by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
and Brad Sorensen, CFA, Director, Sector Analysis, Schwab Center for Financial Research
March 20, 2009

• Finding Our Footing? The credit markets are showing some signs of stabilization as the Obama administration steadies its message after a rough start, and the Federal Reserve finally starts the previously-announced Term Asset-Backed Loan Facility (TALF). The Fed added additional stimulus to the pot by announcing that it would expand its purchases of mortgage-backed securities and begin purchasing longer-term U.S. Treasury securities. Problems remain, however, as toxic assets remain on banks’ balance sheets and the housing market remains weak.
• Consumers deleverage, economy remains fragile. Retail sales have shown some tentative signs of improving, but we remain skeptical about sustainable improvement. The consumer remains key to an economic recovery, and it seems that the process of increasing savings and decreasing debt will take time to work through.
• Housing market risks still weighed to the downside, but at a slower pace. Housing remains at the center of the economic problems in the United States and there are some very modest signs of an uptick in activity in the most beaten-down housing markets. However, there are still multiple headwinds posing major challenges for any sustainable stabilization.
• The states of global economies are not all equal. The global economy is gloomy, but all areas are not equal. China has shown some signs of improvement, but Eastern European banks may be the next big financial crisis that needs to be addressed.
• Schwab Sector Views. Markets continue to be volatile and some properly placed short-term bets could benefit those investors willing to make tactical moves. In the near term, we think consumer staples and telecommunications will likely underperform. To maintain a defensive tilt, we’re keeping an outperform view on the health care sector, while also maintaining an outperform view on technology.
• Schwab Bond Views. With U.S. Treasury yields so low, we see better value in municipal bonds and investment-grade corporate bonds. In the short term, inflation risk is not a major concern. In the longer term, inflation-protected securities (TIPS) appear to be fairly valued and offer some hedge against inflation.

Overview
After breaking through last fall’s lows in the market, it seemed inevitable that we would see a bounce from what were oversold levels. And indeed, there was a rally, stoked by some mildly positive comments from the financial sector. Of course, the inevitable question that arises is whether this is a brief respite from the selling pressure, or the start of a new trend marking the end of the bear market.

We believe it’s folly to try to call it one way or the other, but do want to remind investors that—while we’re in a deep recession, if not worse—the stock market is a forward-looking indicator, and waiting for confirmation of an economic turnaround could be detrimental to a portfolio’s return. In other words, if you stay on the sidelines until you’re sure it’s safe to get back in, you’ll likely have missed a large part of the stock market’s recovery.

The economic news continues to paint a dismal landscape, but there are some signs that the rate at which the economy is deteriorating may be slowing. Jobless claims may be in the process of at least stabilizing, while retail sales numbers have been better than expected. While these developments may eventually provide some light at the end of the tunnel, we remain in a deep recession that will take time to work through.

The labor market continues to post deteriorating numbers, highlighted recently in the February labor report that showed the unemployment rate moving up to 8.1%, the highest since 1983. We believe employment will continue to deteriorate, likely culminating in a peak unemployment rate approaching 10%. However, the unemployment rate is traditionally a lagging indicator, and investors should be cautious about gauging their reentry to the market by looking at that number. Adding additional concern to the consumer side of the economy (which makes up about 70% of economic activity in the United States) is the massive slide in household net worth due to plummeting house and equity values.


The governmental response to the economic situation remains in focus, and after stumbling out of the block, the Obama administration seems to be regaining its footing to some extent, also helping contribute to the recent rally. While no one knows if the plans being put in place will ultimately succeed, the administration has shown more confidence in the recovery process and has portrayed a more convincing tone that it has a plan to attack the issues facing the economy. While the administration has made some steps in a positive direction, the market is waiting to hear the details regarding getting toxic assets off of banks’ balance sheets, while also questioning the approach to attacking the core of the problem—the continuing dismal housing market.

Fighting the credit crisis on another front is the Fed. At their last meeting the committee announced that it was expanding its purchasing of mortgage-backed securities and would begin to buy longer-term Treasuries. The Fed hopes to further support the housing market and foster a recovery in the heavily damaged area of the economy by pushing mortgage rates lower and enticing investors into higher-risk assets.

Additionally, the long-awaited implementation of the TALF (Term Asset-Backed Securities Loan Facility) finally came to fruition, though not before the Fed had to change the program due to lack of interest by financial institutions. With up to $1 trillion committed to this program, the hope is a restart in the vital consumer finance securitization market. A successful program would result in increased lending available for consumer, and potentially, commercial real estate loans.

