Quarterly Market Commentary - Q3, 2008
Third Quarter, 2008
Market Overview
Economic Outlook Municipal Debt Discipline
Peroni 3Q Market Commentary Taxable Disciplines
The 3rd quarter of 2008 is now complete, but unfortunately, strategists, historians
and layman alike will be talking about its events for quite some time. We won’t rehash
every headline; however, the crisis in the credit markets was and will continue
to be the main driver over the near term. On Friday the 3rd of October President
Bush signed into law a $700 billion bill to help bolster US financial markets and attempt
to unfreeze global credit markets that the House had approved earlier in the
day. The first attempt failed to pass the House earlier in the week as most Americans
(~80%) were against the bill. However, after it failed to pass, markets of all
types sold off significantly and Americans quickly had an about face with approximately
70% favoring the bill by week’s end. Ironically, the markets have sold off
more since the bill was signed than they did when the bill failed to pass. This may
be due to investors feeling the bill is too little too late; however, we believe that although
the bill is not perfect, it will help shore up credit markets once the dust settles.
The bill is quite extensive and includes granting the SEC authority to suspend
the mark-to-market accounting rules which has been named as one of the culprits
responsible for our current downward spiral. The bill also allows the SEC to temporarily
increase the FDIC insurance to $250,000 from $100,000. In addition, the
Treasury will be allowed to begin purchasing up to $250 billion in distressed mortgage-
related securities. These securities are wreaking havoc on the balance sheets
of many financial corporations and pensions. The President then can approve another
$100 billion if he deems it necessary, as well as another $350 billion, but congress
has the ability to deny this amount via a vote. Again, it is easy to “arm chair
quarterback” this bill; however, it is clear something needed to be done. Over time,
this bill should help to restore confidence and stability to the US credit markets.
Despite the meltdown in the credit markets, financial stocks actually posted a slightly positive return for the quarter. However,
this was not the case for all equity markets. Specifically the S&P 500 Financials Index gained .85% for the quarter while the
S&P 500 lost 8.33%. The S&P 500 has now lost value in four consecutive quarters and is off approximately 30% since hitting a
high on 10/09/07. The losses are even worse overseas as the MSCI EAFE Index (International Developed Markets) has lost
over 35% and the Shanghai Stock Exchange Composite Index has lost close to 60% since hitting near term highs in October of
2007. Taking a look at the other major asset classes we see mostly red with bonds (as measured by the Lehman Aggregate
Index) off .49% for the quarter and commodities (as measured by the Dow Jones – AIG Commodity Total Return Index) off a
staggering 27.7% for the quarter. The lone positive spot among asset classes was REITs (as measured by the MSCI US REIT
Index), which gained 5.41% for the quarter but still stand approximately 35% below their February 2007 peak. Despite all this
red ink we do believe there are a couple of positives emerging with the primary one being a reduction in inflation as commodity
prices continue to wane.
As stated above, commodities lost 27.7% for the quarter marking their worst performance in the eighteen-year history of the
Dow Jones – AIG Commodity Total Return Index. Prior to this the worst quarterly performance of this index was a loss of
13.02% in the 4th quarter of 1998. Most importantly oil has retreated almost 40% from its recent high which should alleviate
quite a bit of pressure at the pump and help put some money back in consumer’s pockets. We have discussed for quite some
time that we thought commodities were due for a correction, but the speed and the magnitude of the correction has even surprised
the commodity bears. The sell off can be attributed to many things including demand destruction caused by the global
economic slowdown. Additionally, the strength of the US Dollar has also been a major factor as many commodities are US
Dollar denominated. The US Dollar strengthened by 10.56% against the Euro in the quarter which was its strongest quarterly
move in the almost ten year history of the Euro. There is a silver lining in this commodity sell off though, as now central banks
can utilize monetary policy to help address growth concerns vice inflation concerns.
For illustrative purposes only.
