November 24, 2009
A year has passed since those trying days in September 2008 during which the credit markets came to a near standstill, Wall Street titans that had survived for over a century saw their future hang in the balance, and the global financial infrastructure was subjected to stresses that had not been witnessed in several generations. Looking back, we now know that the equity markets would not find a cyclical bottom for another six months. However, the rapid collapse of many global financial institutions that buckled under the stress of what became known as “toxic assets” and evaporating faith in their financial health created a state of panic in the market.
After a failed effort to identify a suitor, the unexpected collapse of Lehman Brothers that culminated in its September 15, 2008 bankruptcy changed the rules of the game. Its failure clearly signaled that the Federal Reserve and Department of Treasury should not be expected to always take over failing institutions (as it had with AIG, Fannie Mae, and Freddie Mac) or hastily arrange for a merger with another institution (as had been the case with Bear Stearns and Merrill Lynch among others), even if that institution had been previously perceived by the market to be “too big to fail.” But the mere bankruptcy of Lehman Brothers was not necessarily the catalyst of the ultimate volatility that occurred over the next two months. Rather, the slope of the market losses increased when it became apparent that policy makers were going to let Lehman’s bankruptcy unwind in a disorderly fashion, truly testing the derivative structures that were intertwined between an institution of considerable size and its counterparties around the world. This disorderly unwind caused a seizure in the credit markets, including interbank lending, with LIBOR moving up to over 4% in a short period of time. In response, the credit markets were sent reeling, followed closely by the real economy.
Market volatility soared to levels not seen since the 1930s. Investors piled into Treasuries, driving the yield on the 13-week Treasury Bill from 1.70% on September 1 to an intraday low of .01% on September 18. All eyes turned toward Washington with the markets teetering and the viability of both commercial and investment banks increasingly in doubt. The market swoon intensified after the House of Representatives voted down a rescue package on September 29, driving the Dow Jones Industrial Average down an unprecedented 777 points that day. Despite the ultimate passage of the measure just days later, the stock market free fall continued, culminating in an 18% drop on the S&P 500 during the week of October 6. It seemed that at every turn, the flow of news quickened and worsened. Fears of a 1929 style crash and an economic depression were stoked by every headline until they ultimately became the headline. Without question, the picture was grim. And let’s face it…this was prior to the real economy feeling the brunt force of the credit crisis. Uncertainty is not the market’s friend, and this was apparent at just about every turn through March 9 of this year, as the stock market continued its sharp decline.
Economic Recovery
The current economic picture in the U.S. has brightened substantially in the last six months. On November 24, the Bureau of Economic Analysis will release its preliminary estimate of economic activity for the third quarter. This revision to the advance estimate is broadly expected to show a downward adjustment to under 3.0% annualized growth for the quarter from the initial release of 3.5%. Nonetheless, the economy has clearly moved out of contraction and back into a growth phase. The Index of Leading Economic Indicators has been positive for six consecutive months. Various measures indicate that manufacturing and service sector activity are picking up. The positive effects of the stimulus programs intended to jump-start anemic auto sales (Cash for Clunkers) and home purchases (the first time Home Buyers Credit) both appear to have been successful in generating increased sales activity. In fact, motor vehicle output accounted for nearly half of economic growth for the quarter. Purchases of residential real estate surged by an annual rate exceeding 23%, the first positive quarterly result in nearly four years.
Meanwhile, although there have been some signs of stabilization in the job market, the big picture for job seekers remains grim. The unemployment rate in October increased 0.4% to 10.2%, blowing through the psychologically meaningful 10% threshold and marking the highest point for the jobless rate since 1983. Moreover, the unemployment rate remains a virtual lock to tick higher from here.