The Fed also noted that it would likely expand the collateral eligible to participate. We, however, remain a bit skeptical that consumers—who are in the process of deleveraging, are looking at rising unemployment and falling net worth, and are increasing savings—will be anxious to add to debt, even if it is more readily available.

With trillions of dollars committed to supporting the financial system (and only a fraction of that actually implemented to date), we’ve seen some tentative signs of success—though there is a risk that some of that hard-fought ground may be lost. In particular, credit spreads have stopped narrowing in some cases, while the Fed’s expansion of the money supply in some cases was showing signs of slowing. However, recent Fed action should reverse that process to a large degree with a more-than doubling of their balance sheet.


While the chart above shows that more work needs to be done, and that there’s a risk that the progress that has been made is in danger of being reversed, we’d be cautious of any new government stimulus-related package proposal at this point in time. We’ve yet to see the full effects of the already-enacted plans; while on the government, corporate and individual levels, we need to ratchet down the unsustainable debt we ran up during the past quarter-century. This will take discipline and time; something that we must accept for the long-term health of the country and our individual balance sheets.

For tactical investing ideas, we’re slightly more cyclically positive in our stock sector views. If you’re willing to take on more risk in your fixed-income allocations, we suggest that you look to corporate and muni bonds. Get more ideas from our bond views at the end of this article.


Finding Our Footing?
Revitalizing the credit markets continues to be at the heart of returning the overall economy, and the stock market, to health. The new administration had some missteps out of the block, which damaged its credibility to some degree. The stimulus plan was met with a thud, while the lack of a concrete plan to deal with the bad assets on banks’ balance sheets continues to haunt the markets, and the rebuffing of the administration’s call for foreign countries to do more was somewhat embarrassing.

Additionally, a shudder went through the market after the Chinese Prime Minister expressed concerns over the credit-worthiness of the United States and hinted that China may be reluctant to fund future U.S. borrowings due to the already large and growing deficit. While we view this veiled threat as unlikely, as China is still reliant on the American consumer, it could give pause to those advocating throwing more money at the problem.

However, the stumbles of the administration are far from the only thing that’s kept the credit markets from improving at a more rapid rate. Until their latest move, the Fed was less aggressive than many would have liked. After announcing the TALF to help restart the vital securitization process, the Fed delayed in getting it implemented until very recently.

There are questions surrounding the kind of collateral that will be allowed to participate in the program and how many companies will actually choose to, or be able to, participate. More recently, there’s reticence on the part of potential investors to participate given the government’s activist role in undoing contracts and taxing bonus payments. This was highlighted by the fact that the Fed had to again delay the launch of the program and rework it at the last minute due to the lack of participants.

The Fed, however, seems to understand that there are issues with the initial plan and, in its recent release, said that it will likely expand the “range of eligible collateral” for the TALF, which could help to facilitate participation by a wider range of entities. The success of getting the securitization process going again is, in our opinion, a centerpiece of the restoration of the credit market. With up to $1 trillion committed to this program, we’re watching closely to gauge the success of this initiative.

Although Treasury Secretary Geithner is on the hot seat, his team took some positive steps toward reestablishing credibility by forcefully coming out against nationalizing financial institutions and instituting new measures designed to determine the financial health of large banks going forward. This was followed by pronouncement of improved health and profitability by major financial companies, whose viability was being questioned, leading to at least a near-term rebound in the stock prices of these companies.

While we believe that these are good developments, we also firmly believe that more needs to be done to address the lingering toxic assets on banks’ balance sheets. How to price those assets remains a crucial component of any plan, and this pricing dilemma seems to be at the heart of stalled steps aimed at attacking the toxic asset problem. Secretary Geithner has promised to provide details on the proposed private/public partnership in the near future, and we’re anxious to see how they plan to deal with this issue.

Any of these proposals, even if implemented in relatively quick order, will take time to actually have a lasting affect on the markets. The success of any of the measures introduced thus far can likely only be judged after at least a couple of quarters have gone by. Also, while these are all areas that need to be addressed, the housing market remains at the center of the crisis and home prices must stabilize before any real progress can be made in the credit arena.

The administration has announced plans to help distressed homebuyers, while major banks have promised to halt foreclosure for a brief period of time in order to give the plans time to be put in place. The recent Fed announcement said it will continue to purchase mortgage-backed securities, while expanding the amount of money dedicated to that activity by $750 billion. Also, in a bit of a surprise, the central bank also said that it is going to begin purchasing longer-term Treasury bonds—up to $300 billion worth at the present time.

