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Plan may spark bank lending again, but damage to economy seen as enormous

INVESTORS had been waiting hopefully and impatiently over a week for the US Congress to approve the government’s plan to buy up to US$700 billion worth of the illiquid assets that have been weighing down banks’ balance sheets and operations. And when the approval came, their reactions were rather subdued.

But if last Friday’s reaction to the passage of the financial bailout plan was any indication of what the stock market faces over the next several weeks, the hard times on Wall Street could be just getting started.

‘Getting the bailout plan in place is obviously vital to keeping the financial system, both here in the US and abroad, from an outright collapse, but no one is under the illusion that the government rescue means we’re okay again. We have a long period of struggle ahead of us,’ said Hugh Johnson, the chief investment strategist at Johnson Illington Advisors, who may request his clients’ permission to reduce their equity allocations below the minimum 35 per cent level to which he has already lowered their portfolios.

Indeed, while most Wall Street analysts and economists agree that the Troubled Asset Relief Program, or TARP, passed by Congress on Friday should ease constraints in the nearly frozen credit markets, encouraging banks to begin lending to one another again and to businesses and consumers as well, enormous damage has already been done to the US economy over the past month.

‘Considering how much of a fragile condition the economy was in prior to the devastation we’ve seen the past few weeks, the economic fundamentals are in pretty bad shape now,’ said Joel Naroff, president of Naroff Economic Advisors. ‘The September jobs report offered ample proof that the credit crisis has moved into the mainstream of the economy. We’ve got the potential for a steep and long recession and are likely to see more months of job losses before conditions turn around,’ he noted.

That gloomy assessment seemed to be the majority opinion on Wall Street last Friday, and with a third quarter earnings season that is expected to be a brutal one getting it’s unofficial kick-off tomorrow, when Alcoa reports its quarterly profits, investors should brace themselves for a continuation of the stock market’s downward spiral.

‘Stock market valuations are attractive right now by many measures, making them potentially compelling investments, but given the extremely negative sentiment weighing on stocks right now, a sustained rebound looks increasingly unlikely given the market turmoil,’ said Tobias Levkovich, Citigroup’s chief equity strategist, who added that he doubts the market will reach his price targets of 1,475 in the S&P 500, and 13,250 in the Dow, which he’d already lowered by 5 per cent each on August 15.

There could be a bargain hunting rally or two this week, as investors venture into the healthier companies in the heavily battered and, some say, oversold financial services sector. But investors will be doing themselves a disservice if they expect stocks to recover even the heavy losses sustained over the past two weeks as Wall Street awaited the outcome of the bailout plan negotiations.

‘The recovery from a bear market typically takes about twice as long as the fall,’ said Mr Johnson.

If Friday’s trading marked the bottom of the bear market, investors did their best to dig the hole as deep as possible. After rising as much as two hundred points earlier in the day, the Dow Jones began a midday swoon that only worsened after passage of the bailout bill, ending with a loss of 157.47 points, or 1.5 per cent, to close at 10,325.38. The S&P 500 lost 15.05 points, or 1.35 per cent, to 1,099.23, while the Nasdaq lost 29.33 points, or 1.48 per cent, to end the week at 1,947,39.

For the week, the Dow lost 7.3 per cent, its biggest weekly drop since July 2002, and is now down 22.16 per cent for the year. The S&P 500 slumped 9.4 per cent, its lowest close in four years, and is down more than 25 per cent year-to-date. The Nasdaq, which lost 11 per cent last week, is down 26.58 per cent for the year.

The stock market could get a quick boost if investors see that banks are willing to lend to each other, so Wall Street will be paying close attention to the London Interbank Offered Rate, known as Libor, which now stands at 3.93 per cent, an extraordinary 144 basis points higher than its 2.49 per cent rate just a month ago.

The fading economy will draw investors to several key pieces of economic data scheduled for release this week, starting tomorrow with the minutes from the Federal Reserve’s most recent meeting, which along with a Wednesday speech by Fed chairman Ben Bernanke could provide insight into whether the Fed will lower rates at its next meeting at end-October.

Consumer credit is also to be reported tomorrow. Pending home sales are released on Wednesday, and weekly jobless claims and wholesale trade are due to be reported on Thursday. Friday brings international trade and import prices.

It’s a light week for the beginning of third-quarter earnings reporting season, with only Alcoa and General Electric scheduled to release profit reports tomorrow and Friday respectively, representing the Dow Jones Industrials, and only six other S&P 500 companies reporting.

But that will be enough to get investors focusing on the estimated third-quarter profit contraction of 4.8 per cent. Most of the negative growth, of course, can be laid on the doorstep of the financial sector which is expected to post a drop of 68 per cent in profits, or a US$27 billion plunge, from the third quarter in 2007.

Source : Business Times - 6 Oct 2008