Last week we wrote that we expected continued stock market volatility in the short term. The primary reason behind this expectation is that global credit markets are still not operating efficiently. The U.S. is at the epicenter of the crisis and while uncertainty persists in that market, equity market volatility will continue.

Take recent trading as an example. On Friday in the U.S., markets rose strongly on a hefty oil price drop and news that beleaguered investment bank Lehman Brothers Holdings Inc. (NYSE: LEH, Stock Forum) may receive a lifeline from a Korean investor. Then, news of more bank failures on Monday sent the financials lower.

When there is as much noise in the marketplace as there is now, it is worthwhile stepping back from the day-to-day action to try and observe what is really going on. Examining the charts is one way to do this.

Below, we show a chart of the S&P500 Financials index, which is down by around 50% over the past 12 months.

Throughout the decline, the major lows of August 2007, and January, March, and July 2008 have all coincided with a large increase in volume, suggesting capitulation selling. Often, prices quickly rebound following such sell-downs. As the chart shows though, the major trend of the index is down and the rebounds, so far, have been short lived.

The most recent decline in July was particularly acute. Did this sell-off represent the final low for the financials? Time will tell. While the broad trend is still down, the lows of July are suggesting that all the known bad news in the sector has been discounted. But the crucial level on the chart is 226. If the index can continue to hold above this level, the worst of the credit market issues may be behind us.

Recent credit market concerns have focused on widening credit spreads. Spreads refer to the difference between what it costs a corporate player (banks, insurance companies, etc.) to borrow and what the risk-free rate, or government borrowing rate, is. As shown in the chart below, spreads on five-year swaps recently breached 100 basis points, levels usually associated with extreme credit market stress.

Over the past 12 months, spreads have been trending higher. This means that despite the Fed’s attempts to keep borrowing costs low by holding the Fed Funds rate at 2%, many companies are not benefiting. A slowing economy is the culprit. Weaker economic growth is raising concerns about default, which is in turn leading to an increase in risk aversion and higher spreads, or borrowing costs.

Paul McCulley, Managing Director of the world’s largest bond fund manager, PIMCO, commented in a recent article how these increasing spreads are raising the cost of capital for financial companies around the world:

Financial sector incentives and central bank incentives appear to be increasingly misaligned today. While the Federal Reserve and select other central banks encouraged the financial sector to use liquidity provisions and raise capital to make new loans, the cost of capital to these very same banks and investment banks is becoming increasingly disconnected from the risk-free rates of capital globally.

In other words, central bank attempts to keep the cost of capital low are not being transmitted through the financial system. This is why we think central banks will continue to use unorthodox methods to support the financial sector.

Swapping illiquid mortgages for cash may be just the start of things to come. The global economy is experiencing a particularly nasty period of asset deflation, and past central bank efforts have failed to alleviate credit market stress. We may soon be moving into round two of the war between central banks and deflation.

McCulley certainly thinks there is a need to act quickly:

...there is an immediate need to address the market costs of capital, either via lowering the global cost of risk-free capital further, or via the provision of a coordinated, new balance sheet.

In other words, McCulley is suggesting further cuts to interest rates, or a coordinated expansion of central banks balance sheets to absorb the bad debts that are building throughout a slowing global economy.

If the S&P 500 Financials Index did indeed bottom in July, maybe this is the scenario being foreseen? As we said, time will tell. It is crucially important though for the financial sector of the world biggest economy to stabilize before the global market volatility subsides.

Much depends on the way the unfolding insolvency of Fannie Mae (NYSE: FNM, Stock Forum) and Freddie Mac (NYSE: FRE, Stock Forum) is handled. As the chart below shows, their respective share prices are collapsing. Freddie is winning the race to the bottom, but it is an even affair. Since the start of 2007, Freddie is down 95% while Fannie is down 91%.

The Treasury department is currently grappling with a rescue plan. The biggest question they have is who to rescue and who to bail out. The chart shows quite clearly the equity holders will not be rescued. But what about the preferred equity holders and the debt holders?

This is an important point because many financial institutions (not just Asian central banks) hold Fannie and Freddie debt and preferred equity. An adverse decision by Treasury could lead to another round of writedowns as Freddie and Fannie’s securities are re-priced, and wiped from other financial institutions’ asset and equity bases.

Or, Treasury could explicitly guarantee the debt and move the risk onto U.S. taxpayers. Talk about a rock and a hard place! Either way, we should know the outcome reasonably soon as both companies have large portions of debt maturing in September. Without Treasury guarantees, it is hard to see how this debt can be refinanced.

If you don’t think the Freddie/Fannie situation is serious, consider these comments from Professor Yu Yongding, a former adviser to China’s central bank, as they appeared in a recent Bloomberg article:

"If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic," Yu said in e-mailed answers to questions yesterday. "If it is not the end of the world, it is the end of the current international financial system."

The article goes on to say that China holds around $376 billion in agency debt, which is mostly Freddie and Fannie paper. Professor Yu is simply voicing China’s views on the matter as U.S. officials deliberate over a rescue plan. He is right, of course, which is why the institutions will not be allowed to fail. The big question is what will a rescue plan do to the U.S. government’s credit?

Turning to the local market, we can see below that the past year has not been kind to the S&P 500. While the market has rebounded nicely off its July lows, we believe it is too early to call a bottom in the market. Support at 1,250 will be important in this respect. A break of this level would indicate that the trend of the S&P 500 is still down.

And as we have pointed out in our daily blog, positive economic news is hard to come by. This is despite the recent revision of second-quarter GDP up to an annual pace of 3.3%. We believe there are a multitude of factors conspiring to make the case that in the second half of the year economic growth will be lower. This will in turn not be positive for the broader market.

The first of these factors is the deteriorating outlook for several of America’s large trading partners. Growth in the U.K. has ground to a halt while in the Euro zone second-quarter GDP contracted. This is important because the largest component of growth in the revised American GDP number was due to strong exports. If the country’s trading partners are experiencing slower growth then this does not bode well for exports continuing to expand.

Meanwhile, closer to home, consumer spending is going to struggle to expand. While rebate checks helped in the second quarter, going forward stagnant wages, high levels of indebtedness, falling home prices, and a worsening jobs outlook should, in our view, keep consumption under wraps.

Corporate America does not look like it’s offering much in the way of help either. Credit conditions as we know are tight. And while increasing investment spending during an economic downturn might make sense conceptually in anticipation of future growth, in practice this is rarely the case as corporate profits are the focus rather than ways to increase spending.

This still leaves government spending. And here despite the election year, the budget deficit is already running high enough that we do not believe there is room for a meaningful fiscal boost. So slower domestic consumption, exports facing an uphill battle, businesses watching their pennies, and government spending tapped out all come together to cloud our outlook for U.S. growth later this year despite yesterday’s revised GDP numbers. In a slower growth economy, earnings expansion will be moderate at best in our view.

Has the market factored in the effects of a slowing economy? This brings us to the question of value. According to Standard & Poor’s, the S&P 500 is currently trading on a price-to-earnings multiple of 21.9 times. This PE ratio’s long-term average is closer to 15 times, indicating that the broad market could be set for further falls later this year and into 2009. As such, it would not appear that the market has fully factored in a slowing economy.

We believe this highlights the need for investors to be selective in their investment decisions rather than just watching the market. We aim to achieve this by remaining committed to the mining, oil & gas, and precious metal sectors. In addition, we are building exposure to defensive sectors and those companies with significant operations abroad. Later, when the domestic economy works its way through the current downturn, we will be on the lookout for opportunities in the beaten down sectors that investors have given up on.

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