The Fed hopes that this action will help push mortgage rates down even further in an effort to support the housing market. We believe this was a necessary step in attempting to put a bottom into housing, thereby supporting the balance sheets of many consumers and businesses. But there’s justifiable criticism that this is nothing more than a shell game: the Treasury issues more debt and the Fed prints money to buy more of said debt. Time will tell whether the plan will ultimately be successful—certainly it’s already benefitted mortgage rates.

There’s also the additional possible benefit of pushing yields to such a level that investors will start to look to more risky assets, including equities, in order to boost their return potential.

One cautionary note, however, is that no matter how low mortgage rates get, prices need to stabilize for a sustainable recovery. Few rational buyers are excited about borrowing money at 5% to purchase an asset that may be declining at a 15% rate—resulting in a 20% “real” mortgage rate.


The overall tolerance for risk-taking—a critical factor to unfreezing credit markets—has shown signs of improvement. The credit markets—the lifeblood of the economy—depend on the confidence of investors. We continue to watch for signals that the measures being implemented are having the desired effect.

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Consumers deleverage, economy remains fragile
Consumers hold the key to the economy, as they comprise nearly 70% of GDP. A rebound in retail sales in January and February, while positive, was likely the result of extreme weakness in holiday spending, and was likely triggered by a combination of steep price drops in prior months and a slight increase in pent-up demand.

The trend in retail sales is unlikely to continue, as consumers are retrenching as a consequence of massive destruction of consumer wealth, as seen above. On the liability side, consumers have spent years living beyond their means, and debt levels remain excessive.

Consumers are saving more to reduce debt, rebuild their retirement accounts, and increase their emergency savings while facing a deteriorating job market. After years of decline, the personal savings rate increased to 5.0% in January 2009—the highest rate in the past five years.

However, the 60-year average for the savings rate is 7%, suggesting the retrenchment is not close to reaching its peak, and the trade-off for higher savings is a reduction in consumer spending. The process of deleveraging has only just begun. The gross debt-to-income ratio dipped 2.3% in the fourth quarter, leaving it at an elevated 133%, versus the 90% average of the 1990s.


In response to falling demand and excess capacity, businesses have slashed prices in an effort to stimulate sales. Capacity utilization continues to fall, and was 70.9% in February. This increases the risk of a deflationary spiral (where declining demand precipitates downward prices), and keeps downward pressure on demand.

Corporations, suffering from falling revenue and profits, must cut expenditures and jobs. Businesses tend to wait for confirmation of lower demand before furloughing workers, and the unemployment rate tends to lag economic activity by about seven months. The unemployment rate will continue to rise, and while we were hoping it would peak in the single digits, that’s looking less likely the longer the economic decline continues and the feedback loop becomes further entrenched into consumer and business behavior.


The pace of decline of some economic indicators has slowed in early 2009, while others have deteriorated further. What’s clear is that the path to recovery will not be in a straight line. We’re likely undergoing a deep and extended recession, but investors need to be reminded that the stock market is a forward-looking mechanism. As Liz Ann Sonders mentioned in “Get On Your Boots: Economy Sinks While Market Improves,” we don’t know if the fourth-quarter GDP will be the ultimate low for the economy, but history is full of examples of the stock market finding its footing while the economic news is most bleak.

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Housing market risks still weighed to the downside, but at a slower pace
Positive aspects for the housing market include: 

• Improved affordability through lower prices 
• Mortgage rates falling—Fed to buy up to $1.45 trillion in mortgage-related securities and $300 billion in longer-term Treasuries! 
• Foreclosure mitigation programs in place

However, risks remain: 

• Unemployment will likely continue to rise 
• Inventory levels remain elevated 
• Prices likely to fall further

The positive impact of lower prices and falling mortgage rates has been demonstrated by increases in sales of existing homes in some markets where the steepest price declines have occurred. Prices are down over 40% from their peak in Las Vegas, and sales more than doubled month-over-month in February—with some reports of multiple bids!

However, home prices seem unlikely to stabilize while supply remains elevated—in January, the numbers were nine months for existing homes and 13 months for new homes (versus the five or six months that’s considered normal for both measures).


Additionally, housing prices remain elevated when measured by the historical relationship of prices to implied rental values, and when compared to median income.


Currently, one in five homeowners is “underwater”—owing more on their house than it’s currently worth. The Obama administration has announced a $75 billion plan aimed at mitigating foreclosures, which will likely slow the rate of foreclosures at the margin.

However, the plan does little to compel lenders to write down principal or give relief to owners of jumbo mortgages or homeowners who are significantly underwater. Critics say that more needs to be done to significantly improve the foreclosure situation.

A weakening job market and future declines in home prices implied by high inventories serve to increase future foreclosures, as well as undermine consumer confidence to make a home purchase. Stabilization in the housing market, like the broader economy, will likely not be fixed quickly, but will just need time to work through.

