MARKET COMMENTARY • AUGUST 2008
BEAR MARKET
The widely accepted definition of a bear market is a 20% price decline from a prior high. The
S&P 500 index, after its worst June since the 1930s, has now breached this unofficial mark and
entered bear territory. This dismal performance reflects renewed fears about the financial sector
and record high oil prices.
Bear markets vary in severity and duration. During the past 60 years, these markets have lasted
on average 388 days and witnessed a median price decline of about 25%. Based on such
averages, the current bear market may run another four months and fall an additional 3% to 5%.
As usual, the majority of the damage occurs before the market reaches the 20% mark.
But averages can be misleading. Each bear market has its own unique features and fundamental
context. These variables determine the ultimate length and magnitude of the decline.
The current market is the result of the ongoing housing, credit and energy shocks that have
slowed economic activity and seriously damaged investments in the financial and housing
sectors. The major contributor to the market’s decline has been the S&P 500 financial index,
which has fallen almost 60% from its February 2007 peak.
What variables will determine when this market bottoms, and economic prospects improve,
include:
Housing prices. Home prices have been falling under the weight of high inventories of unsold
homes and rising foreclosures. Their decline, according to the widely followed S&P/Case-Shiller
Home Price Indices, has reached a postwar record of -18%. Home prices affect consumer
spending, residential investment and the continuing writedowns in the value of mortgage-backed
securities.
There are signs, however, that the housing cycle, after 31 months of decline, is in the early stages
of recovery. The evidence:
•
•
•
•
•
Sales of existing homes are showing tentative signs of stabilizing.
Housing affordability has returned to 2003 levels.
New housing starts have declined more than 1 million units from their peak and are below
the rate of new-household formation.
Subprime mortgage origination peaked in the third quarter of 2006, and the damage these
mortgages are causing has already been released into the system.
House prices rose between March and April in eight of the 20 markets covered by the
S&P/Case-Shiller Home Price Indices.
821 East Main Street • Richmond, VA 23219 • 804-644-2848 • Fax: 804-644-6922 • www.middleburgtrust.com
MARKET COMMENTARY • AUGUST 2008
MIDDLEBURG TRUST COMPANY
PAGE 2
Home sales are running at an annual pace of about 5 million units, or near the same level as a
decade ago. During these 10 years, the population has grown by 25 million, new jobs have
increased by 10 million, and housing starts are well below the net annual addition of 1.6 million
units required by new household formations.
Credit crunch. The credit cycle abruptly turned down 12 months ago and initiated the ongoing
period of defaults, retrenchments and deleveraging. Credit losses at worldwide financial
institutions have now exceeded $410 billion.
Despite new wrinkles like the turmoil surrounding Fannie Mae and Freddie Mac, credit markets
have been stabilizing. Many aggressive investors have, in fact, been shorting financial company
equities and buying their credit.
Liquidity pressures are easing as indicated by declining dealer usage of the Federal Reserve’s
lending facilities and stability in bank-to-bank lending spreads. The TED spread, the difference
between the yield on the three-month Eurodollar and the three-month U.S. Treasury bill, remains
at the low end of its 2008 range.
But many banks do need to restructure their balance sheets and raise additional capital. More
small regional banks may fail and be seized by federal regulators. The ultimate solution to the
capital problem likely will involve four investment groups — sovereign wealth funds, oil
exporters, hedge funds and private equity groups — that continue to see rapid growth in their
assets under management. It’s not surprising that the Fed is currently working with private equity
firms who are interested in investing in banks.
The reconstruction of bank balance sheets and their cash flow statements will require years of
positive, and preferably steep, yield curves. The Fed will likely keep the Fed funds rate low to
help make this happen.
Oil prices. A sustained drop in oil prices from recent peaks is necessary for economic recovery
and stronger equity markets. Every $10 per barrel increase, if sustained for 12 months, reduces
gross domestic product 0.2% to 0.3%. If oil remains near $140 per barrel, a recession in the
already weakened U.S. economy appears certain.
The spike in oil prices appears to be producing the necessary reactions for a price reversal.
Demand for oil is slowing, particularly in developed countries, and output, notably from Saudi
Arabia, is rising. In developing countries, subsidies are being reduced, which will also constrain
demand at the margin.
Nonetheless, the supply/demand balance is still tight, and any supply disruption could cause
prices to again surge higher. In other words, predicting short-term price movements with any
degree of confidence is folly.
821 East Main Street • Richmond, VA 23219 • 804-644-2848 • Fax: 804-644-6922 • www.middleburgtrust.com
MARKET COMMENTARY • AUGUST 2008
MIDDLEBURG TRUST COMPANY
PAGE 3
There often are meaningful rallies in bear markets, as evidenced by the rally this spring. The
current market is oversold, short selling is at record levels and sentiment is dreadful. Thus, the
conditions for a rally appear in place.
Such rallies should be used to manage portfolio risk lower, as the ultimate bottom will be a
combination of emotional exhaustion and fundamental improvement, particularly in house
prices, credit conditions and energy prices. This will take time.
Commentary provided by Orie L. Dudley, Jr.
821 East Main Street • Richmond, VA 23219 • 804-644-2848 • Fax: 804-644-6922 • www.middleburgtrust.com