New Market Commentary

Near Term Relief
December 8, 2008

The stock market roller coaster in the U.S. continues its volatile trend. During the last week of November, the market soared 10%, its biggest one week rise since the early 1930s. Last Monday though, the market dropped about 680 points, or 7.7%, its fourth largest one day decline in history. On Friday, December 5th, the market rose 259 points, or 3%, despite the announcement of job losses of over 500,000 in November. Despite it all, the market remains in a bear trend and the U.S. economy is formally acknowledged to be in a recession.

While we believe the negative factors influencing the market are well known and may remain with us for some time, there are positive developments which should not be overlooked. Mortgage rates are at their lowest levels in three years or about the time the housing bubble began to burst. In the last week of November, applications to buy houses leaped 38% and refinancing demand soared 203%, but from the lowest levels in eight years. Nonetheless, home inventories remain high and weakening employment trends are likely to dampen housing purchases. Still, efforts by the government to bring down interest rates are beginning to pay off. Another example of lower rates reflecting policy initiatives is the drop in three month LIBOR from a peak of 4.8% two months ago to less than 2% currently. Given this plunge in LIBOR, it appears that banks have restored their confidence in one another and are more willing to lend to each other than they were in October. Like most commodities, oil prices have plummeted in recent months. Noteworthy is that the price of gasoline in inflation adjusted dollars has dropped from over $4.00 to less than $2.00 per gallon, putting it in line with its 22 year price trend.

In the past, we have warned of increasing weakness in profits from historically high levels. Indeed, earnings continue to soften and we believe that profits will decline in 2008 and 2009. Nonetheless, some measures of valuation are beginning to look increasingly favorable. The price-earnings ratio based on a 10 year average of trailing earnings is nearing its previous lows of the early 1980s and 1940s. Similarly, market cap as a percentage of GDP is nearing its historical lows of the early 1980s and 1940s. The question remains as to whether stock prices have yet discounted weakening profits. While valuations are becoming more reasonable, much of this improvement is coming in the financial area. Our concern remains about the trend of profits in the non-financial sector. Still, all stocks are not valued similarly and all companies have varying prospects, so some firms are likely to have a positive outlook and valuations are probably not reflecting their future.

Of great interest is the fact that the yield on the stock market is slightly greater than the yield on 10-year Treasury bonds. This is the first time since 1958 that stock yields have been higher than bond yields. Since 1958, the spread between the two, favoring bonds, has averaged 3.7 percentage points. Why has this relationship between bond and stock yields shifted? Two reasons: First, bond yields have been driven down by investors’ concern about the U.S. financial structure and future growth in the economy. Deflation concerns have overtaken inflation concerns. Second, equities investors have also become concerned about future growth, especially for profits. Because of this concern, stock prices have dropped, driving yields higher. Investors, thus, are demanding higher current yields to compensate for the slower growth they expect in the future. Reflecting diminishing growth expectations, stock price volatility has increased. Interestingly, as stock yields have moved higher, yields for money market funds are at all time lows with money market assets at all time highs. Clearly, a large number of investors have become more risk averse. Consequently, stock yields have risen. Since 1900, the total return on stocks has averaged about 10%. Dividends represented 50% of that return. Clearly, increased notice should be taken when dividend yields rise as they have recently, especially among quality non-financial and non-energy stocks.

While the intermediate term trend of the market remains uncertain, a number of factors suggest, at least, a positive trading move over the near term. Despite the high volatility of recent weeks, the volatility index appears to have peaked. Investor sentiment remains negative, yet both individual stocks and the market are responding well to negative news, such as the November employment statistics. For the time being, the downward pressure on the market in recent months is likely to ease as the calendar year ends. Cash reserves in institutional portfolios are very high. Market leadership appears to be starting to appear in the financials and consumer discretionary sectors. These sectors typically lead off the bottom of a long term bear market. This leadership may be early and is likely to be tested in the future.

Nonetheless, the best scenario would be to build a base over time by evolving into a trading market. We still believe it is early to call the end of the U.S. bear market.

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