The following is a research report that was issued by my firm LPL Financial.
Contrary to what the title of this piece may suggest, we are not here to discuss the sequel to a famous 1966 spaghetti western movie. Instead, we intend to focus on recent developments in the financial markets and review how the market is constantly weighing three inputs to determine its direction and risk profile: what it views as positive, what it views as negative, and what it does not yet understand. In this veritable screenplay the characters are faced with the Good, the Bad and the Missing. While no one can argue that the Bad has been the most influential of the three inputs as of late, it is important to understand the dynamics of these three factors and how the market values and weighs them.
Contrary to what seems logical, the market does not need to have more “good” than “bad” to reverse a downturn and move to an advancing posture. In fact, given that the market is a forward looking machine, it does not wait to completely emerge from the dark before it starts to improve, but rather, it just needs to view the light at the end of the tunnel. Examining every recession and bear market since WWII reveals that stocks have always bottomed before the recession was over and delivered, on average, returns with a powerful 25% upside potential, as measured by the S&P 500 Index, and furthermore, recouped nearly all losses by the end of the recession.
So, the question remains, when will the market find the balance between good and bad that will propel it to shift from fear to opportunity? It is LPL Financial Research’s opinion that this transition is upon us now. While this may contradict the many negative headlines reported by the media, the fact remains that the velocity of the good things happening in the market is increasing, while the velocity of the bad is slowing. The inflection point as to when the market improves surrounds the timing of when the bad stops getting worse and the good starts to gain frequency.
Improvements are Becoming More Frequent
As far as the Good, we are starting to see it trickle in a bit faster than it did just a few months ago. The stimulus package and foreclosure relief were approved and we have gotten some encouraging news on retail sales, wages, and inflation data as of late. In addition, volatility has eased and liquidity in the credit markets has improved. Below we explore some of the areas where good news is beginning to sprout.
1. Government Stimulus Packages
The U.S. Government appears to understand the severity of the economy’s situation and is beginning to take action at unprecedented levels. By augmenting existing economic stimulus policies and creating new ones, the
Obama administration has enacted the following to jump start the economy and, subsequently, the financial markets:
- American Recovery and Reinvestment Act of 2009 (commonly known as the stimulus package)
- Emergency Economic Stabilization Act of 2008 (commonly known as the bank bailout)
- Troubled Asset Relief Program (Purchase of troubled assets)
- Term Asset-Backed Securities Lending Facility (Help holders of asset backed securities)
- Foreclosure Mitigation Plan (Mortgage relief plan)
Only time will tell if these programs will work as well as they could, however, the financial markets should consider them positive. For example, based on initial estimates from the non-partisan Congressional Budget Office (CBO), the stimulus package should add between 1.4% and 3.8% to GDP on an annualized basis in 2009. Also, the Federal Reserve is buying $3 billion to $4 billion in mortgage-backed securities on a daily basis. These actions suggest that government policies should benefit market sentiment and eventually the economy.
2. Improvement in the Corporate Bond Market
Credit markets were at the epicenter of the credit crunch and have been and will continue to be a key signpost on the road to recovery. Because the credit markets are one of the best signs of the market’s view on risk and survivability of companies, improvement on this front is vital to spark a recovery. The good news is that there have been very positive signs on this front as of late. Corporate Bonds have shown notable improvement since the fourth quarter of 2008. The average yield advantage of investment grade Corporate Bonds above comparable Treasuries has shrunk from a peak of 5.8% to 4.8%. The high-yield market witnessed greater improvement with the average yield advantage to Treasuries narrowing from 22% to below 17%. This is important as lower yield spreads indicate that investors are willing to assume less compensation (lower yields) for the assumption of risk. This is a clear sign that the credit markets are seeing an improving landscape on the horizon. New issuance has picked up substantially in both markets, another encouraging sign.
3.Healing of the Bank Lending Markets and an Improvement in Liquidity
One of the major contributors to the market’s decline was the seize up in liquidity, resulting in a virtual shut down of intra-bank lending. However, we have seen a very positive trend on this front over the last few months suggesting that liquidity has improved and the credit markets are healing. The best measure to illustrate this is the TED Spread, a gauge of liquidity taken by subtracting the 3-month T-Bill yield from 3-month LIBOR. While the measure remains at elevated levels and well above its historic average of 0.3%, dramatic improvement has been seen off of the recent historic highs, suggesting a positive trend for the bank lending markets. Only time will tell if these programs will work as well as they could, however, the financial markets should consider them positive.
