Calvert News & Commentary

First Quarter 2009 Equity Market Commentary

Road to Recovery or Bear Market Rally?


Untitled Document

By Natalie Trunow, Senior Vice President, Head of Equities
Calvert Asset Management Company, Inc.

Natalie Trunow, Head of Equities

The first quarter of 2009 was one of the most eventful periods since the end of World War II. Unprecedented government intervention was brought about by the continuing crisis of the financial system and sharp economic downturn, resulting in a drop of 13.3% for the Dow Jones Industrial Average,® the index’s worst first-quarter performance since 1939. The S&P 500® fell 11.01% during the same period.

Economic Data Set the Tone

Economic data released in January 2009—from gross domestic product (GDP) figures, housing and jobs, to consumer confidence, manufacturing and corporate earnings—confirmed that the global economic recession was synchronized and deepening. The Federal Reserve signaled its intention to provide additional capital injections and guarantees for banks to help normalize the credit market environment.

While U.S. investors looked for signs of potential relief from overseas, little was forthcoming. The Chinese economy continued to slow at a higher-than-expected rate, threatening an even deeper impact on its trading partners, including other emerging market countries.

As we expected, economic data released at the end of February came in worse than had been anticipated. The Commerce Department reported that the U.S. economy shrank by an estimated 6.2% in the fourth quarter of 2008, a much larger decline than the previous estimate of 3.8% for the quarter and the worst decline since 1982. Consumer and business spending, along with consumer sentiment, declined.

Pressure on Home Prices Continued

On the real estate front, housing figures during the quarter showed that the U.S. real estate market has lost about $2.4 trillion since its peak in 2007. We believe, especially given recent increases in the jobless rate, that there may likely be another 10% to 15% downward move before housing prices stabilize. This will continue to hurt consumers who are highly leveraged on their homes, fuel foreclosures, and will further intensify the impact on bank balance sheets, where securities leveraged to shrinking home equity reside.  

In March, the unemployment rate reached 8.1%, which was higher than anticipated. Unfortunately, our forecasted 10% to 11% unemployment rate may occur before the end of 2009. This continuing growth in unemployment will continue to diminish households’ ability 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.

Government Intervention Ramps Up

With both the consumer and corporate parts of the economy continuing to look grim, investors looked to the government to stimulate the economy. A stimulus bill providing tax relief, additional government spending and direct payments to individuals was passed. In the beginning of the quarter, the Obama administration proposed the creation of a “Bad Bank” that would absorb toxic assets in the U.S. financial system. However, with the cost potentially running as high as $3 to $4 trillion and a lack of clarity about the valuation methodology used to price toxic assets, this original idea seemed to raise more questions than it answered.

Toward the end of March, the Obama administration unveiled details of 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, this time with more details. 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 plans to 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 the funds’ 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.  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.

New hedge fund regulation was also introduced during the quarter, which proposed bringing hedge funds under the supervision of the SEC and imposing registration and transparency requirements on the largely unregulated industry. A likely result will be a permanent reduction in the levels of leverage and risk-taking within this asset class.

Financial Services Sector Feels the Heat

In the financial sector, pressure intensified as talk of the nationalization of select banks affected financial stocks after government-proposed stress tests for the top 19 U.S. banks.

Dividend-focused investment strategies also came under pressure. Confidence in the reliability of dividends of all companies, not just financials, was eroding with companies like GE, Dow Chemical, Citigroup, and JPMorgan cutting dividends. Dividend strategies have gained popularity in the past few months as defensive plays. However, the prices of dividend-paying companies have proven to be volatile of late, as the threat of declining debt ratings has pushed companies to slash or eliminate dividend payouts.

Equity indexes broke November 2008 lows in February before rebounding in the last three weeks of the quarter. During these three weeks, the Russell 1000® Index of U.S. largest market capitalization companies was up 18%. All major sectors participated, but the bulk of the performance came from previously beaten-down materials, automotive, and financial stocks,suggesting that a good portion of the rally was due to short covering. Financials were a distant leader, returning an astounding 38% for the quarter closing rally.

Financial stocks rebounded strongly on comments from Citi about good profitability during the quarter, short-covering, 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.

Performance of Market Benchmarks
March 31, 2009

Unscreened US Benchmarks



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Unscreened non-US Benchmarks














MSCI Emerging Markets IMI







In the financial sector, while the franchise value of large banks certainly still exists, their fundamentals will continue to be questionable until the toxic asset issue is resolved and until more bad assets are written off. Because of this, it is unlikely that a financials-led market recovery will be sustainable.

We believe the so-called “cram-down” legislation will push car loans and credit card debt into bankruptcy court along with mortgages. This will likely 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. It is encouraging to see better performance in the information technology sector for the quarter. Tech stocks were the only group posting positive returns during the quarter within the Russell 1000.

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 will create some of the most attractive investment opportunities on record for investors with long-term investment time horizons. In the short term, however, we are likely to continue to see sharp pull-backs followed by short-covering and window-dressing rallies.

#8889 (4/09)

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