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Schwab Market Perspective: Stocks Climb Wall of Worryby Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.and David Kastner, CFA, Director, Market Analysis Group, Schwab Center for Financial Research August 15, 2008 Stocks climb the wall of worry. A breakdown in the price of oil and other commodities, combined with a rally in the dollar, is lifting investor sentiment. Although there could be some more upside for the market, the history of bear markets shows that new lows could be in the offing. Financial crisis still simmering, but edging toward a boil. Many of the government's efforts to shore up the credit markets have been somewhat successful. Yet, continued turmoil in the mortgage market is spilling into the broader economy. Until the housing market stabilizes, this is likely to continue. The elusive housing market stabilization. As inventories remain stubbornly high, home prices continue to fall. While further declines are likely, the pace of house depreciation has slowed, offering some hope of stabilization next year. Fall in commodities eases inflation concerns. Key measures of inflation continue to climb, but slower economic growth prospects around the globe have brought commodity prices lower. Inflation gauges, which are lagging in nature, should recede in the coming months. Consumer and corporate woes. Retail sales have been bolstered by the federal stimulus checks, but the boost is quickly fading. As the unemployment rate rises, dour consumer sentiment threatens to reinforce a negative feedback cycle of slower consumer spending and weaker corporate confidence. Global inflection point playing out. It is now clear that the U.S. is not alone in the economic slowdown. Although this is negative in many ways, it has brought commodities down and the U.S. dollar up—sparking a shift in U.S. and regional performance.  Stocks climb the wall of worry The markets continue to climb the wall of worry—a bullish market trend in the midst of negative circumstances—after seeing at least an interim low in mid-July. A breakdown in the price of oil and a rally in the U.S. dollar helped lift investor sentiment and U.S. stocks. Financials led the charge with the help of an emergency enforcement of a U.S. Securities and Exchange Commission (SEC) rule prohibiting naked short-selling, as well as a U.S. Treasury plan passed by Congress to support Fannie Mae and Freddie Mac. Yet, setbacks along the way keep tensions high. With the expiration of the SEC short-sale rule, and some gauges of financial stress at or above levels seen in March, financials are struggling once again. Economic growth both in the United States and abroad continues to deteriorate, weighing on earnings expectations. Despite the sharp pullback in oil and other commodities—even with the Russian invasion of Georgia and threats to regional oil pipelines—lagged readings on consumer prices are disconcerting to investors. And, of course, the elusive stabilization in the housing market—seen as a necessary condition to ease strains in the global financial system—is still a major focus of the markets. These worries are, in some sense, the bricks in the wall of worry that stocks tend to climb. In the short-term, markets could potentially continue to churn higher—likely peppered with more days of sharp volatility—as sentiment improves, although it is not yet at extremely optimistic levels. As we often note, excessive optimism regularly marks at least a short-term high-water mark in stocks. Many technical indicators do not yet reflect overbought conditions like those we saw in mid-May when the spring rally gave out.  Has the market bottomed yet? Although we're now officially in a bear market (down more than 20% from the October 2007 high), history shows that more downside could be in the offing. On average, bear markets culminate in a 35% loss, and less than 15% of the bear markets since 1929 have bottomed with a 22.4% or less decline (which is where the S&P 500 index was on July 15, 2008). The markets did quite well in the second-quarter earnings reporting season, during which third-quarter estimates were cut in half (to 6% growth). But fourth-quarter estimates remain at a lofty +64% year over year—which we believe is way too optimistic. Financial stresses are nearly boiling over once again, offering little hope of a jump in financials sector earnings. And the ongoing slowdown in economic growth in the U.S. and around the world doesn't appear to be completely factored into robust earnings expectations for energy, materials or nearly any other sector. Although we've seen some panic in the market, we haven't reached the level of capitulation and despair that often marks the bear market low. Read more on the history of bear markets and earnings growth in Liz Ann Sonders' article, Slow Ride: Market Digesting More Economic Pain. Return to top Financial crisis still simmering, edging toward a boil The U.S. government has made significant efforts to stabilize the financial markets and stave off a recession. The Federal Reserve took aggressive and unprecedented measures in offering credit facilities to financial companies outside of the traditional commercial bank recipients, as well as brokering the sale of troubled Bear Stearns earlier this year. The U.S. Congress granted authority to the Treasury Department to lend unlimited support to the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac, in addition to providing more than $100 billion to cash-strapped U.S. consumers and a lifeline to potentially 400,000 homeowners facing foreclosure. In spite of these measures, financial turmoil continues to evolve and seep into the broader economy. Banks have written off close to $500 billion in subprime-related losses. Although sovereign wealth funds (SWFs) were quick to resupply capital to banks early in the crisis, new capital is harder to come by. BCA Research estimates that there has been a $120 billion shortfall in capital raising. The failure of IndyMac in July and continued stream of multibillion-dollar charge-offs are eye-opening to investors.  