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The states of global economies are not all equal
While many economies continue to decelerate, China has demonstrated recent signs of relative strength. The Chinese $585 billion stimulus package has raised the China’s Purchasing Manager’s Index for three straight months, with the most recent reading climbing to 49 in February—edging close to the line that signals expansion (50).

Additionally, the Chinese government seems willing to expand its stimulus package. There are reports that more than 20 million migrants have lost their jobs in China, and since the government has a strong positive trade balance, they have the flexibility to use aggressive fiscal policies to jumpstart growth in an attempt to avoid social unrest.

Possibly related to the Chinese stimulus, as well as other supply/demand dynamics, commodity prices appear to be stabilizing (albeit near cyclical lows), and shipping rates have rebounded from the recent bottom.


We’re watching the reflationary practices other countries are implementing, as the interconnectedness of economies globally means that it’s in the interest of all countries to implement measures quickly. The International Monetary Fund (IMF) and U.S. Treasury Secretary Geithner have called for countries to implement fiscal stimulus packages equal to 2% of GDP. Currently only the United States, Saudi Arabia, China, Spain and Australia are on track to meet this goal. European countries argue that they already operate generous welfare states, automatically providing unemployment benefits when jobs are lost, and worry about the impact rising debt has on destabilizing the euro. Germany led a rejection of a call by Hungary for a sweeping bailout of Eastern Europe.

Calls for coordinated global moves have been met with increasingly protectionist tendencies. According to the World Bank, at least 17 of the 20 major nations that vowed at a November summit to avoid protectionist steps have violated that promise, with countries from Russia and the United States to Mexico and China enacting measures to limit the flow of imports.

We’re also watching the weakening economies and falling currencies in Eastern Europe, which has borrowed $1.7 trillion, largely from Western European banks. According to the IMF, Western European banks are 50% more leveraged than U.S. banks. As a result of the high leverage, banking systems in some countries have extended loans in excess of GDP levels, and some countries may be unable to rescue their banks, as the size of their problems is simply too big.

While not coordinated, a series of unconventional moves by central banks in March could significantly increase the money supply and stimulate growth in selected countries. The Swiss central bank became the first major bank to announce foreign exchange market intervention since Japan did so in 2004, to devalue their currency. The Bank of England announced a program to buy large amounts of its government security, the gilt, as well as non-government bonds. The Fed’s announcement to purchase $300 billion in Treasuries over the next six months effectively deflates the U.S. dollar.

During recent times of market stress, the U.S. dollar has risen as investors have fled to safety. A modest decline in the dollar would be positive, as it would enable the United States to stave off the negative impact deflation has on U.S. dollar-denominated debt, and stimulate exports.

We continue to watch for moderate U.S. dollar weakness and strength in commodities as a sign that policy stimulus actions are gaining traction and that some increase in risk tolerance is occurring. In conjunction, we’d expect to see resource-related currencies and markets (both developed and emerging) improve to confirm a revival in the global markets.

If you invest in international stocks, we suggest you review your holdings and bring your allocation back in line with your long-term target if necessary.

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Schwab Sector Views
While the recent sharp rebound in the stock market was certainly a welcome respite from the selling that had been prevalent for the previous couple of months, we aren’t moving to a more aggressive stance with regard to our sector calls. We will note, however, that we have been gradually moving toward a more cyclically-oriented stance, as we believe the reflationary policies being put in place around the globe will begin to have some effect—leading to a bit more risk taking among market participants. At this point, however, we believe it’s too early to make an even more aggressive move, but are watching incoming data closely in order to make further moves as necessary.

For a deep-dive analysis into our current thinking, read the complete “Schwab Sector Views” by Brad Sorensen.

Here’s a snapshot:

Sector	Schwab's Current Recommended Deviation from Benchmark	Year-to-date Total Return as of 3/18/09
Consumer Discretionary	Marketperform	– 10.35
Consumer Staples	Underperform	– 11.35
Energy	Marketperform	– 9.62
Financials	Marketperform	– 24.64
Health Care	Outperform	– 8.56
Industrials	Marketperform	– 22.63
Info Tech	Outperform	0.68
Materials	Marketperform	– 5.87
Telecom	Underperform	– 5.52
Utilities	Marketperform	– 12.38
S&P 500		– 11.45

Technology: outperform
In our opinion, the technology sector seems to be well positioned in this difficult investing environment. While traditionally being a more cyclical sector, we’ve noted that the group has held up well during the recent market selloff, leading us to believe that there may be a bit of a defensive aspect to the group in this unique environment. Companies in the group have relatively solid balance sheets with good cash positions—certainly an attractive quality in this tight-credit environment—while there’s also a pro-cyclical component, as we believe capital expenditures undertaken by companies in the near term will be biased toward efficiency-enhancing technology.

