Spring 2009
First Quarter Market Commentary
By Julie Grandstaff, Vice President, StanCorp Investment Advisers, Inc.
After a dramatic rally in November and December, the market experienced an equally dramatic decline to new lows in early March.
The decline in the equity markets was sparked by greater uncertainty regarding the resolution of the financial crisis following Treasury Secretary Timothy Geithner’s announcement of a bank rescue plan that was severely lacking in details. In addition, January economic statistics largely failed to show signs of stabilization, with additional job losses and further declines in home starts and values. The International Monetary Fund (IMF) revised expectations for global growth in 2009 down from 2.5 percent to only 0.5 percent. Further declines in growth are expected in the first half of 2009, followed by stabilization, but not necessarily growth, in the second half of the year.
The market abhors uncertainty. While hopes that the Treasury secretary would be able to announce a workable, detailed plan for removing toxic assets from bank balance sheets were unrealistic, we are left without a clear path for stabilizing the financial system.
The prospect of bank nationalization drove bank stock prices to low single digits. Citigroup stock was valued at $1.65 at its lowest, while Bank of America fell to $2.53. Continued declines in home values coupled with rising losses in credit card and auto loan portfolios raised the prospect for additional losses in financial industry balance sheets, broadening the number of firms at risk. It’s not surprising that an announcement by Citigroup that it was experiencing its strongest operating quarter since 2007 sparked a rally in the stock market in March.
The Treasury secretary’s plan for a public/private fund to acquire distressed bank assets has merit and precedence. Its intentions are similar to the Latin American debt bailout in 1989. In that case, banks were allowed to exchange their claims on defaulting Latin American countries for tradeable securities with U.S. government guarantees known as Brady bonds. The banks were able to reduce the Latin American exposure on their balance sheets. Due to the guarantees, the new securities were worth more than the original loans, and as a result, bank capital was improved. The program was a success all around, restoring confidence in banks, providing a healthy return to investors and minimizing losses to taxpayers.
The mortgage assets at the heart of the current crisis are opaque, and as a result, it will be difficult to get private participation without some government insurance against losses. This appears to be the direction the Treasury is taking.
The decline in the housing market does not yet appear to be bottoming. Valuations continue to slide, inventories remain high and housing starts remain low. The inventory of unsold new homes, as reported by Case-Shiller, continued to rise to a nearly 13-month supply at the end of December; however, the existing home inventory declined to just under nine months. The inventory of unsold homes must be worked down to stop the slide in values.
The Housing Affordability Index, at 158.8 at year-end, is 15.6 percent better than it was in November, and 29.1 percent better than it was at the end of 2007. Federal Reserve Chairman Ben Bernanke aims to keep it there. His plan to buy Treasury securities promises to keep the benchmark rates upon which most mortgages are priced, the 10-year Treasury rate, low. That does not have a direct impact on mortgage loan rates, but over time it will provide an incentive for banks to make loans, instead of hoarding cash in government securities, in order to make a better return. If bank balance sheets can be stabilized, this will be even more likely.
Most of all, we need time. It takes time to plan and implement any program under the best of circumstances. It will take time for the variety of Federal Reserve programs to improve liquidity. It will take time for the Treasury to plan and implement its asset purchase program. It will take time for the federal stimulus package to work its way through the economy. However, much is teed up to help improve the situation, allowing for optimism that we are approaching a corner, if not actually turning it.
Many analysts are anticipating a stronger market recovery than economic recovery. That is certainly possible. Valuations are extremely low, and there is a significant amount of cash on the sidelines. The price earnings ratio on the S&P 500, based on Standard and Poor’s forecast of 2009 operating earnings, is less than 12. The average dividend yield (expected dividends divided by price) for the S&P 500 is 2.73 percent, which is close to the yield on the 10-year Treasury bond. There is a significant amount of uninvested cash as well. Money market assets now exceed equity fund assets, and the more than $8 trillion of cash on the sidelines is close to 80 percent of the value of the U.S. equity market. Since the value of the equity market is down substantially and investors have been traumatized, it could take some time for this money to make its way back to the market. However, the market’s performance has been driven by uncertainty and fear. If we begin to see signs of stabilization, the fear and uncertainty will dissipate, allowing the market to recover.