While Still Worsening, Some Indicators are Showing Signs of Stabilization
While the Bad is too numerous to list, the velocity of negative news from many areas of the market has begun to slow. Many economic indicators still point in a negative direction, however, the signifi cant development here is that we are beginning to see a slow down in the downward spiral of the news. Remember that the market does not wait until the “all clear” is sounded and all bad news has evaporated. Rather, the market looks for indicators that the negative factors are diminishing and beginning to level off. A few important areas of the economy that continue to see negative trends, but are showing a decline in velocity and an increase in stability include:
1. Housing Market
The U.S. has been in the midst of a housing bear market for almost four years now. While the housing market is still showing signs of continued weakness, the pace of further declines has begun to slow. Notice the nearby chart illustrating existing home sales. While still on a downward trajectory, the pace of the downside has slowed and more importantly, signs of some stabilization over recent months have become evident.
2. Mass Layoffs
One of the key measures to watch in any recession is employment. LPL Financial Research expects that unemployed workers will continue to rise throughout most of 2009 and peak sometime in early 2010. However, some signs are emerging that the velocity of unemployment is beginning to ease. One measure is to examine mass layoffs, which is an index accumulating the total number of announced layoffs by U.S. companies. The recent spike in announced layoffs has shown signs of stabilization. While we continue to foresee more announced layoffs through the remainder of 2009, the velocity is showing signs of slowing and thus becoming “less worse”.
3. Retail Sales
If there is one thing we can count on, it is that the U.S. consumer can only stop spending for a short period before the “itch” becomes too strong to ignore. There is no doubt that the retail consumer has dialed back and households have begun to de-leverage their own balance sheets by forgoing spending, reducing expenses, and paying down debt. The nearby chart shows that even during the 2000-2002 downturn, the consumer only moderately slowed, not reversed spending. However, over the last year, consumers have cut back dramatically. But this trend appears to be stabilizing. Given that consumer demand may now stop declining and perhaps even rise, low business inventories (things on the shelves for us to buy) could lead to an increase in production.
The Final Piece of the Puzzle
By now, you may be asking yourself, if the equilibrium between the good and the Bad has indeed turned to a more positive (or at least less negative) balance, then why haven’t the markets improved? It is because of the third factor: the Missing. There is currently a clarity void overhanging this market, which has been the primary catalyst for stocks retreating back to and even slightly below their November 20, 2008 market lows. The remaining unanswered questions largely surround the details of the government’s many stimulus and rescue packages as well as the future state of the financial services industry.
- Do the banks need further capitalization?
- Will the banks be nationalized?
- Will the recent Citigroup transformation be the model to handle the rest of the banking industry or was that just a one-off?
- What is the plan to remove the toxic assets off bank balance sheets?
It is our belief that answers to the market’s lingering questions are forthcoming. The Obama administration knows that the market is waiting for details and in our opinion has learned that the “trust me”, high-level descriptions of its plans to improve the financial markets through fiscal and monetary policy are not enough clarity for the market to be comfortable. We are in a “show me” market that wants details. Once these missing details are uncovered, the market can once again refocus its attention to the increasing pace of good news and the declining pace of bad news, with the likely result of the market establishing the basis for a bottom. Two of the major lingering “missings” include:
1. Full Details on Treasury Capital Assistance Program
Financials have been pressured on concerns that the U.S. Government would possibly nationalize banks, consequently making common equity of these institutions worthless. Policymakers have attempted to quell these investor concerns. However, until the government releases full details about the Treasury Capital Assistance Program, under which the potential for bank nationalization exists for those that do not pass the economic stress tests, the financial markets will likely remain uneasy and nervous.
2. Full Details on Government Stimulus Packages
The good news is that policymakers have passed multiple stimulus packages from those targeting homeowners to those focusing on the financial system. Unfortunately, outside of their announcements, few details are available on how the plans will work, who will administer them, when we will see real benefits, and the exact time frame of their release. Until the policymakers finalize the details about these packages and the market appreciates them,volatility will remain.
The market and this economy have more tough bridges yet to cross. But as the Good gets better, the Bad diminishes, and the Missing gets answered, it is LPL Financial Research’s view that the backdrop for market improvement will be established. These retesting challenges and subsequent small victories are what make a market bottom. There is currently a clarity void overhanging this market, which has been the primary catalyst for stocks retreating back to and even slightly below their November 20, 2008 market lows. It is our belief that answers to the market’s lingering questions are forthcoming. The Obama administration knows that the market is waiting for details. The market and this economy have more tough bridges yet to cross. But as the Good gets better, the Bad diminishes and the Missing gets answered, it is LPL Financial Research’s view that the backdrop for market improvement will be established.
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