Monthly Market Monitor - October 2008

Congressional Inaction Leads to Market Meltdown
Stock investors were reminded again about political risks, as the U.S. House of Representatives failed to pass key legislation regarding a bailout plan for financial institutions. It is more common for political risk to be a significant factor in returns for emerging and international markets, yet recently U.S. political uncertainty experienced a significant spike. The catalyst for the recent large swings in both domestic and global markets has been the congressional gridlock regarding the $700B bailout package. It should come as no surprise that this year is also an election year. This bailout legislation has not been well marketed or understood by U.S. citizens and constituents. Currently, it is estimated that only one in ten Americans are in favor of this perceived bailout of Wall Street firms. The economic reality, however, is that without any legislation in place to free up capital for certain U.S. banks and investment firms, lending will continue to be severely constrained and will ultimately shut down major areas of the economy. This credit crunch has already led to the drying up of important fixed income markets, such as commercial paper and the leveraged loan markets (floating rate). These are critical markets that grease the wheels of the U.S. economy by offering borrowing options for U.S. corporations and consumers to cover basic needs. Without liquidity in these markets, some U.S. companies are forced to pay significantly higher interest rates for loans and ultimately this will lower corporate profits.

For bond and money market investors, the liquidity crunch has been creating many pricing inefficiencies. Municipal bond and high yield corporate bond markets, which are “over the counter” markets, often trade significantly below fair value during times of duress. Investors must use great discipline not to sell into these discounted prices because at some point liquidity will return. In the municipal bond market, state budget deficits have grown significantly, so investment decisions should be made as to whether or not state tax exemption is worth the perceived individual state risk. Larger states such as California, New York, New Jersey, and Michigan are showing signs of budget stress and credits may experience downgrades that could question the quality of certain municipal bonds. High yield and floating rate bond markets are also becoming increasingly illiquid and investment time-horizons need to be reevaluated. These investments generally require a minimum of two to three years as an investment horizon but in the current environment, individual investors may wish to have more immediate access to their funds. Even money market funds are being impacted due to the drying up of the commercial paper market. Once again, the U.S. government put in place a safeguard measure for the next year as well as offered an additional $72B in short-term liquidity to assure that money market funds can move high grade paper easily to meet demands.² So far, money market funds have not shown significant signs of credit stress but yet are still being impacted by a lack of liquidity. In short, fixed income exposure still poses significant risks to the individual investor and credit, duration, and sector bets need to be reevaluated more frequently.

Market Upside Exists with Greater Certainty
Generally, uncertainty in the stock and bond market translates to higher volatility and often downward pressure on prices. Today, the level of uncertainty has been rising dramatically, especially as it relates to credit market rescue legislation. Furthermore, there is political uncertainty surrounding both the presidential and the congressional elections coming next month. It also should be recognized that earnings uncertainty exists during the fourth quarter as the bulk of corporate earnings is often delivered at the end of the year. Often this leads to downward pressure on the stock market during the third and fourth quarters and historically, September and October are usually the worst months for equity returns. Not surprisingly, however, November, December and January, are often the best months for equity returns. The Thanksgiving week on average produces about a 2%+ return and December and January are often battling for the spot of best month of the year on average. These seasonal trends should not be underestimated because they often coincide with large institutional investments that need to be committed at the beginning of the year. Even IRA contributions can have a lifting effect on the total market. Looking forward, as more certainty emerges to the political, legislative, and earnings landscape, investors should expect an improvement in returns. This will likely begin with the passage of some legislation to aid certain firms currently confronted by the liquidity crunch. As a result, much is at stake for investors as it relates to hurdling this current obstacle and bringing greater certainty back to the marketplace.

1. Wall Street Journal, 10/1/08
2. Ignites, 9/29/08

The views are those of Robert Garland, Vice President, Research Department/ING Advisors Network, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy.

All economic and performance information is historical and not indicative of future results. The market indices discussed are unmanaged. Investors cannot directly invest in unmanaged indices. Please consult your financial advisor for more information.

Additional risks are associated with international investing, such as currency fluctuations, political and economic instability, and differences in accounting standards.

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