We previously discussed bonds (as measured by the Lehman Aggregate Index) were off .49% for the quarter, however, US
Government bonds fared very well as investors abandoned most investments en masse in favor of the safety of US Government
obligations. For the quarter we saw yields move down across the spectrum of maturities with the short end moving the
most. The 3-month obligation lost .83% in yield and returned .65% for the quarter despite only carrying a current yield of .51%
and the 10-year lost .15% in yield and returned 2.26%. The 10-year now carries a yield of 3.43% which is its lowest level in
about six months and we would expect it to begin to move higher as more confidence is gained in the credit markets.
For illustrative purposes only.
Though officially it has not been declared that we have entered a recession based on the data, it is widely becoming the consensus
that the US has entered a recession. With this in mind two questions are concerning investors. How long will it last?
How severe will it be? Obviously these are two very hard questions to answer and although they are extremely important we
think there is one other important question. Are the right things being done to minimize the recession’s length and severity?
As mentioned above it is very easy to sit back and critique the various government agencies’ handling of the current financial
crises and although this makes for intriguing discussions it doesn’t help us solve or deal with the current crisis. Given this, we
think the new legislation, though not perfect, should help institutions clean up their balance sheets enough to give them confidence
in their peers to begin to lend again. Though the Fed Funds rate is low at 2%, a reduction seems in order given the economic
data that came in late last week. This includes the change in nonfarm payrolls which came in with a loss of 159,000 jobs
(its worst reading since a loss of 212,000 in March of 2003) and the ISM Manufacturing Index which came in at 43.5 (below 50
indicates contraction and ~43 has been indicative of recessions in the past) which is its lowest level in eight years. Yet, all the
data is not so pessimistic. The ISM Non Manufacturing Index came in at 50.2, which is below its 10-year average of 54.5 but
well above levels that have been indicative of recession in the past. In addition, Quarter-over-Quarter Nonfarm Productivity
came in at 4.3% which is also well above levels hit in past recessions (usually productivity goes negative, too many workers
producing too few goods). Despite these readings the Fed elected to lower rates by 50 basis points on October 8th (intermeeting)
and we believe this was the correct course. This is in stark contrast to just ninety days ago when the futures were
predicting a 60% chance of an increase in rates at the October 29th meeting.
Economic Outlook
As mentioned, the 3rd quarter of 2008 will be a topic of discussion for quite some time and our belief is the 4th quarter will be
etched in people’s minds for some time also. However, we believe it will ultimately be remembered as the time when the markets
began to heal and move forward. In our last commentary we opined that it is often darkest before the dawn. What we
failed to quantify and emphasize was how long that darkness can last. We do believe the new legislation will help the credit
markets begin to mend, but we also need to remove the mark-to-market accounting rules. The Fed can also provide more assistance
by cutting rates and based on the futures there is a 92% chance of a 25 basis point reduction at the October 29th
meeting. However, we have to realize that this is more a crisis of confidence than anything else and the current market action
has the feel of outright panic. As an example, the S&P 500 revenues increased 9.48% quarter-over-quarter (+6.7% if you back
out Energy and Financials which were the best and worst growers respectively) in the last reporting period and shareholder
equity increased 1.64% year-over-year. It is numbers like this that make us realize that there is more than fundamental analysis
at work when some investment vehicles (senior loans and preferreds to name a few) are priced at levels which indicate default
rates and failure rates that would even eclipse ones encountered during the great depression. Given this we do expect
data in the near term to show a further deterioration in the economy; however, we believe this has been more than accounted
for in the current prices of most asset classes and would advise clients that the time appears to be right to continue to add risk
exposure vice decrease it.
