THE GIST

>> Over the past six months, the financial sector led one of the biggest market rallies since the Great Depression. Suffering financial companies got a boost when the government stepped in and backed them up, improving investor confidence. But once the Fed stops propping these companies up, they’ll sink or swim based on performance – not just investor confidence.

THE FULL STORY

September is over, and it’s time to look back at what happened in the market over the past six months. First, the big news: from March to the end of September, the S&P 500 gained 58% – that’s one of the strongest market rallies since the Great Depression! The biggest mover in the market was the financial sector, which gained 142%, but other sectors (materials, consumer discretionary, and industrials) each also gained more than 70% over the same time period.

Before March, many stocks were priced so low that they seemed doomed to failure (because their companies were, in fact, about to fail). But when the federal government (specifically “The Fed”) stepped in to bail them out, these once-shaky companies suddenly became much safer investments, and their stock prices skyrocketed. This was actually a historic event in the financial world, since the government basically said that companies “too big to fail” should be protected by taxpayer, not investor, money. That dramatic change from low investor interest to high investor interest is responsible for a lot of the increase in the market over the past six months.

But while any improvement in the market is a welcome change from these recession doldrums, there’s a reason to be cautious here. The financial sector didn’t post huge gains because it found a new market, or improved profitability, or created a newer, better way of doing business. Its stock prices actually fell and rose independent of these factors. What drove the change in stock prices was perceived risk. To oversimplify a bit: when investors thought the companies were going to fail, they sold. When they saw that the same companies were going to be bailed out by the government, they bought.

At some point, though, investors are going to return to their old ways of evaluating whether a company is a good investment or not – studying the management, market share, profit margins, operating costs, and valuations of a company. And when that happens, these companies may find the price of their stock dropping once again.

• Over the past six months, the financial sector led one of the biggest market rallies since the Great Depression.
• Stocks that were suffering because of the economic crisis got a boost when the government stepped in and assured investors that their money was safe.
• But as the Fed stops propping these companies up, they’ll sink or swim based on performance – not just investor confidence.

September is over, and it’s time to look back at what happened in the market over the past six months. First, the big news: from March to the end of September, the S&P 500 gained 58% – that’s one of the strongest market rallies since the Great Depression! The biggest mover in the market was the financial sector, which gained 142%, but other sectors (materials, consumer discretionary, and industrials) each also gained more than 70% over the same time period.

Before March, many stocks were priced so low that they seemed doomed to failure (because their companies were, in fact, about to fail). But when the federal government (specifically “The Fed”) stepped in to bail them out, these once-shaky companies suddenly became much safer investments, and their stock prices skyrocketed. This was actually a historic event in the financial world, since the government basically said that companies “too big to fail” should be protected by taxpayer, not investor, money. That dramatic change from low investor interest to high investor interest is responsible for a lot of the increase in the market over the past six months.

But while any improvement in the market is a welcome change from these recession doldrums, there’s a reason to be cautious here. The financial sector didn’t post huge gains because it found a new market, or improved profitability, or created a newer, better way of doing business. Its stock prices actually fell and rose independent of these factors. What drove the change in stock prices was perceived risk. To oversimplify a bit: when investors thought the companies were going to fail, they sold. When they saw that the same companies were going to be bailed out by the government, they bought.

At some point, though, investors are going to return to their old ways of evaluating whether a company is a good investment or not – studying the management, market share, profit margins, operating costs, and valuations of a company. And when that happens, these companies may find the price of their stock dropping once again.

9/30/09

• Health care reform passed, extending coverage to 32 million Americans. The bill still faces resistance from Republicans and some state governments.
• Interest rates were kept low to stimulate bank lending. Though the folks in charge see some economic recovery, they’re not optimistic yet.
• TALF, one of the government’s bailout programs, expired this week, reducing federal financial support to the struggling financial sector.
• Mortgage rates are low, but the housing market is still in pretty bad shape. The rate of inflation hasn’t changed since last month.

Health Care Reform and Rebellion

The health care reform bill finally passed on Sunday, extending health coverage to 32 million more Americans – including those with “pre-existing conditions.” Democrats say that after 10 years, the costly bill would actually reduce the federal deficit, though there is much debate. Before the bill turns into a law, the Senate will go through a process called “reconciliation,” which is basically a final touch-up. With Republicans uniformly opposed to the bill, reconciliation is not expected to go smoothly.

A dozen states want to sue the federal government, possibly in the Supreme Court, because they believe the bill is unconstitutional. Virginia and Idaho have even passed laws that directly interfere with the bill’s national healthcare requirements for every citizen.

The bill will largely be funded by increased taxes: When the “Bush Tax Cuts” expire in 2011, the tax rate for certain individuals will increase by 5 to 8.8%.The Medicare tax, which comes out of everyone’s weekly paycheck, will increase by slightly less than 1%. There will also be a 3.8% tax increase on “unearned income” for folks making more than $200k per year. (Unearned income includes investment income such as capital gains, dividends, and interest income.)

Rates and Recession Recovery

This week the Senate passed a bill designed to promote hiring by reducing the tax burden on businesses who hire new employees in 2010 – as long as the new employee has been out of work for at least two months.

Elsewhere in D.C., the committee in charge of setting an interest rate for banks borrowing money from other banks (the FOMC) has decided to keep their interest rate very low (0.00%-0.25%). The idea behind keeping this rate (the “federal funds rate”) low is that allowing banks to access money more easily (and cheaply) will encourage them to spend that money – ultimately stimulating the whole sluggish economy. Though the FOMC mentioned in their statement that the economy was “stabilizing,” they decided to keep the rate low because of continuing problems: the high unemployment rate, reluctance on the part of small buisinesses to rehire, and a weak housing market. The committee also decided to end TALF – the government buying program created to minimize some of the damage done by mortgage- and other loan-based securities. This move shows some confidence in the economy’s ability to recover, but the folks over at FOMC made it a point to not sound too optimistic.

After these FOMC annoucements, rumors circulated that the committee might raise the discount rate to 1%. The discount rate is the interest rate that Federal Reserve Banks charge when they loan money to banks. Like the federal funds rate, lowering the discount rate allows banks to access money more cheaply, which is supposed to stimulate the overall economy. Raising the discount rate might mean that the government is stepping away from its role as economic bailer-outer in the wake of the financial crisis. Senator Dodd proposed that the Fed only be responsible for the nation’s 35 largest banks (those with assets totalling more than $50 billion). Oversight of smaller banks would go to the FDIC and the Office of the Comptroller of the Currency. But Ben Bernanke, Chairman of the Fed, shot down that idea because it would limit the insight the Fed has into the state of the banking system. He also expressed concern that the proprosed reform would make the Fed the “too-big-to-fail regulator.”

Elsewhere in the Economy…

According to the Consumer Price Index, the rate of inflation didn’t change much this month. Excluding food and energy costs, the current “core” inflation rate is only 1.3%.

Applications for mortgages fell -1.9% this week because of a decrease in both home purchases and mortgage refinancing, and the housing market is still doing very poorly despite the fact that mortgages are their cheapest in months. 30-year mortgages were being handed out at an average rate of 4.91%