While many elements of economic activity appear to have stabilized, we remain concerned that the gains in auto and home sales may be fleeting. We believe that the number of sales under the Cash for Clunkers program was skewed both by individuals who may have temporarily deferred earlier purchases so they could participate and by individuals who accelerated their purchase decisions to benefit as well. The result is that, while the $4,500 credit probably induced some buyers to make the plunge, most would likely have done so anyway. This bunching of sales into a short period juiced the August auto sales numbers, but in September, sales declined by 23%. While sales picked up again in October, they remain well below the August results and are down on a year-over-year basis
Similarly, most expected the expiration of the first time home buyers credit to have a similar impact on home sales volume. In response, and given the program’s success in generating activity, the federal government recently extended that credit well into next year and expanded the program to include existing homeowners. Without question, this program will again come at a price, but the need to continue to stabilize the housing market at this point remains the trump card. With the threat of another wave of foreclosures emerging (this time resulting from Alt-A and Option ARMs) and unemployment still rising, there is a chance that this program will be the equivalent of bailing water out of a boat while water continues to rush in through a crack in the hull. Unfortunately, options to fix the crack itself are limited at best; the authorities are simply trying to keep the housing boat afloat long enough to allow natural demand to increase, thereby allowing the banks and other investors that hold bonds backed by these housing assets to get to shore without drowning.
Most of you will likely recall the political catchphrase that became the core issue of the 1992 Presidential election: “It’s the economy, stupid.” If you’ll permit us to mix this metaphor by tossing in a dash of investment theory from Benjamin Graham, we would take a slightly different angle on the same topic:
“It’s the sustainability, Mr. Market.”
Then and Now
A great deal has changed in the past year. A year ago, a level of fear not seen in a long time was gripping the market; since March, investors have demonstrated their willingness to increase their risk exposure, driving positive returns for risk-oriented investments.
Conversely, ample reasons exist to believe that the economy and banking system are far from out of the woods. A year ago, the viability of large national and global institutions was at the center of concern. A year later, the number of bank failures continues to rise exponentially, but most are comparatively small institutions that individually may seem inconsequential. The collective impact of these continuing failures, however, should not be overlooked. Through November 20, a total of 124 banks had failed in 2009 as compared with just 25 in 2008. The resources of the Federal Deposit Insurance Corporation (FDIC) have been strained as a result, and the agency is scrambling to replenish its capital while still absorbing losses from further failures, which are sure to happen. The FDIC currently has over 400 banks on their current “watch” list, but some bank analysts believe that over 1,000 banks may fold or be taken over before this market cycle is over. Needless to say, this would put severe stress on the FDIC’s Deposit Insurance Fund.
A strong case can be made that a convergence of positive factors has nurtured an environment in which stocks and other risk assets could rally, which is exactly what the fiscal authorities were hoping to do through the stimulus programs. One way to stop (or at least slow down) a debt deflationary spiral is to inflate asset prices. Investors breathed a sigh of relief that the massive stimulus efforts and direct intervention by the Federal Government, Federal Reserve, and other foreign central banks appeared to be accomplishing the goal of avoiding a continued downward spiral into a deeper crash and depression. While asset prices seem to have stabilized for the time being, Consumer Price Inflation remains low, thereby allowing this support to continue for the time being. Moreover, signs of growth and the potential for a sharp economic recovery further emboldened investors in anticipation of rapidly rising corporate profits.
But as can be seen in the chart below, bank loans have contracted since the fourth quarter of 2008 when many companies had to draw on lines of credit. Subsequently, many companies circumvented the banks and accessed credit markets directly, which has contributed to the stabilization of the economy. Credit growth is a sign of a growing economy. Eventually, a growing economy will likely need bank loan growth to get back to a positive trend.
In the second part of this commentary that will be released next Tuesday, we will shift our focus to expectations for both the economy and capital markets in the near term and over the long term. We will specifically examine the prospects for growth, its impact on corporate profits, the long-term threat posed by the accumulation of debt that threatens long-term growth, and alternative paths to addressing America’s debt burden.
Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.
Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other source believed to be reliable. However, some or all information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis non-factual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.
Plante Moran Financial Advisors publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the sectors mentioned herein may not be appropriate for you. You should consult a representative from Plante Moran Financial Advisors for investment advice regarding your own situation.