That was a wild ride last week,
and we don’t mean the “Simpsons Movie.”
The stock market as measured by the Dow Jones Industrial average
reached 14,000 in mid-July and at the end of July was down
about 5%. The broader S&P 500 Index has declined about
6% over the same period. So what is behind this sudden down-drift?
Wall Street has a new term for any market declines, and it
is called “re-pricing risk.” It is widely assumed
that liquidity (cash and assets) drives the markets. Unfortunately
many took to including credit availability in that assumption.
The strong economic growth since 2002 coupled with low interest
rates pushed lenders to issue shaky mortgages to even shakier
buyers (sub-prime loans) thus stimulating a housing boom.
As with any boom, prices go to excess and need to be “re-priced.”
We are on the downside of that boom currently. Enter leverage.
Leverage is a wonderful thing when the market is going your
way, however, when it turns, it can create an over reaction
among investors. The initial correction in housing was being
absorbed in the market place until the failure of two Bear
Stearns funds that were backed in part by these sub-prime
loans. Bear Stearns raised about $1.5 billion and then borrowed
enough to buy $12 billion of these securities. Then the defaults
hit. Initial estimates were that losses in these two funds
would be 10-15%, however, that was just the tip of the iceberg
and losses now are expected to be much higher, rendering these
funds virtually worthless.
Now we get to the credit availability part of the liquidity
equation. Lenders have drastically reduced new mortgage loans
by raising interest rates and tightening lending requirements.
More importantly for the stock market, the tightened credit
restriction will slow down the leveraged buyouts (LBOs) that
have been a major driving force behind the bull market. Companies
that are or were planning to buy back shares of their own
stock (to increase earnings per share) may be constrained
by the new credit restrictions.
How will this impact the bond market? There is definitely
a flight to quality as investors are buying government bonds
and pushing rates across once again under 5%. Another way
to view this flight to quality is to look at the spread between
10 year treasury bonds and junk bonds. In 2003 when investor
optimism was still low that spread was eight percentage points.
As confidence in the economy and the market increased that
spread narrowed to less than three percentage points in May
of this year. The recent sub-prime scare has increased that
spread to four percentage points. The long-term average for
this spread is 4.5 points. The market is a wonderful self-correcting
mechanism.
How about the stock market then? When we have a decline
of 300 points in the Dow, it sounds huge but is only about
2%. So far in total, the Dow has declined about 5% from its
peak. The broader S&P 500 has shed about 6%. Normally
we could expect a “dead cat” bounce from here
and some further testing of these interim lows. We have not
had a 10% correction in the stock market since the bull began
his run in 2003. That’s over four years and the bull
needs a rest before continuing his run. If the market were
to decline 10%, it would take the Dow to 11,200. Somehow we
do not think that will happen. We expect the market to continue
a consolidation phase where some stocks will make new lows,
while others will be forming a solid foundation for the next
advance. The same can be said for industry groups. Housing
activity is still in a downturn and may not rebound until
next year. Consumer spending slowed to a 1.3% rate in the
second quarter down from a 3.7% rate in the first. Don’t
ever count the consumer out, however, as this slowdown may
be temporary with the holiday season fast approaching. The
Gross Domestic Product came in at a 3.4% annual rate for the
second quarter, up from 0.6% in the first. The core consumer
price index rose at a 1.4% annual rate in the second quarter,
a four year low.
Unemployment remains a low 4.5%. Healthy demand abroad has
sent exports surging and the trade deficit declining. Government
spending and non-residential construction continue to be strong.
All in all, a good backdrop for economic growth. The markets
will acknowledge this in their own time, and it is still a
good time to own common stocks.
Random thought for August 2007:
"In the business world, the rearview mirror is always
clearer than the windshield."
- Warren Buffett
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