Economic & Market Update: October 13, 2008

“A Week of Rebound Ahead?”

Chip Norton, Managing Director of Fixed Income & Economic Analysis

This Week's Plan

After last week's historic downturn, we open this week on a much more positive note with equity markets up worldwide. This is, in large part, due to actions taken over the weekend by the G-7, as well as by world central banks. There are at least three to four new actions expected to be announced in the next few days, including possible direct investment in banks by the Treasury Department (similar to what the UK has done), a backstop facility to guarantee interbank loans, and another cut in interest rates by the Fed. Will the market be able to sustain today’s early rally? That will be a function of both the near-term success of the actions taken over the weekend and, more importantly, the renewal of confidence in the markets and the financial system. This latter challenge may take quite a bit more time.

Already this morning the Federal Reserve announced it will provide banks worldwide with as much dollar funding as needed. The Fed announced this morning that, "In order to provide broad access to liquidity and funding to financial institutions, the Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank (SNB) are jointly announcing further measures to improve liquidity in short-term US dollar funding markets.

The BoE, ECB, and SNB will conduct tenders of US dollar funding at 7-day, 28-day, and 84-day maturities at fixed interest rates for full allotment. Funds will be provided at a fixed interest rate, set in advance of each operation. Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction.

The actions already appear to be working, as seen in the TED spread, which is the difference between what banks and the Treasury pay to borrow money for three months (Libor minus the 3-month T-Bill). It narrowed 7 to 10 bps to 4.57% basis points, one of the biggest declines in 25 years. Libor was just 2.92% a month ago, while the 90-day T-bill rate was near 1.72% - a TED spread of 1.20%, about one quarter of what it is today. 

From G-7

This past weekend the G-7 agreed to take broad and "exceptional" actions to stabilize the world financial markets and unwind the paralysis in the credit markets. Here are the five steps the G-7 agreed to this weekend:

1. Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent valuation.

Help on Student Lending

With the decline in equity prices comes declines in college saving plans such as 529 programs. Indeed, the declines have been so severe that there is serious concern that the costs of education may not be able to be met this coming year. To help reduce the stress on this part of the market President Bush signed H.R. 6889, the extension of the Ensuring Continued Access to Student Loans Act, which renewed temporary powers to use federal funds to ensure students and families continue to have access to student loans.

Historic Perspective

Year-to-date through October 8th, the S&P 500 has fallen 32.9%. If this were the full-year performance it would rank as the fourth worst calendar-year decline since 1900, behind 1931 (-47.1%), 1937 (38.6%), and 1907 (-33.2%). What’s interesting about the current bear-market decline is how it has so closely followed history. The current 37% peak-to-trough decline is close to the average decline of 38% for all bear markets since 1929. In addition, this bear market has taken back 74% of the prior bull market’s point rise, which is a shade above the long-term average.

This is the 15th bear market since 1929, according to Standard & Poor’s.  S&P defines a bear market as a price decline of 20% or more. S&P’s chief strategist, Sam Stovall segments historical bear markets into “Garden Variety,” in which the S&P 500 slumped 20%-40%, and “Mega-Meltdowns,” during which the S&P declined more than 40%. Stovall looks at it this way to provide a twofold distinction: price decline magnitude and time to recoup what was lost in the prior bear market. Since 1946, Stovall indicates that the average time it has taken a “Garden Variety” bear to get back to break-even is 12 months.

“This relatively short time span is encouraging, in my opinion, and reminds us that while it is not smart to try investing next month’s rent money, one needs to take advantage of – not run away from – stock market declines,” say Stovall.  The next category, “Mega-meltdowns”, is more ominous, mainly due to the long draw down period.  According to S&P data, since WWII it took 63 months, or a little longer than five years, to recoup all that was lost in the 1973-74 and 2000-02 bear markets. If you started with 1929, the average would be skewed dramatically, since it took 25 years to get back to break-even post the stock crash in October of that year. The S&P 500 reached a high of 31.92 in September 1929, and it wasn’t until September 1954 that it made it back to breakeven.

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