market sentiment hits bottom?

Financial market turmoil has returned with a vengeance, weighing on the dollar and pressuring global stocks to distressing lows. However, an extreme in negative investor sentiment, a break in oil prices and some better-than-expected bank earnings spurred a rally in stocks this week—led by an impressive comeback in financials.

Stresses in the short-term funding markets are elevated once again, but not to the extent seen in mid-March. The Federal Reserve's aggressive rate cuts and lending facilities appear to be working. The latest market riot revolved around worries about the stability of the broader financial system—specifically the fate of government-sponsored entities (GSEs) Fannie Mae (FNM) and Freddie Mac (FRE).

Together, the GSEs own roughly $1.5 trillion in mortgages and guarantee $3.7 trillion. According to BCA Research, a failure would expose $4.3 trillion in mortgage-backed securities (MBSs) to losses, as well as $1.5 trillion in agency debt to potential default. Of course, the government cannot allow this to happen: An emergency weekend meeting July 12–13 of the Federal Reserve and the U.S. Treasury Department resulted in a plan to keep the GSEs in the "current form," assuaging concerns that they will be allowed to fail.

However, in one of the largest bank failures in U.S. history, the FDIC was forced to take over IndyMac Bancorp (IDMC), which was a large player in the Alt-A and subprime mortgage market. Although the majority of IndyMac's deposits are insured, the bank's failure sparked concerns that many other regional banks could potentially see the same fate.

With many financial institutions scheduled to report second-quarter financial results, investors became increasingly concerned that banks would not be able to raise fresh capital to cover losses—particularly because sovereign wealth funds (SWFs) could potentially shy away after seeing their investments during the past year lose value.

This dour outlook on the financial sector, in combination with still-high oil prices, pressured nearly all investor sentiment measures to below the March-low levels and close to the lows seen in the 1998 Long-Term Capital Management crisis (an infamous Fed-orchestrated bailout) and the 2002 tech bubble. Volume and volatility measures have not registered capitulation levels, but the depressed market and economic sentiment set the market up for a significant bounce. Although more banks and thrifts are likely to fail, calamitous failures (like IndyMac) have historically occurred near market lows.

Remember, it's not just fundamentals that drive stocks and markets but the relationship between fundamentals and expectations. At market lows, the expectations bar has usually been set sufficiently low for fundamentals to hurdle them, even if those fundamentals remain weak in absolute terms.

As panic gives way to the reality that the financial system and federal regulatory bodies are well-equipped to deal with this crisis, and/or if oil prices continue their descent, we see the potential for additional sharp rallies like those we witnessed this week. However, we remain skeptical that an enduring rally is in the offing until inflation pressures ease significantly and the U.S. housing market stabilizes.