With 20/20 hindsight, hardly a soul argues that Lehman Brothers should have been allowed to founder. The firm’s bankruptcy filing on September 14 precipitated a waterfall that created a host of knock-on effects. In retrospect, the authorities failed to appreciate how interlinked the global financial system had become. Had Lehmans survived, markets would still have suffered, but the nosedive would probably have occurred at a less frantic rate.
Superlatives abounded this autumn: the lowest rate, the deepest swoons, the most wrenching volatility. October saw the worst-ever monthly point declines in the Dow Jones Industrial Average and the S&P 500 index, with the former plummeting 14% and the latter 17%. In the five days starting Monday, October 6, American equity markets shed 20%, effectively constituting a crash, led by forced and relentless selling pressure. Buyers had evaporated.
The financial sector is reeling. Morgan Stanley and Goldman Sachs have converted from investment to traditional banks. JP Morgan, which had ridden to the rescue of Bear Stearns in March, this season took over most of Washington Mutual for $1.9 billion (GBP 1.3 billion). Bank of America bought Merrill Lynch. The government first ploughed $85 billion into American International Group, then another $37.8 billion, and by November 10 had raised the tally to $150 billion.
Dan Genter, of RNC Genter Capital Management in Los Angeles, gives a warning: “Typically when regulators and politicians have tried to manage any industry- be it railroads, airlines, saving and loan banks or farms – productivity severely diminishes.”
We have a central bank and Treasury that has taken on the multiple roles of judge, jury and executioner. Yet it is one matter to bail out individual sectors and another to remake the entire base of capital formation. The upheaval has been bewildering to markets, which perceive that normal dynamics are no longer working.
“There is no rhyme or reason,” Genter says with a sigh. “We don’t know who will live or who will die, or why.” The worst of the carnage took place while the Federal Reserve was lobbying for the Troubled Assets Relief Program (Tarp) to be approved. That marketing effort eroded all confidence, as it provided so little detail or substance. Why should the government save Bear Stearns while it let Lehmans go down? (One hypothesis holds that Lehmans may have guessed wrong, when it bet the house. When it declared bankruptcy, it expected the same treatment as Bear had received. Why else would it have tried to compact negotiations into one weekend and failed to draw down on credit at the Fed window? The bluff misfired when the Fed decided to sacrifice Lehmans to help get the $700 billion “tarpaulin” bail-out passed.)
In fact, earnings have not been as dire as headlines may suggest, at least if you exclude the financial (down 124%) and consumer discretionary (down 45%) sectors. As of mid-November, with 93% of the S&P companies reporting, the third quarter stands at negative 18.4%, but without the financials would achieve a positive 8.5%. “So there must be some pockets of strength,” points out Ashwani Kaul, Investment & Advisory at Thomson Reuters. He deduces that, even in a challenging business environment, most companies have still been able to execute. Kaul notes that from 2000 to mid- 2002, over eight quarters, earnings were down about 25% on average. “And then we didn’t even have a financial crisis, just a bunch of dotcoms shutting down,” he says.
This time, energy performed the best, with a 59% gain, with integrated oil and gas contributing 70% of the sector’s growth. With oil prices down 130%, industrials could fare a bit better, Kaul suggests, considering the burden high transportation costs impose. On the other hand, sharp declines in all commodity markets have hit the producing companies. The irony is that “people are nervous about energy on both sides now,” says David Wyss, Standard & Poor’s’ chief economist. “Normally, either producers or consumers of energy should do all right, but now both are under pressure.” Consumers have enjoyed a large respite from high petrol prices, down 14.2% in October, while overall consumer prices plunged by 1%, the steepest dive since 1947. “People have become excessively nervous about spending and borrowing, as they see their neighbours in trouble,” says Wyss.
There is little doubt that recession will crimp the economy in coming months. The best hope is that markets generally bottom out six to nine months before a recession ends. Andrew Burkly, financial markets strategist at Brown Brothers Harriman, an investment bank, offers some advice for those seeking a floor. “You would want to see stocks very oversold, with pessimistic sentiment, to show selling pressure has worked its way through the system,” he says.
After the past month’s trading range, or basing pattern, he fears a break on the downside. Historical lows from 2002 reveal support at about 770 on the S&P, and 7500 on the Dow. Taking another technical approach, a long-term trendline on the S&P, dating back to 1932, shows a 7% annual gain, based on historical growth. The massive bull markets in the 1980s and 1990s shifted us far above that trajectory, while the movement since 1998 has been sideways. A return to that trend would bring the S&P to 700.
Burkly counsels investors to wait for both capitulation and signs of sustained aggressive buying before wading in. It would also be encouraging to see credit spreads tighten in the corporate bond market.
It is hard to imagine that markets will turn north again without a couple of quarters of stabilisation in the financial sector. Investors will demand incrementally better news at least, in the absence of potential catalysts to prompt buying. After bazookas full of catalysts – to paraphrase Treasury secretary Henry Paulson – few remain available.