanese Banking Crisis in the early 1990’s and the Great Depression. Poor decisions by the Federal Reserve during 1929, allowed the money supply to shrink by 25%, resulting in sharp deflationary pressures. You may recall that the US was still on the gold standard, so regulations were partly to blame, as limitations required that credit be backed by gold (see below).
Large bank failures, including the Bank of the United States, which failed in 1929, produced panic and widespread runs. Meanwhile, the Federal Reserve didn’t react quickly or sufficiently enough and businessmen could not get new loans, or have their old loans renewed. As a result, many were forced out of business. Unemployment rose to 25%…and the downward spiral continued. Nearly 80 years later, in 2008, despite general commotion, history once again is being made in an attempt to restore order to the financial markets and to keep the global banking system from collapsing. While some suggest stimulus may have come a bit too late to avoid a global recession, it may have been enough to stem the financial bleeding and keep the world economies from the unthinkable.
Much like a long garden hose, when the water is turned on, it takes a while for it to flow through the length of the hose before water begins to emerge from the other end. The seven hundred billion dollars recently added to the system via Wall Street to liquefy the US economy, will also take time to find its way through to Main Street. We are optimistic, nonetheless, that the current recession (official or not), under a new administration in the White House, will ultimately run its course and give way to better days ahead.
While there continues to be lots of finger pointing to assign blame for the current financial fiasco, availability of credit, particularly in the short-term fixed income markets, has been prominently at the heart of the issue. In the chart below, note the significant decrease in short-term rates and the considerable steepening of the yield curve as of 9/30/08.
Roughly two years ago, at year-end 2006, while the economy continued to show growth, the spread difference between the 30-year Treasury Bond and the 3-month Treasury Bill was -20 basis points (4.81%-5.01%). This generated a flat/negatively sloped yield curve. Historically, a curve in this shape has forecasted a subsequent period of recession. Since then, the Fed had begun easing monetary policy and lowering interest rates, such that the spread at year end 2007 turned positive, at 121 basis points (4.45%-3.24%). Interestingly, as of September 30, 2008, the yield curve steepened further, to a whopping 338 basis points (4.30%-0.92%)! Optimistically speaking, this suggests that a period of growth is forecasted for the future, as a positively sloped yield curve has historically led to a stronger economy. But patience is required as lead times generally are in the range of 12-18 months. The chart below further illustrates the yields in the various maturities, including the changes from period to period.
While interest rates dropped substantially during the third quarter, the main thrust was a flight to quality, as investors sought haven in US Treasuries, particularly short term Treasury Bills, where by mid-September, investors became so risk averse that they were willing to accept as little as 0% on 1 month T-Bills and not much more for 3-month T-Bills!
The flight to Treasuries and Treasury money market funds was further precipitated by a scare in the short term markets, as the unit value of the Reserve Primary Fund, a prominent money market fund, dropped below the standard $1.00 per share. With trillions of dollars invested in such funds, considered historically to be safe havens for cash because of their very short maturity, high quality and excellent liquidity, the fact that one fund “broke the buck” sent jitters throughout the markets. The Federal Deposit Insurance Corporation (FDIC) stepped in quickly and eased investor’s concerns as many of these funds became eligible for FDIC insurance…at least for a while. The FDIC bank limits were also increased to ease investor concerns and prevented the potential outflow of deposits from banks where individual limits had been exceeded.
In the international markets, LIBOR, the London Interbank Offered Rate (the rate banks charge each other for loans) surged to nearly 4% during this period. As a result, it became extremely difficult for corporations to borrow in the money markets, as many loans are tied to spreads over the Libor rate.
This affected the TED Spread, which represents the difference between interest rates on 3-month inter-bank loans via LIBOR and short-term US Government debt via 3-month Treasury Bills. (TED: T=Treasury ticker; ED= Eurodollar Futures Contract ticker). Wall Street analysts increasingly refer to this Spread, which suggests that a rising trend forecasts a downturn in the US stock market, as liquidity is withdrawn. While the TED Spread has generally fluctuated within a range of 10-50 basis points, note that the spread as of Sept 30th had risen to roughly 350 basis points, and is clearly heading higher.
S ource: BearingAsset.com
Remember, when interest rates move higher, bond prices move lower. However, given the illiquidity in the system and the flight to quality, it was primarily the very short maturity segments, as well as the very high quality sectors (AAAs and Government issues) that performed best. Long term maturities and lower quality issues generally did poorly, while the financial sector, not surprisingly, posted the worst results.
Source: LehmanLive
Yields on high yield “junk” bonds also surged upwards from their trough levels, with spreads (difference in yields versus Treasury bonds) approaching the peak levels of October 2002. In other words, with the 10 year US Treasury yield at roughly 3.8% and a high yield spread of roughly 1100 basis points, companies with “junk” ratings had to pay close to 15% to borrow money! Spreads also widened in the investment grade companies, to over 400 basis points more than comparable maturity Treasuries.