The cost of borrowing from the capital markets is increasing. Banks are moving quickly to shore up their balance sheets and rein in risk. As part of this effort, they are rapidly tightening lending standards—for mortgage, consumer and commercial/industrial (C&I) loans alike. In some categories, lending standards are at the tightest levels since the 1980 recession—and these figures include survey results from a wide swath of banks, not just the large ones with subprime-related exposure. Indeed, this reflects a negative feedback cycle that was sparked by the housing meltdown but has transgressed throughout the broader economy. The International Money Fund (IMF) estimates there will be $945 billion in total losses, but some (including Schwab) believe that number could be significantly higher, with renowned economist Nouriel Roubini putting the final bill closer to $2 trillion. Ultimately, U.S. house prices will determine where this crisis ends. In an interview with the Financial Times this week, Former Fed Chairman Alan Greenspan said that an end to the decline in house prices is "a necessary condition for an end to the current global financial crisis … Stable home prices will clarify the level of equity in homes, the ultimate collateral support for much of the financial world's mortgage-backed securities. We won't really know the market value of the asset side of the banking system's balance sheet—and hence banks' capital—until then." Return to top The elusive housing market stabilization Recently, we've seen a sprinkle of encouraging data on new homes: The inventory of unsold new homes has started to recede somewhat—albeit from still-high levels. And starts of new homes are at 1990 levels. Unfortunately, new homes account for just 15% of the housing market. After a disappointing spring sales season and a continued flood of foreclosures (+55% in July year over year), the inventory of existing homes for sales remains bloated. With GSEs taking on less risk (buying fewer loans) and the secondary (non-GSE) mortgage market at a near stand-still, even would-be buyers are having a tough time getting financed. Mortgage rates remain sticky—near the same level as before the financial crisis broke out—despite lower Treasury yields (reflecting increased risk premium). Sharply higher lending standards contribute to the problems. To make matters worse, the fragile economy and higher unemployment rate reduce the number of potential buyers, as well as increase the supply of homes for sale. This toxic mix—plus the fact that houses are not yet cheap (on average)—is keeping many bargain hunters at bay. By our estimates (based on the historical relationship of median house prices and median incomes), house prices can come down another 10%–15%, and that assumes no overshoot. Fortunately, we see some signs that house price depreciation is slowing. As illustrated in the chart below, the month-over-month decline in house prices has become less dire. Although still declining, the slower pace of decline could begin to provide some solace to banks and consumers alike.  Return to top Fall in commodities eases inflation concerns Lower oil prices have given investors and the Fed some reprieve over concerns about inflation. But it's not just oil prices providing encouragement. Nearly all commodities have fallen in recent weeks, and the U.S. dollar has apparently found its footing (at a six-month high)—quelling worries about import inflation.  But just when inflationary concerns seemed to be easing, the consumer price index (CPI) for July showed that pricing pressures may be spreading beyond food and energy. This followed the 21.6% year-over-year jump in the import price index in July—the biggest jump in the index's 26-year history. The consumer price index rose 0.8% (above the Bloomberg estimate of 0.4%), and the core rate, which excludes food and energy, increased 0.3% (above the expectations of 0.2%). Year over year, the headline rate rose from 5% to 5.6%, which marks the highest rate since January 1991. The core rate increased from 2.4% to 2.5%, well above the Fed's implied comfort range of 1%–2%. Although higher than expected, these CPI readings (which are lagging indicators), may not be as concerning to investors and the Fed as they could have been if commodity costs, including energy, hadn't seen sharp declines during the past month—and the dollar hadn't strengthened against most major currencies. These recent corrections should help future inflation readings moderate, easing pressure on the Fed to respond with higher interest rates. With unemployment rising and economies around the world slowing, the Fed doesn't relish the prospect of having to tighten monetary policy in the United States. Fed members will continue to look for signs that inflation expectations are becoming unhinged and will act as necessary. However, we believe inflationary pressures will quickly recede in the coming months as wage pressures remain tame and sluggish economic activity continues. And though we expect earnings expectations to subside further, lower inflation will likely offer support to the market as earnings multiples are generally supported by lower inflation.  Return to top Consumer and corporate woes The housing implosion has impacted U.S. homeowners two-fold: mentally, as they watch their homes lose value; and materially, as it is increasingly harder for them to tap their homes for cash. Some banks have even closed existing home equity lines of credit (HELOCs). Because energy prices have come down sharply, we have hope that consumer sentiment will rebound from recessionary levels. Indeed, our consumer stress index has come off of recent lows, but the consumer still faces significant challenges. Wage growth remains moderate, which is good from the perspective of keeping core inflation at bay and suggests wages are still growing despite increased corporate caution. On the flip side, still-high food and energy prices have eroded real spending power. Consumers are now spending a record 56% on essential items. Although the unemployment rate remains low by historical standards, the rise to 5.7% in July has consumers on edge. The prospect for a severe spike is low given that the over-hiring in previous economic expansions didn't occur during this past one. But the longer the housing malaise continues, the more risk there is of a negative feedback loop from weaker consumer spending and corporate confidence.  