New Market Commentary

A Bouncing Market
October 30, 2008

On Tuesday, the stock market soared 11%, its second best daily gain ever. This strength came on the heels of firmer overseas markets and speculation the Federal Reserve would cut short term interest rates by 50 basis points. Despite some late slippage in the market Wednesday, global markets are stronger today. The question on investors' minds is whether the market's strength will be sustained.

Technically speaking, this week's market surge came from similar levels that marked a low point earlier this month when the market rose about 900 points on one day. Short term, this action suggests that the market is making a bottom and is rebounding from a dramatically oversold condition. Nonetheless, the longer term trend for the market remains negative and for the moment, it appears that the market is rallying within the context of an ongoing bear market.

Fundamentally, there is some good news providing support for the market. Inter-bank lending rates are falling and lending among banks is beginning to occur, suggesting that recent monetary and fiscal policy initiatives are beginning to have a positive effect on the banking system. We expect to see more positive news about increasing activity in the banking system in the weeks and months ahead. While the economy is currently in a recession, it is heartening to see September sales of existing homes increasing at the strongest rate in a year. More importantly, existing home sales have been stabilizing in recent months. Nonetheless, inventories of unsold homes remain high. Durable goods orders were recently reported to be positive. Oil and commodities prices are down which is a plus for inflation and the cost of living. So, all is not bleak with the fundamentals, but neither is it all bright.

As we pointed out in our October 13th commentary, the basic question remains what will growth be and where will it come from. Consumers are challenged by the double whammy of declining housing prices and stock prices. This double negative wealth effect is bound to contain confidence for some time in the future. Jobs and incomes will feel greater pressure in the months ahead. Credit will continue to be relatively difficult to obtain. Certainly, there is the potential for increased government spending, but even here there are limits, especially at the state and local levels. More infrastructure spending is possible, but how much and how it will be financed remain vital questions.

We continue to expect very little growth over the next year or more and importantly for the stock market very little growth in profits. Stock markets have already been dealing with financial stress and a recession. A major challenge ahead is the trend of profits. Profits are high historically, well above their long term trend. Given current and expected economic conditions, profits and profitability are likely to decline in 2008 and 2009. Such weakness will represent an obstacle for the stock prices of many companies. Some of this prospect may already be discounted, but we can not be sure how much. We are only certain that a profits recession has begun after years of better than expected earnings results. If the 2000-2002 bear market represented a correction of excess valuations, then 2008-2009 may be a period of correction representing a downward adjustment in profits to trend or below trend levels. Consequently, while stocks appear cheap currently, we suspect that they are not as inexpensive as they appear. A better analysis of stock valuation may be an examination of tangible net worth and cash flows.

Our conclusion is that the current rally in the markets may continue for awhile. The passing of the election may be a psychological plus. The seasonally stronger period of November to January may assert itself. Forced selling may begin to dry up from the biggest tax loss selling season in history. Nonetheless, further markets strength should be used to rebalance portfolios. We would favor the large cap sector over small caps that we liked this summer. Equity income looks quite interesting in view of relatively high yields among many blue chip companies.

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