Health care: outperform
Also, we’ve kept our outperform outlook on the health care sector. The release of the president’s budget proposal and its cutting of Medicare reimbursements caused investors to move out of the group. We think this reaction was overdone, and continue to believe, in this environment, that health care should return to outperformance in the near future. The sector sports solid balance sheets, nice dividend yields and attractive valuations, while we’ve also seen increasing activity in the merger-and-acquisition area. Additionally, despite our recent move to a more cyclical stance, we don’t necessarily want to get out of all defensive positions, for reasons mentioned above, and the health care sector provides that aspect to our calls as well.

Consumer staples: underperform
As opposed to health care, which we think offers attractive valuations and decent growth opportunities, the consumer staples group is a more pure-play defensive sector, with valuations that have started to concern us. Investors flocked to the sector during the extreme volatility seen at the end of 2008, leading to what we believe is a pretty crowded trade. As such, and because competition for consumer dollars remains fierce, we believe the consumer staples sector will return to underperformance in the coming months.

Telecom: underperform
We believe the defensive reputation of the telecom sector has been degrading during the past couple of months, leading to some poorer performance for the group. We continue to believe the sector will underperform in the near future, as the group is much more reliant on the discretionary consumer that it used to be when it was largely filled with fixed-line, regulated companies. With consumer spending down, we believe telecom upgrades may be one of the areas Americans delay first when they seek ways to save money.

The recent market rally aided our move to a more cyclical stance, but we aren’t ready to call the bear market over just yet. As such, we’re refraining from becoming more aggressive at this point in time, and are maintaining some defensive exposure. We continue to watch the credit crisis in the United States, the housing situation and the response of foreign governments for clues as to whether our next move will continue the recent trend toward a more aggressive stance, or force us to retreat a bit. Our sector recommendations can and do change relatively quickly at times, and for Schwab clients the latest views can be viewed on Schwab.com.

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Schwab Bond Sector Views
We continue to believe that now may be the time to step outside of cash investments or Treasuries and look to take advantage of higher yields elsewhere in the bond waters. It may make sense to take calculated—but still manageable—risks to seek better returns.

Municipal bonds: attractive
While the difference in yields between munis and Treasuries has narrowed in January and February, munis remain attractive for higher-income investors. Despite the talk about budget problems, we believe that they’re still among the safer bond investments. And they are still yielding more than comparable Treasury bonds, even with the additional tax advantages.


To learn more, read the related articles by Rob Williams, "Are California State Muni Bonds Secure?" and "Are New York Bonds Secure?"

TIPS over Treasuries
Despite their recent gains, we’re less keen on Treasuries. Current yields, especially for short-term bills, have been driven to all-time lows.

But TIPS (Treasury Inflation-Protected Securities) are another matter. Although we’re not concerned about inflation now, as the economy recovers, TIPS are a way to buy protection. They look inexpensive to us compared to Treasuries. Right now, TIPS are priced to anticipate just under 1% annual inflation during the next 10 years—low compared to historical averages and the Fed’s current 1.7%–2% projections.

Investment-grade corporate bonds: value
To add a bit of extra return, we think investment-grade corporate bonds offer relative value. Due to the credit crunch, yields relative to Treasury bonds remain near historical highs. If credit markets continue to improve, we think yields will fall (and prices will rise)—but be sure to diversify by issuer and industry sector.

Maturity and duration
Given current low interest rates, maturities in the seven- to10-year range appear safer to us than longer-term bonds. We don’t expect a dramatic rise in rates soon, but Treasury rates can’t go much lower. If rates begin to rise significantly, maturities in the seven- to 10-year range would limit the downside due to interest rate risk.

For most bond investors, we think bond mutual funds are the best bet, unless you have sufficient funds to diversify across issuers and maturities. Schwab clients can log in to Schwab.com for recommendations from the Bond Fund Select List.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

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Important Disclosures

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the United States and Canada. As of May 2005, the MSCI EAFE Index consisted of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The MSCI Emerging Markets Index^SMis a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. As of May 2005, the MSCI Emerging Markets Index consisted of the following 26 emerging market country indexes: Argentina, Brazil, Chile, China, Colombia, the Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.

The S&P 500® index is an index of widely traded stocks.

Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Past performance is no guarantee of future results.

Investing in sectors may involve a greater degree of risk than investments with broader diversification.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information contained herein is obtained from sources believed to be reliable, but its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not a solicitation or a recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinions are subject to change without notice.