Some Experts See Market Recovery by Year End

IF IT IS indeed always darkest before the dawn, then perhaps the blackness enveloping the stock market will soon be penetrated by rays of sunshine.

This week's government takeover of Fannie Mae (FNM) and Freddie Mac (FMC), as well as the meltdown of the financial sector led by Lehman Brothers (LEH), added to the volatility that has gripped Wall Street for months. But for all the short-term turbulence, Jeffrey Kleintop at LPL Financial sees a light at the end of the tunnel. He believes equities will rally late in the fourth quarter once the presidential race is settled and better data trickle out on housing and earnings, including results from Lehman, Morgan Stanley (MS) and Goldman Sachs (GS).

"We continue to believe the markets are likely to remain volatile in the coming weeks as it has all year," Kleintop wrote on Monday, "but look forward to a year-end stock market rally as we move past September milestones and key catalysts combine to lift the market including: receding inflation, rising dollar, moving past the peak in adjustable rate mortgage reset and fading election uncertainty."

Citigroup's Tobias Levkovich also anticipates improvement in the markets, though on a slightly longer time line.

"Even if credit conditions quickly improve, economic recovery will take months," he cautioned on Sunday, noting that credit conditions have been slipping badly for the last 12 months. "We would not expect the tone of business to get better until well into first quarter 2009, at the earliest, and thus maintain our underweight stances on the industrial, energy, materials, utilities and technology sectors."

The trading week started out with promise after the feds on Sunday seized control of Fannie and Freddie, sparking a quick 300-point jump in the Dow. Investors celebrated both the scale of the government's policy response and the anticipated calm that would be brought to the markets. Not everyone was sold, however, and the calm proved short-lived.

According to Yardeni Research founder Ed Yardeni, the Treasury's role in the conservatorship of Fannie and Freddie, which he called the world's two largest hedge funds, effectively meant U.S taxpayers were footing the bill for years of serious mistakes.

"Thanks to the government's implicit guarantee of their debts, they were able to leverage their capital by as much as 50-to-1," he wrote on Monday. "It doesn't take much in loan losses to wipe out capital with that kind of leverage." Fannie's and Freddie's shares, already decimated before the takeover was announced, quickly faded to penny stocks.

While the promise of eventual stability afforded by the government's move was welcome, Merrill Lynch's Richard Bernstein wisely cautioned against hopping back into financials prematurely.

"First and foremost, we continue to believe that it is too early for investors to overweight financial stocks despite these actions," he wrote Sunday, accurately presaging a disastrous week as shares of Lehman melted down and Merrill Lynch (MER), AIG (AIG) and other big financial names took massive hits.

By week's end, Lehman was desperately seeking a knight — preferably white, but any color would do — to ride to its rescue. Not surprisingly in this year of government bailouts stretching back to the March rescue of Bear Stearns, the feds are helping to look for suitors.

Also See:
Fannie, Freddie Bailout Should Be Good for Stock Market
Some Fund Managers Clung to Fannie, Freddie
Mortgage Bailout Latest Blow to Free Markets