Municipal Debt Discipline
Throughout the third quarter, the unprecedented historical events that occurred in the equity and government/corporate bond
markets had their impact on the municipal bond market as well. The acute concern for liquidity showed itself through strong
demand and strong bids for high quality municipal paper maturing within 5 years. By comparison, municipal bonds with longer
maturities, particularly bonds due beyond 15 years, saw sharply rising yields, declining prices, and sizable negative total returns
for the third quarter. Continued weakness in the housing sector, a struggling labor market, and subdued economic activity
generally translated into growing concerns for municipal credit quality and widening credit spreads. By the end of the quarter,
Bloomberg estimated that yields on 10-year Baa1-rated municipal bonds were 114 basis points above Aaa-rated municipal
bonds of the same maturity. That was nearly double the average spread of 58 basis points over the past five years.
For virtually all of 2008, we have been pointing out that municipal bonds are at attractive, even historical, levels. One measure
of that attractiveness can be illustrated by viewing municipal bond yields as a percentage of Treasury bond yields. This high
grade municipal/treasury yield relationship in the 10-year maturity range has averaged 87% over the past five years. By the
end of the third quarter, this measure was at 108%. This measurement of attractiveness is not only significantly above its 5
year average but it has endured above the unusual 100% level for an unprecedented, extended period of time. Quality municipal
bonds in the AA and single A-rated categories can be found at 120% to 135% of Treasury bond yields. By the end of September, a high grade 10-year municipal bond yield of 4.25% equated to a 6.54% taxable yield for investors subject to the top
Federal Income tax rate of 35%. That 6.54% compares very favorably to the 3.82% ten year Treasury bond yield that prevailed
at the end of the quarter.
Throughout the third quarter, we bought both insured and uninsured paper always making our own judgment on the credit quality
of each underlying issuer. We took advantage of the strong bids in the municipal marketplace for high quality, short maturity
paper by selectively swapping out of that type of paper and into bonds in the 5 to 10 year range with underlying ratings of single
A to double A. Our purchases were primarily at spreads of 40 to 125 basis points above the Municipal Market Data high
grade scale. Our balanced approach to municipal portfolio management from the perspective of maturities, coupons, credit
quality, sectors, regions, and bond types continues to be an important contributor to our long term performance through a variety
of interest rate cycles. Our Investment Grade Tax-Exempt and Conservative Tax-Exempt Disciplines remain ahead of their
benchmarks on a net basis for the third quarter, year to date, the past year, and since inception.
At any point in time it is possible to create a “things-to-worry-about” list in the municipal bond market and a “things-to-feel-goodabout”
list. Given the recent unprecedented turmoil in the markets, it is not surprising that the “worry” list appears to be overwhelming
the “feel good” list. We recognize the growing concern regarding deteriorating municipal credit quality from weak
housing/property values, declining or stagnant economic activity, poor labor markets, issuer derivative exposure, and pension/
post-employment benefits obligations. And yet, we recognize the basic, essential services municipal issuers provide and the
historical resiliency of the municipal bond market in general. In addition, there are trends which could impact municipals positively.
These potential trends include higher federal income tax rates if Democrats capture the White House and maintain their
hold on Congress, a general “return to the mean” richening of municipals given the historically high percentages to Treasuries
that currently exist, and a move to a single standard rating system for municipals by the rating agencies (and the resulting upgrades
that would follow). Given the unusual volatility and crosscurrents, we believe this environment in particular highlights
the need for experienced bond managers in the “traditional bond picker” mode. It is what traditional bond pickers have (an uncluttered
eye for value) and don’t employ (leverage, tender option bond programs, auction rate securities, credit default swaps)
that makes them well-suited to the tumultuous periods municipal investors are likely to face in the coming quarters.
Peroni 3Q Market Commentary
Massive price declines, colossal volatility and further rounds of takeovers and takedowns in the financial sector made the third
quarter a period fraught with anxiety, confusion, uncertainty and, ultimately, a buyers strike. To complicate matters further,
Congress failed to muster enough votes to pass the crucial bailout plan before the Rosh Hashanah holiday. Few sectors escaped
the resulting selling avalanche following that event. Despite the sharp decline September 29th, there were few signs of
capitulation or climatic selling that would typically usher in a speedy recovery. Neither the percentage declines nor volume levels
were present in that session to qualify the lows that day as a decisive bottom. This has left open the possibility of further
lows before a final bottom can be established. High cash levels among portfolio managers and hedge funds (our SMA held
32.8% cash at the end of the third quarter) underscores the understandable lack of buying conviction given the economic and
political landscapes. This has been exacerbated by recent reports that a major money market fund ‘broke the buck’ by 3 cents.
