"...What's happening out there? It's very clear to me-we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down."

—Morgan Stanley CEO John Mack, 9/17/08

I. Recent News

• Equity markets continued their recent slide, as investors appeared unimpressed by the government's rescue of American International Group, credit markets tightened, a large money market fund broke below the standard $1 per share, and investors wondered what company would be the next victim of the financial fallout.
• As a result, the S&P 500 fell 4.7% yesterday, and is now down 26% from its October peak, around the average seen in economic contractions since 1945, yet still below the typical bear market retracement of 30.4%. At the same time, investors fled to the safety of Treasury backed assets; and during the trading day, the yield on one-month T-Bills dropped below zero (meaning investors were basically locking in a loss) and Gold rose close to 11%, its largest gain since 1982, according to Bloomberg.
• In a response to the dislocations in the credit markets, central banks around the world -- including the Federal Reserve, the European Central Bank, the Bank of England, and the Swiss National Bank -- announced a coordinated plan to pump in $180 billion into global markets with the goal of improving liquidity. Credit markets have been very tight recently as banks have been reluctant to lend because of the fear of further financial failures.
• Understandably, investor confidence has been rattled, as the financial markets face extraordinary challenges and it remains unclear how long it will take for the current deleveraging phase to unwind. Nevertheless, as some financial entities are supported by government, some fail, and others are combined, the market becomes a step closer to removing some of the remaining uncertainties, which should eventually lead to the healing process, though admittedly it's a painful road and the duration and depth of the journey is unknown. To this point, after yesterday's close, the Wall Street Journal reported that Morgan Stanley was in preliminary merger talks with Wachovia and, separately, Washington Mutual was setting itself up for a possible sale.
• Also, last night the Securities and Exchange Commission's Chairman was reportedly seeking a proposal that would require larger investors, including hedge funds, to start disclosing short positions on a daily basis. If enacted, it could potentially discourage some short sellers, because everyone could see what they were doing, and their positions could be more apt to cause a short squeeze (this occurs when short sellers start to feel pressure from a rising stock, which causes increasing losses as the stock price moves higher.)

II. Longer-Term Perspective

• Amid the uncertainty, one thing to remember is that over longer-term periods, equities generally track earnings growth and not all companies are going out of business (even though it may feel that way). Over roughly the last 40 years, the S&P 500 has had an annual price appreciation of 6.2%, which corresponds rather closely to its growth in earnings per share as shown in Figure 1. Once dividends are included, the total return is increased.

Figure 1: A Long-term Perspective of the S&P 500 and Earnings

Source: StockVal

1 | 2 | 3 | 4 |