Update on the Current State of the Markets: 9-16-2008

A lot has been happening in the financial markets over the past 30 days.  The government took over management of Freddie Mac and Fannie Mae, Lehman Brothers filed for bankruptcy, Bank of America announced they are buying Merrill Lynch, Washington Mutual’s stock price is down more than 60% in the past week, and one of the world’s largest insurance companies, AIG, is muddling through its own financial troubles.

Although the world (at least the financial world) might seem like it’s coming to an end, big shake-outs such as this usually create opportunities down the road.  The U.S. Government seizing control of Fannie and Freddie has essentially provided needed stability to the mortgage market.  According to BlackRock, one of the largest investment management firms: “The actions taken by the Treasury ensure that Fannie Mae and Freddie Mac will continue to have a positive net worth by essentially using the "full faith and credit" of the United States government as a backstop to the balance sheets of the two companies. This means the debt issued by Fannie Mae and Freddie Mac now enjoys the explicit backing of the U.S. Treasury.”  They go on to comment: “In addition to the impact on the valuation of agency and mortgage-backed debt, there are other aspects of this move that investors should consider. The Treasury has been clear that one of the motivating factors behind its decision was to provide support to the broader housing market. It expects that shoring up Fannie Mae and Freddie Mac will ultimately lead to lower mortgage rates, which should help to stabilize the residential real estate markets.”

Additionally, the fact that the U.S. Government did not step in to save Lehman Brothers may actually be positive in the long run.  It is not the role of the Federal Reserve or the Treasury Department to protect the interest of equity investors; rather their role is to protect transactional relationships and provide liquidity to the broader economy.  Companies that take great risks must accept the consequences – not just participate on the upside.  Japan’s slow growth economy was mired in government bailouts that in the end restricted the free flow of capital to high growth opportunities.  Although we do not know what the ultimate outcome will be in terms of new rules, it is abundantly clear that the U.S. Government will not bail out those institutions that make poor decisions and/or take on too much balance sheet risk at the peril of their shareholders and employees as this creates a moral hazard.  The ongoing credit crisis, which has now lasted more than a year and a half, leads us to believe we should expect significant regulation in the complicated derivatives market that would make trading more orderly, transparent and understandable.  In addition to government regulation, we also believe it is incumbent on institutions to self-regulate, or in other words, monitor their own behavior and business practices.

In regards to Bank of America acquiring Merrill Lynch, it is likely that the latter’s credit quality rating will be upgraded with a stronger balance sheet backing its obligations on various counterparty transactions.

While all of this uncertainty has certainly stressed out some investors, there have been positive developments in other areas of the market and general economy:

  • Oil is now under $100/bbl, down more than 37% from its all-time high earlier this year.
  • The fact that Hurricane Ike did minimal damage to the oil industry in the Gulf of Mexico bodes well for prices heading even lower.  The decrease in oil prices is similar to a tax rebate and lowers inflation expectations going forward.
  • The U.S. Dollar has rebounded nicely against both the Euro and the Yen.
  • The combination of lower oil prices and a stronger Dollar have essentially decreased the U.S. trade deficit by a substantial amount.  More importantly, these two factors may allow to Fed to ease interest rates in the near future without the fear it would spark another round of inflation.  A rate cut would in turn provide more liquidity to get the slowing economy going again.
  • The takeover of Fannie and Freddie has already resulted in lower mortgage rates as there is now an explicit guarantee with greater stability in the system.  This should lead to an improvement in the housing market.
  • Finally and maybe most importantly, with equity markets retreating, valuations in most sectors once again look attractive - potentially leading to a rebound.  Historically, markets tend to rebound six to twelve months before the economy turns.

So what does all this mean for our clients?

In these turbulent times, investors may wonder if their mutual funds are safeguarded.  If you own a mutual fund managed by a financial firm that has failed or is at risk of doing so, you have protections.  By law, the shares of each mutual fund are owned by the fund's shareholders, not the company that manages the fund.  The securities in each mutual fund are custodied in a third-party account separate from the parent company's assets, and therefore are not available to the parent company and its creditors.

Innovest has always preached the value of having a diversified portfolio and a long-term outlook.  Although we can’t predict when the current credit crisis will end or when the equity markets will bottom out, we do believe that remaining invested in the market is essential for long-term investment success.  On an ongoing basis, we look to see where the new opportunities may arise.  Because the markets remain volatile and the current situation fluid, it is a bit early to determine where those opportunities reside.  However, we will remain on top of events as they unfold and keep you, our clients, informed.  For updates on current events as they unfold please be sure to explore our Innovest Blog, where we post commentary from some of our most trusted investment advisor sources.  Should you have any questions or concerns, don’t hesitate to give us a call.

Steve Karsh, MBA

Director of Research