Freedom One Investment Advisors
Market Commentary – October 2008
By Norman C. Leon, Investment Analyst


The Market
October 2008 was one of the most stressful months in U.S. stock market history.  On October 10, the Dow had collapsed as much as 25% for the month – not the year – the month!  Specifically, the Dow closed at 10,371 on September 30, and it plumbed 7,773 intraday on October 10.  At that point, the Dow was down about 45% from its all-time intraday high (14,279) on October 11, 2007, and down about 41% for 2008.  It was an historic meltdown. 

However, by the end of October stocks had reclaimed a lot of lost ground.  The Dow finished the month down about 10%.  That’s still a tough month, but it sure is better than being down 25%.  Encouragingly, the Dow and S&P 500’s intraday lows set on October 10 were retested several times during October and both indexes managed to snap back from oversold levels with ferocity.  In fact, there were two 900 point Dow rallies during the month, one on October 13 and the other October 28.  As such, many analysts think the stock market has found a bottom.  Especially since the latest retest and subsequent rebound occurred in the midst of a storm of tough economic news. 

For example, consumer confidence hit a 41-year low, the unemployment rate is expected to reach the 8% neighborhood, consumer spending is falling, third quarter Real GDP growth fell 0.3%, and home prices dropped 16.6% year over in 20 cities in August.  In other words, we’re in recession.  News around the world has been challenging too.  The U.K. is slipping into an economic recession, the Japanese Yen has been surging (not good for their exports), Argentina is nationalizing their pension funds, and European banks are scrambling for capital, and so on. 

The great news is government central banks around the world have not been sitting idle. There has been a massive coordinated effort to increase the supply of money in the system. Many central banks are cutting interest rates simultaneously (e.g., U.S., Canada, Japan, Britain, Sweden, Switzerland, Saudi Arabia, China, South Korea, Taiwan, Hong Kong, and New Zealand), and the global rescue package is approaching $4 trillion and rising. 

The U.S. Federal Reserve cut key interest rates by 0.50% twice in October, back to only 1%, based on the Federal Funds Target Rate.  After the 9/11 terrorist attacks, the Fed cut key interest rates to the same level and it helped to spark a strong economic recovery, arguably in hindsight too strong.  

The Emergency Economic Stabilization Act (EESA)
The Treasury Department effectively forced nine major banks to agree to issue preferred stock with a 5% yield in exchange for the $125 billion infusion.  $25 billion was each handed to Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo, while $10 billion each went to Goldman Sachs and Morgan Stanley.  The balance went to the Bank of New York ($3 billion) and State Street ($2 billion).  Another $125 billion is now in the process of being handed out to small and mid-sized regional banks.

The Treasury’s (or, taxpayers) preferred stock is callable after three years.  After five years, the Treasury’s preferred stock will convert to a 9% yield with an incentive to pay the Treasury Department back within five years.  The banks involved will not be able to increase their dividends for three years while the Treasury is an investor and cannot get rid of the investment for three years unless they raise high-quality private capital.  These banks must also get the Treasury’s consent to buy back their own stock.

The other big string attached to any bank borrowing money from the U.S. Treasury is the salaries for their Top Five Officers of the company are capped at $500,000 per year.  This obviously provides tremendous incentive for bank executives to repay the Treasury Department as fast as possible (or find another job).  For the record, the banks that were part of the first $125 billion Treasury infusion recently paid a total of $289 million, an average of $32 million a piece, to their CEOs, including stock option grants.  This group of CEOs will now only be able to make a combined $4 to 4.5 million per year, until they pay off the U.S. Treasury.

After Treasury Secretary Hank Paulson said the U.S. government intends to make money on the first phase of the bailout program, Fed Chairman Ben Bernanke recently suggested the need for a second stimulus program.  Specifically, Bernanke said in prepared remarks to the House Budget Committee that, “With the economy likely to be weak for several quarters, and with some risk of a protracted slowdown, consideration of a fiscal package by the Congress at this juncture seems appropriate.”  Obviously, any such package will likely be finalized after the November presidential election.  Yesterday, the Treasury and Federal Deposit Insurance Corporation (FDIC) said a $500 billion mortgage-guarantee plan was being considered to stem the foreclosure rate in the housing market.

Conclusions
The amount of liquidity being injected in markets around the world is staggering.  Governments are unquestionably doing their job.  Now we need the banks to stop hoarding cash.  As soon as the November election is over, much of the stock market’s volatility may subside and banks should get back to the lending business (albeit, more prudently).  This is mostly because the uncertainty surrounding the election will be over.

Less stock market volatility could also lead to higher investor confidence, which could result in a continued rebound in stock prices.  After all, the approximate value of the U.S. stock market is $10 trillion, and there’s about another ~$4 trillion sitting in cash on the sidelines.  That’s a record amount of firepower.

The best news for investors is the seasonally strong time of year is finally here.  The stock market is much healthier between November and April than it is between May through October.  In fact, if you invested in the S&P 500 Index on May 1 and sold on October 31 every year since 1950, you actually lost money in the past 28 years, according to the Investor’s Almanac.  On the other hand, if you invested in the S&P 500 Index on November 1 and sold on April 30, your money would have appreciated by over 2,200%. 

Some people think this seasonal anomaly exists because people cheer up during the holidays.  Others believe that pension funding at the end of the year through April 15 causes these extreme seasonal distortions.  Frankly, it’s probably a little of both and a lot more economic issues as well.  In addition, most economists expect the U.S. economy will experience 3-4 consecutive quarters of negative real GDP growth, starting with the third quarter of 2008 and ending after the first or second quarter of 2009. 

In a nutshell, the stock market re-tested the October 10 lows numerous times this month, it’s now rebounding in the face of bad news, government central banks have primed the pump for growth, commercial banks should start lending again after the election, investor confidence will improve after the election, there’s ~$4 trillion in cash looking for higher returns (in a low short rate environment), we’re in the seasonally strong time of year, and history suggests the best time to invest is about four months before the end of a recession. Things are looking up.

Norman C. León is an Investment Analyst for Freedom One Financial Group.  Mr. León joined the firm in 2005 and has over 15 years in the investment industry.  Mr. León's background includes portfolio analysis, portfolio risk analysis, quantitative equity analysis, equity and industry research analysis, capital market analysis and public investment newsletter and commentary.