Source: Loomis Sayles
Spreads between US Treasuries and mortgage related issues, which had spiked early in the year after the Fannie Mae and Freddie Mac debacle unfolded, rallied and then moved up again dramatically in Mid-September, after credit concerns heightened again.
On the mortgage front, with residential real estate and the irresponsibility surrounding the sub-prime lenders still topping the blame chart, the problems continue, with realistic expectations that an additional 10%-20% downside in real estate is likely.
There are more than 10 million homeowners (1 in every 6) that are underwater (negative equity), with mortgages greater than the current value of their homes. As such, it is likely that we will see more foreclosures over the next several months. Of those who purchased their home in the past five years, 29% have negative equity, while for those who bought homes in 2006 and 2007, the percentages are 4% and 6%, respectively.
Also, with consumer confidence and consumer spending levels near extreme lows, one might suspect that US economic conditions are approaching a bottom in which some level of stability may be on the horizon.
Though the stock market has factored in much of the negativity and pain that has accompanied the economic downturn, the road to recovery is much like a fever that gets worse just before it breaks…and health ultimately restored. The current health of the economy, including employment conditions and productivity, vary considerably throughout the country. Just because a national recession hasn’t been declared officially, doesn’t mean that one doesn’t exist, While most of east and west coast metropolitan areas are experiencing recession or near recessionary conditions, many in the mid-west and mid-south continue to enjoy growth.
Source: NY Times
A recent bright spot in the economy has been that food and energy prices have come down considerably from the highs seen during the previous quarter. Gas prices had spiked upwards to sky high levels, and impacted the driving and traveling habits of virtually the entire nation. The chart below estimates that the impact of the recent change has already had dramatic affect on individuals and their average daily cost of living.
Source: Bespoke
The good news on the inflation front, however, has had little impact to mitigate the anxiety caused by the “Fear Index”. This index, otherwise known as the VIX (Volatility Index), is another measure frequently cited by the financial media. It is an implied measure of volatility based on a weighted blend of prices for the range of options on the S&P 500 Index. A high level on the VIX suggests increased market uncertainty, while a lower number points to greater stability in the market. For example, if the VIX was reported at 15%, the formula would predict a 68% change (one standard deviation) in the magnitude of the S&P 500 Index and a change of +/- 4.33% during the upcoming month. (For the technical geeks, the formula is the % volatility divided by the square root of 12 (months
Compared to its long-term mean of 19%, the VIX, at the end of September, was dramatically higher, at 48.36%, suggesting that the S&P 500 Index would the likely move plus or minus roughly 14% over the next 30 days!
Still, there is more positive news on the horizon based on the longer term technicals. In the chart below, you’ll notice the 10-year moving average of Large Cap stocks approaching a quintuple support level, from which the stock market has historically reversed course, developing into a positive trend.
Source: Stifel Nicholas
While it’s likely that there may be more downside through year end, it seems that we’re fast approaching a market bottom. An increase in the value of the US dollar, along with a dramatic reversal of the upward surge in oil and gas prices, as well as in other commodities, has had a beneficial effect for US consumers. Though a stock market bottom may be in sight, we feel that we are likely to remain in a trading range for the foreseeable future.
Over the next few quarters, we expect that we will have seen the worst of the failures in the financial markets. Also, despite the likelihood for several quarters of slow or no economic growth, the positive affects of the current recapitalization of the financial system should begin to become evident.That said, we have continued to maintain a cautious market outlook. Earlier in the year, we advised our clients to increase their cash positions by 30%-70%, depending upon their investment objective and their individual risk tolerance. We have only recently, however, begun to consider reinvestment of these assets, most of which have been invested in US Treasury money market funds during the interim. Our strategy is to begin reinvesting roughly 20% of our cash positions each quarter, for the next 5 quarters, as the Dow Jones Industrial Average falls beneath the 8500 level. Depending upon market circumstances, we could potentially increase our target reinvestment rate to as much as 40% if the Dow should fall to the 7000 range.
Our current focus is primarily on the higher dividend producing stocks, though as extreme values are identified in various sectors, we will look to rebalance our model portfolio weightings of Equities (US, international, emerging markets and private equity), Bonds (US and International), Real Assets (real estate, commodities, Treasury inflation protected securities, Infrastructure) and Special Opportunities as they arise.
Clearly, this has been a very difficult environment. Market setbacks such as this are likely to be a once in a lifetime experience, though there are still many who remember the Great Depression from their youth. Nonetheless, tough times are generally followed by periods of good returns.
We also acknowledge that emotions are running high, fueled by uncertainty and unusually elevated volatility in the markets. As always, we are available to review your long-term plan and your portfolio asset allocation, where we continue to stress the importance of diversification. Please don’t hesitate to contact us, as we welcome your thoughts, questions and concerns.
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