October Market Commentary: October’s Stock Market Decline Reflects a Recessionary Global Economy and Constrained Credit
Too soon to call a market bottom, but valuations in some sectors appeal to long-term investors
By Natalie Trunow, Senior Vice President, Head of Equities
Calvert Asset Management Company, Inc.
A synchronized global recession, declines in market confidence, panic and forced selling by institutions, weak consumer spending and deteriorating corporate balance sheets all fed the sharp market declines over the past few weeks despite efforts by national governments around the world to stem the impact of the credit crisis. For the month ended October 31, the S&P 500 Index declined 16.79%, while the MSCI World Index fell 18.93%. The CBOE VIX Index, a widely recognized indicator of stock market volatility, set a record high of 90 on October 24, 2008.
The turbulent month ended with a one half of a percentage point cut in the benchmark short-term Federal Funds rate and the release of economic data showing a more modest than expected 0.3% decline in U.S. gross domestic product (GDP).
Historically, this kind of sharply declining, volatile equity market environment has culminated in a major bout of indiscriminate selling, followed by investor capitulation, and the eventual emergence of a market bottom. However, we expect this elevated volatility to persist, given the raft of disappointing economic and financial data likely to be reported in coming weeks, and to prevail until catalysts for fundamental economic and earnings improvement emerge.
U.S. Equity Markets: Defensive Sectors Hold Up Best
In the U.S., cyclical stocks continued to be the worst performers for the month. Energy, materials, industrials and consumer discretionary stocks experienced the greatest declines, with losses of approximately 23% to 27% for the month. More defensive sectors, including consumer staples, telecommunications, and utilities, fared the best with only modest declines ranging from 3% to 13%.
Even though consumers are getting some relief in the form of significantly lower energy prices (oil recently traded below $67 a barrel, compared with more than $100 a barrel at the end of September), retailers are feeling the pinch of weak consumer spending patterns. Third quarter 2008 earnings for retail companies fell just over 60% from the third quarter of 2007.
Concerted Government Intervention Fails to Calm Credit Markets
Beginning in the U.S. with Congress’ approval of a $700 billion financial rescue package in early October, national governments around the world have undertaken coordinated action to inject liquidity and restore confidence in the credit markets.
A portion of the U.S. bailout package will be used to invest in preferred stock and guarantee the debt of nine of the largest financial firms. The U.S. Treasury subsequently extended support to second tier regional banks as well. In mid-October, France, Germany, Spain, the Netherlands and Austria committed $1.8 trillion to guarantee bank loans and take stakes in lenders.
Nevertheless, investors remained skeptical that these measures would be sufficient to reverse the global recession or cure the credit availability issue.
The credit crisis is continuing to constrain the ability of individuals and corporations to borrow, resulting in increased home foreclosure rates and corporate failures. Third quarter earnings declines for those U.S. companies that have reported results have been steeper than generally expected, and many firms are guiding revenue and/or earnings forecasts lower for the fourth quarter and beyond. We think Wall Street earnings estimates generally remain too high and reported results are shattering markets’ confidence in corporate earnings profiles.
Impact on Emerging Markets
Emerging market economies, the unstoppable engines for most of the year and source of earnings growth for many large multi-national corporations in developed markets, have been the next shoe to drop. The de-coupling story – the widely touted notion that emerging market countries had succeeded in insulating themselves from the economic and financial market fortunes of developed countries – failed to materialize. During October, some emerging markets experienced their largest declines in more than two decades, reflecting fears of global recession. Major stock market indices in Brazil, Mexico and Hong Kong fell by 20.03%, 23.73% and 29.50%, respectively, for the month, and we are seeing near-default sovereign levels in emerging markets in Argentina, Belarus, Ukraine, and Pakistan.
There were some positive days amidst these challenging economic times. On October 13th, the Dow Jones Industrial Index saw its biggest rally in history, an 11.08% increase. However, hopes of a sustained rally during the month ended in a subsequent sharp sell off suggesting that it was a bear market rally driven by investors bottom fishing and covering their short exposures.
The turbulent month ended with a market rally on news of a 50 bps Fed cut with more cuts expected in the future and the release of economic data that the GDP decline (-0.3%) was not as great as economists expected (-0.5%).
Despite unprecedented amounts of liquidity pumped into the system by central banks worldwide, deflation is now a worry, as sharply declining asset prices and wages threaten to counter-balance these unprecedented moves by regulators. Consumer credit remains quite tight with confidence levels at record lows. Belt-tightening and cost-cutting by consumers and corporations across the board are becoming wide-spread and self-reinforcing. This can further damage the economy in the medium term, but should be a healthy development long-term, as both consumers and corporations move to reduce debt levels and leverage.
While there are some signs that credit markets are stabilizing, the availability of credit remains constrained. LIBOR, the London Interbank Offered Rate and the interest rate at which large international banks are willing to lend to each other short term, and the TED spread, the difference between the three-month LIBOR and the three-month U.S. Treasury bill yield, pulled back substantially, to 3.42% and 2.85%, respectively, but remain elevated. These levels are approximately half of what they were on October 10 at the height of the credit market crisis, but double the levels prevailing on September 15.
Counterparty risk continues to be a major area of concern, however. During the month, a central clearing facility was proposed through a partnership between the Chicago Mercantile Exchange and Citadel, a large hedge fund, to help remove some of the credit risk and counterparty clearing risk associated with credit default swaps.
During the month, markets seem to have returned to trading on fundamentals, reflecting rapidly deteriorating corporate earnings profiles and sharply decreasing consumer spending and not relying solely on government intervention to stabilize markets. As a result, sharp stock market declines in October caused valuation multiples to contract substantially and in some cases, reach levels that present attractive buying opportunities for long-term investors. Global stocks are now trading at less than 11 times earnings, with European shares trading at less than eight times earnings. However, earnings estimates may still be too optimistic. The counter-cyclical sectors where earnings are more visible and sustainable should outperform in the medium term. Our longer term economic view remains guarded, dependent on the emergence of tangible catalysts for fundamental economic and earnings improvement. We note, however, that market bottoms tend to form from four to six months in advance of an economic bottom.
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