March Market Commentary: Equity Market Responds to New Proposed Regulation
After a rough start, March markets rally to a strong finish
By Natalie Trunow, Senior Vice President, Head of Equities
Calvert Asset Management Company, Inc.
While the month of March began with a down week—that also happened to be the third down week in a row for global markets—ensuing weeks brought much brighter results. During that first week of the month, roughly 95% of all stocks fell, with select gold, biotech, generic drug, and food companies providing what little shelter there was available. Financial stocks led the declines, falling 17%. After that point, however, markets recovered strongly through the rest of the month bringing March returns into positive territory.
The Russell 1000 Index of the largest market capitalization companies in the United States finished the month up 8.75%. All major sectors participated in the appreciation, but the bulk of the month’s performance came from the previously beaten-down automotive (GM +88%, Goodyear +49%) and financial stocks (+30.6%), suggesting that a good portion of the rally was due to increased buying by short sellers to cover their short positions (Citigroup +73%, Bank of America +83%, Wells Fargo +62%).
Financial stocks led the rally, rebounding strongly on comments from Citigroup about good profitability during the quarter, the prospect of a private-public resolution of the toxic asset issues, potential FASB rule changes on mark-to-market accounting, and the market’s perception of the franchise value still resident in many large financial companies.
Toward the end of the month, the Obama administration unveiled its plan to remove toxic assets from bank balance sheets—if banks agree to sell their illiquid investments at steep discounts—in an effort to help revive the U.S. financial system without outright nationalization. The proposed Public-Private Investment Program will finance about $1 trillion in purchases of illiquid real-estate assets using the remaining $75 billion to $100 billion of TARP money, Federal Reserve financing of up to a maximum of six times the capital (or equity) provided, and debt guarantees from the FDIC. The plan will give asset managers cheap leverage with which to magnify potential upside return.
By May, the Treasury will select private asset management firms “with demonstrated track records of purchasing legacy assets” to participate in the Program. Only the largest players will be eligible, since qualifying firms will need to have at least $10 billion invested in real estate-related securities and will have to come up with $500 million to invest along with the government. Participating managers will be overseen by the FDIC and will be given time to raise private capital, in return for which the managers will receive matching funds and “senior debt” from the Treasury of 50% to as much as 100% of that capital.
The FDIC, which has experience disposing of devalued loans from failed banks, will ultimately auction off pools of loans controlled and managed by participating investment managers. The recent backlash on Capitol Hill over AIG bonuses and compensation could mean that private firms might not be eager to take part in the Treasury’s public-private partnership, despite limited downside and potentially attractive returns. But National Economic Council Director Lawrence Summers was quick to state that any restrictions on executive compensation won’t apply to investors in the Treasury’s plan. In addition, the $1 trillion Term Asset-Backed Securities Loan Facility (TALF) program will now expand to include legacy securities linked to residential and commercial mortgages, with the goal of establishing a pricing mechanism and stabilizing the market for mortgage-backed securities.
During the month, the unemployment rate reached 8.1%. Unemployment has risen faster than expected, which indicates that we could reach our projected unemployment level of 10% to 11% sooner than anticipated. This continuing growth in unemployment will continue to diminish the ability of households to service debt. In fact, recent data show that the latest wave of home foreclosures has a different mix, adding a much higher percentage of jumbo and prime mortgages to the already large sub-prime component.
In terms of the financial sector, while the franchise value of large banks certainly still exists, the fundamentals will still be questionable until the toxic asset issue is resolved, and until more bad assets are written off. We also believe that the so-called “cram-down” legislation will push car loans and credit card debt into bankruptcy court along with mortgages. Because of this, it is unlikely that financials-led market recovery will be sustainable.
This will also likely to be bad news for the automotive and retail sectors. Automakers now appear headed toward bankruptcy reorganization, after all.
It will be important to see some leadership emerge in other sectors for the market recovery to continue. So far, utilities and consumer staples stocks seem to continue to provide refuge, but it will probably take better performance in the information technology or health care sectors to keep the rebound alive in the short term.
For the rest of 2009, we continue to expect further economic weakening with equity markets positioning for a rebound. Historical data indicate that economic cycles have a median recession-to-recovery time span of 11 months. With the current recession well into its 16th month and no immediate upturn evident, it is clear that this is no ordinary recession. While we expect this downturn to be more pronounced and drawn out than most past recessions, we expect the economy to start recovering sometime in 2010.
We believe that, once the unprecedented excesses of multiple bubbles of 2007-2008 are flushed out, a healthy foundation will emerge from which markets can recover. Most market participants are now aware of the depth of the recession and its global nature. As negative economic and earnings news continues to unfold throughout the year, we expect that the extreme pessimism in the markets should create some of the most attractive investment opportunities on record for investors with a long-term investment time horizon. In the short term, however, we are likely to continue to see sharp pull-backs followed by short-covering and window-dressing rallies.
Investment in mutual funds involves risk, including possible loss of principal invested.