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Weekly Market Commentary of July 21st 2008

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After a six straight weeks of losses, the S&P 500 posted a modest gain last week. While the price of oil fell by over $16 (the biggest one week percentage decline in three years), even more significantly the Financial sector posted double-digit gains. After falling 8% in the first two days of last week, the financial sector rose a dramatic 24% from the intraday low on Tuesday morning to the close on Friday to end the week with a gain of 11%.

The message of last week’s financial sector volatility—which included the biggest one day gain in the financial sector in history—is that sentiment had become too negative. The combination of better than expected earnings reports from companies like Wells Fargo and Citigroup, along with a proposal designed to curb short-selling on certain stocks, was enough to result in a powerful bounce. The key question is: Will it last?

To answer that question, we need to assess what outcome is priced into the financial sector. In our view, financial stocks are reflecting the challenges posed by the current environment, with the sector falling 50% from the peak of a year and a half ago to the low on Tuesday of last week. Furthermore, the S&P 500 Thrifts and Mortgage Finance industry index had lost 87% from the
peak-to-trough—exceeding the peak-to-trough decline in the NASDAQ after the internet bubble burst. These losses reflect the outlook for more writedowns, asset sales, dividend cuts, dilutive capital infusions, bank failures, and the many years it will take to return the financial sector profits to the levels of a year ago.

With this outcome largely reflected in current prices, what could transpire to further depress prices in this sector? One scenario would be the emergence of a deep and prolonged recession combined with the failure of some of the largest banks in the U.S., extending from the difficulty financial institutions are having in raising capital to meet requirements. In the worst case, the banking system would then be forced to cut back sharply on lending, resulting in a prolonged credit crisis and acting as a drag on economic growth—a set of circumstances that would likely entail additional substantial losses for the Financial sector.

This worst case is not merely theoretical. A similar scenario played out in Sweden in the early 1990s as a financial crisis led to a 6% decline in GDP over several years and a 50% peak-to-trough decline in the stock market led by the financial sector. While there were several drivers of that crisis, a key contributor was the bursting of a housing bubble. Home prices in Sweden doubled in fi ve years then fell 20% from 1991 to 1993. Bad loans at banks rose from 0.5% in the mid-1980s to 5.0% in 1992 as defaults soared. The banks suffered heavy losses. The total amount of the bad loans was much larger than the banking sector’s total equity capital. Many of the largest banks obtained capital infusions. After a few of Sweden’s largest banks announced that they could no longer meet the regulatory capital requirements, the government stepped in, guaranteed all these banks’ existing liabilities, and
took ownership of three of the largest banks. The government guarantee provided protection from losses for all creditors except shareholders. With many of the largest U.S. banks having fallen over 90% from peak-to-trough, the markets were beginning to price in the potential for an outcome similar to Sweden’s experience of a massive government bailout and the elimination of equity value, wiping out shareholders.

How likely is it that this scenario develops in the U.S.? The markets may hold the answer to this question. Current measures of the state of the credit markets do not reflect worsening conditions, a necessary precursor to a prolonged credit crunch.

1. Instead, high yield bond credit spreads are narrower than they were back in mid-March when Bear Stearns failed.
2. In addition, the credit market is pricing in a lower risk of failure by major U.S. banks than back in mid-March, based on the pricing of credit default swaps.
3. In short-term money markets, firms are becoming less reluctant to part with their cash. The spread between three-month London interbank offered rate (LIBOR), and the expected federal-funds rate over the next three months remains elevated, but is narrower than back in mid-March. This spread shows the difference between what firms charge each other for short-term cash and what they expect to pay in the relatively risk-free overnight fed funds market. The current spread, 73bps, is down from the March high of 104bps.

Due to the actions of the Federal Reserve, Treasury, and corporate leaders, there is no credit crunch of the magnitude to evoke a deep and prolonged recession—at least not yet. Then the suggestion is that last week’s rally in the financial sector was the result of the realization that the stock market had overreacted, pricing in a far worse outcome than the credit markets.

However, the rally will not necessarily continue. The sector is likely to remain volatile in the months ahead as investors assess the cross currents in the data and react to the actions taken by the major financial institutions to manage their losses and remain solvent. We will continue to watch the unfolding events very closely to assess changes in the likelihood of various outcomes. Stability in the financial sector would be a key positive contributor to overall market performance.

The focus issue for the overall market may now be shifting to the outlook for inflation rather a recession stemming from a credit crunch. A further decline in oil prices may change the prevailing outlook on inflation that is keeping pressure on the S&P 500 price-to-earnings ratio. The current 13–14 price-to-earnings ratios reflect an expected inflation rate of 4–5%. As we highlighted in last week’s Weekly Market Commentary, an easing in inflation pressures could lead to a greater than 20% rally in stocks that would raise the price-to-earnings ratio to the 16–17% level that reflects a 2-3% pace of inflation.

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IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fl uctuation and political instability. Investing in small-cap stocks includes specifi c risks such as greater volatility and potentially less liquidity.

Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.

The opinions voiced in this material are for general information only and are not intended to provide specifi c advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

© LPL Financial

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