Equity markets across the globe reflected a rough start to 2008. Value-oriented categories weren’t down as much as the growth categories were, but there was no refuge to be found among equities. The only area showing a positive return was the bond market, as declining yields in both short- and long-dated bonds with good credit quality produced strong returns.
The weakening economy, coupled with the credit crisis that’s roiling financial markets, has prompted the Federal Reserve to more than halve the Fed Funds rate since September 2007. In addition, the Fed has initiated some creative policy changes to help ease liquidity for financial institutions. The Fed has opened its credit facility to investment banks and is now taking non-Treasury assets as collateral for loans. These actions were taken in order to prevent a repeat of the Bear Stearns debacle, which caused the Fed to step in and broker a sale of the company at a bargain basement price to JP Morgan in mid-March.
These steps helped calm the market. While the Dow Jones Industrial Average has been volatile, it has not dipped below 12,000 since the Bear Stearns deal was announced, despite some negative economic news. In addition, the yield spread on agency mortgage-backed securities relative to Treasury bonds has come off its high, indicating the market is regaining some confidence in these securities.
Analysts expect more interest rate reductions as news continues pointing toward a recession. Durable-goods orders are down, and the housing market remains under duress. Continued declines in these areas will translate to fewer jobs. One bright spot for the economy is exports, which are up because the weak dollar makes U.S. goods more price-competitive abroad. Unfortunately, the weaker economy has yet to translate into lower inflation. The weak dollar and rising commodity prices are keeping prices at the upper end of the Fed’s comfort zone.
The economic outlook and the market volatility are unnerving. Staying the course with investment strategies becomes difficult when indicators point to continued weakness. However, investors should take heart: History shows that the stock market has recovered faster than the economy. The following chart shows the rolling 12-month returns for the Standard & Poor’s 500 Index1 since 1964, with the highlighted areas representing official economic recessions during that time period. In each recession, the S&P 500 recovered before the end of the recession.
Market participants are looking ahead, and prices should reflect expectations.
The decline in stock prices and the sharp rise in Treasury bond prices indicate
the market’s current aversion to risk, but also expectations that conditions
will worsen. The effects of the current crisis are yet to be fully realized,
but if the Fed’s recent actions prevent additional failures on the scale of
the Bear Stearns collapse, the market should begin to look ahead to recovery.