While October is not usually a good month for stocks, it has proven the endpoint of a bearish cycle in the past, most recently in
2002. Also, analysts have aggressively reduced their third quarter earnings forecasts across a bro spectrum of sectors. This
could potentially prove a pivotal stage for stocks if these lowered estimates can be topped by actual earnings results and bolstered
by accompanying constructive outlooks. Finally, the Presidential elections in November could remove another uncertainly
overhanging the market, possibly reducing the partisan wrangling which has contributed to a steep drop in investor confidence.
In the months ahead, I believe a bottom will be first recognized by the improving relative strength behavior of specific industry
categories rather than by a top-down study of the major indices. It is encouraging that several major financials are exhibiting
better relative behavior, but it is far too early to read too much into these initial findings. I expect a broad, extended bottom
rather than a V-type recovery. If we can glean a time line from 2002, the market required months to bottom but it ultimately
surged when a key catalyst (the U.S invasion of Iraq) arrived the following year.
Taxable Disciplines
As with other markets, the taxable market had its share of unprecedented moments and unpredictable occurrences. A quick
recap of events in the third quarter reveals the financial system was stressed by unprecedented occurrences.
- Fannie Mae and Freddie Mac are placed in conservatorship
- Lehman Brothers is allowed to fail
- AIG is given an $85 billion dollar lifeline by Treasury
- Merrill Lynch is sold to Bank of America
- Washington Mutual fails and is sold to JP Morgan
- Citigroup attempts to buy the banking operation of Wachovia
Portfolio returns reflect these events. Add in the volatility of recent weeks and you begin to see a clear picture of the effects the
events will have on returns. All disciplines were affected from the most conservative down to high yield and distressed.
The Treasury and the Federal Reserve have been using all the tools at their disposal to right the economic ship and went to
Congress and the American people with a plan to recapitalize the banking system.
Although no one was happy with what had to get done, we believe the actions taken by the Treasury and Federal Reserve
were necessary. The benefits of these actions including the liquefying of bank assets will take time to implement but in the end
should prove beneficial to the markets. The markets appear to be taking a “show me” attitude. Although there have been several
actions taken over the quarter to shore up fundamentals, the performance of the market is seems to be based on emotions.
This will probably lead to a slower recovery than what might have been anticipated. To add to the wait and see attitude
is the introduction of a global economic slowdown or recession that has to be dealt with once the financial markets get a floor.
Although many including us have felt that the economies already were in recession, it now appears that those that were not in
that camp may be rethinking their position.
We continue to believe opportunities exist in the Mortgage markets based on the anticipated high percentage of home owner
defaults. The focus in this sector remains the detailed evaluation of each mortgage pools’ underlying loans and identifying undervalued
situations. During the third quarter we adjusted our Mortgage allocation up to 35% to take advantage of opportunities
in the marketplace. To achieve this, we lowered our allocation to Other and maintained our allocation to Treasuries, Agencies,
and Corporate.
| | Prior Asset Allocation | New Asset Allocation |
| Corporates | 50% | 50% |
| Mortgages | 30% | 35% |
| Treasuries | 5% | 5% |
| Agencies | 5% | 5% |
| Other | 10% | 5% |
What we see for the fourth quarter and beyond is a foundation being built in the financial sector and a reevaluation of the U.S.
and global economies. We feel our portfolios are positioned for the long term and should benefit when the economy and particularly
the financial sector starts to return to some form of market normalcy
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reinvestment of all distributions and interest payments and do not take into account brokerage fees or taxes. It is not possible to invest directly
in an index.
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