The federal government distributed nearly $100 billion in rebate checks through July. In recent months, this liquidity helped support retail spending, but that is already fading. Although another stimulus plan is now in the works, consumers are increasingly boosting their propensity to save rather than spend—and much of that first round simply went toward offsetting higher food and energy costs. Cutbacks are particularly evident with big-ticket items, with General Motors announcing plans to slash output further amid an ongoing sales slump. Outside the beleaguered financial sector, corporations remain generally healthy. They have plenty of cash on hand and their relative debt levels remain low. Default rates have stayed tame in comparison to the profit recession earlier this decade—and their generally healthy state is likely in reaction to the hard times they experienced during that recession. However, mindful of concerns about the U.S. economy, corporate spending and hiring is slowing. The National Federation of Independent Business' (NFIB) latest small business survey reflects a weakening trend in job openings and recessionary levels of capital expenditure plans. While still positive thanks to strong energy earnings, profit growth outside of the financials sector has been under pressure from slower consumer spending, higher input costs, and now potentially from weaker global growth. Return to top Global inflection point playing out As expected, mounting signs of slowing global growth are taking their toll on the commodity complex. Oil prices have fallen sharply (as have most other commodity prices) and the U.S. dollar has rallied sharply from multiyear lows. We have been long-time skeptics of the theory that global economies had divorced themselves from the U.S. economy. To us, the notion that the U.S. economy could falter without triggering a significant impact on emerging and developed economies alike is inconsistent with the explosion of global trade in recent years. Many emerging markets are now fundamentally stronger and less susceptible to catching a cold when the U.S. sneezes—thanks in large part to less dependence on external financing—but we see a greater interconnectedness, not a decoupling or separation, between developed and emerging economies. The United States faces some significant and unique challenges. However, because of the high level of international trade and financial-system integration around the globe, numerous commonalities also exist. It has been our view that the United States has simply led the globe in an economic slowdown, which contributed to the sharp declines in the U.S. dollar earlier in the year. But we now see mounting signs of slowing around the world. A broader global slowdown could lead to continued strength in the dollar, as economic sentiment between different economies moves into closer alignment. Most of the developed world is exhibiting signs of an economic slowdown, noticeably in Japan and Europe. In the United Kingdom, a housing bust is weighing on growth (just as in the United States), with consumer confidence and retail spending flagging. European growth (second quarter –0.8% annualized) succumbed to excessive currency strength, tighter financial conditions and a stubborn European Central Bank (ECB), which raised interest rates as recently as early July. And Japan's government is now calling for stimulus as its economy ended the longest post-war expansion in the second quarter with a –2.4% annualized contraction in gross domestic product (GDP). In emerging markets, inflation has increasingly become a problem. Although most of these economies are still growing strongly, a rapid rise in commodity prices has quickly filtered into a wage-push inflation problem. The requisite tightening measures necessary to bring inflation under control will likely stymie economic growth—particularly in Asia (including China), where slowing export growth is already weighing on those economies. Slower global growth translates to less demand for natural resources—thus weighing on the commodity exporters.  We've been expecting this scenario. For the first time since February, oil has broken below its 50-day moving average, and it's approaching the 200-day moving average for the first time since May 2007. Many of the resource markets, such as in Latin America, have begun to underperform Asian markets, which are generally commodity importers. And globally oriented U.S. industries have begun to underperform those industries that derive their revenues domestically. The U.S. dollar has held up relatively well considering the recent market turmoil, and U.S. shares have outperformed international markets since the interim high in mid-May. We expect these trends to continue, and potentially accelerate if the dollar can rally further—though heightened volatility in oil and the dollar is expected. Read more about our views on the international landscape in David Kastner's article, Global Inflection Point? Return to top
As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started. Important Disclosures The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 2005, the MSCI EAFE Index consisted of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The MSCI Emerging Markets IndexSM is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 2005, the MSCI Emerging Markets Index consisted of the following 26 emerging market country indexes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela. The S&P 500® index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly. Past performance is no guarantee of future results. Investing in sectors may involve a greater degree of risk than investments with broader diversification. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks. The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice. (2008-3753) Return to Top |
August Market Snapshot
With Liz Ann Sonders 
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