New Market Commentary

Long and Short Term
October 13, 2008

Last week the S&P 500 plummeted 18%, its biggest weekly decline in 75 years. Since the October, 2007 stock market high, the S&P 500 has fallen 40%. Much of the recent market weakness reflects fears about whether the credit crisis will be managed well enough to prevent a more difficult economic environment in the months ahead. Consequently, confidence in the policy makers successfully navigating this period has deteriorated dramatically and swiftly.

Policy makers are clearly aware of the gravity of the economic situation. Already, the Federal Reserve and central banks around the world have poured enormous amounts of liquidity into the global financial system and short term interest rates have been lowered. Nonetheless, lending among banks remains frozen reflecting worries about counter party risk. The Congress has passed and the President has signed the Troubled Asset Relief Plan (TARP) which calls for the auction of problem mortgages. Presumably, this initiative will be activated in the weeks ahead. Late last week the Treasury directed Fannie Mae and Freddie Mac, the now government controlled mortgage entities, to increase their purchases of hard to sell mortgage bonds. This process could be quicker and less formal than the Treasury proposed auctions. Moreover, Treasury plans to purchase non-voting stock in banks. Finally, the Group of Seven finance ministers agreed to work together on the financial crisis.

The technical position of the stock market is deeply oversold. The volatility index (VIX) reached 76 Friday. Investor sentiment is negative, but surprisingly not as extremely negative as at major market lows in the past. The duration of the market's decline at 250 trading days since the October, 2007 peak is relatively short compared to past bear markets. Cash levels in institutional hands are relatively high, largely due to the possible need to fund redemptions. Consumer confidence is at levels similar to major stock lows in 1974, 1982, and 2002. The normalized P/E for the S&P 500 is over 10% below its historical median of normalized earnings. All the market declines since 1945 bottomed within 10% of the median historical normalized P/E ratio. Finally, the market should gain significant support in the area of the 2002 market low, where it is now.

So we believe a decent bounce is ahead for the stock market and the onset of the seasonally positive November-April period reinforces this outlook. Nonetheless, we would expect at least a test of any near-term lows at some point. It is even possible that the market might move to a new low, and the bear market might be extended longer. Much depends upon how successful policy makers are in restoring functionality to the financial system. Moreover, the financial stress has definitely pushed the economy into a recession. How long and how deep the recession will be will continue to be an uncertainty for the market over the near to intermediate term.

The fundamental question is one of growth and how it will be generated. Consumers, which have been the bulwark of growth for the economy, are likely to contract their real spending through 2009. They will continue to suffer from a negative wealth effect brought on by reduction in housing and stock prices. Over time, the impact of the negative wealth effect may fade, but consumers are likely to remain in a more thrifty mode than they have been pursuing for years. Moreover, increased bank regulation and conservative lending practices ensure that credit for consumers will not be as available as in the past. With all the fiscal support in place to support the financial system, it is doubtful that additional fiscal stimulus for consumption will be enacted.

With a constrained consumer and spending of governments at all levels constrained, the burden of growth falls upon capital spending and exports, both of which have been strong recently. Infrastructure needs are significant but there is a question of financing. Still, this would seem an obvious area of growth potential. Exports are likely to weaken near to intermediate term as the world slows down.

Consequently, profits and profitability, which have recently been at historic highs, are likely to fall because top line growth will be more difficult than in recent years. Profits will be down this year and despite optimism of Wall Street analysts about 2009, we would not be surprised to see weakness rather than strength in profits next year.

We suspect the market has not yet fully discounted the foregoing scenario. Moreover, we believe that this country is at or near an inflection point in terms of longer term economic, profits and political trends. Many of the drivers of the economy and the political scene are shifting. Our concerns long term are more regulations, greater aversion to risk, and modest growth, all of which are not the factors that produce high stock valuations.

Because of the questionable longer term outlook, we recommend investors keep some powder dry for the time being to see if the market can put in a sustainable bottom. For those investors that are fully committed, we suggest generating some liquidity when and as the market rebounds from current levels.

A. Marshall Acuff, Jr., CFA
Managing Director
Chair, Cary Street Partners Investment Committee
Cary Street Partners Investment Advisory, LLC