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 January 2008 You Just Knew
There are times when you know something, but you just don't know why you know it. In a simpler time, this was know as good old fashioned horse sense. In today's information age, it doesn't get much respect, but perhaps it should. Sometimes when purported experts are extolling the virtues of the latest investing strategy or business model, it's hard to trust your gut and believe they can be wrong. That's especially true when there are a lot of them saying the same thing and people are making money following their advice.
This is exactly what happened in the 1990's internet craze. Shares of initial public offerings were enjoying triple-digit percentage gains in their first few days of trading despite the fact that the issuing companies had no profits or oftentimes, no revenues. You just knew that couldn't go on, but it did. Finally when so many analysts and market experts were touting the "New Economy" you may have finally joined the party -- probably just about when it ended. When the bubble ultimately burst, you probably kicked yourself for being drawn into something so outlandish. You should have known better and you did, you just ignored what you knew.
You Knew The Housing Market Was Overheated But things got out of hand as rising demand drove housing prices higher and higher. Buyers -- some encouraged by unscrupulous lenders -- stretched to borrow every last penny they could in the belief that prices would continue to rise. Many took out adjustable rate mortgages or interest-only variations believing they could tap their rapidly growing equity or refinance at even lower rates when payments reset. As long as demand stayed hot, homebuilders kept on building. At the beginning of 2007, homebuilders (and some of the sell-side analysts that follow the industry) were characterizing the business as no longer cyclical. Although some economists warned of a collapse, almost no one was listening. The longer the boom persisted, the more people it drew in. But you knew this couldn't go on forever. You knew adjustable rates would eventually reset at higher levels. You knew there was only so many times anyone could refinance to tap additional home equity. You knew the real estate industry was, is, and always will be cyclical. But did you finally succumb to the hype and participate either as an investor, borrower, or both? Many did and now that the cycle has turned, many are suffering. This isn't just true for individuals or the uninformed; even the so-called "smart money" got burned, and quite badly at that. Indeed, this goes to the heart of the subprime lending mess. As more and more homeowners refinanced and new buyers entered the market, lenders had to scramble to make new loans. Their solution was to extend credit to a broader section of the market that had remained largely untapped by conventional lenders, the "subprime" borrowers. These are higher risk borrowers with spotted credit histories.
Many lenders generate their revenues from fees charged in originating loans. They then sell them to banks or other financial institutions who service the debt. Often the loans are packaged up and sold to investors who receive the passed through interest and return of capital. Subprime loans are no exception. Lenders solicited buyers, originated the loans, and sold them to large financial institutions such as Citigroup and Bank of America. They, in turn, packaged them up and sold them to willing buyers including some major hedge funds, mutual funds, and pension plans. While the purchasers of subprime debt may have ignored the danger, the banks must have had an inkling. In order to get them off their books as liabilities, banks established "structured investment vehicles" (SIVs) to service them. These off-balance sheet entities "took ownership" of the loans after paying the issuers a fee. Any liabilities accrued to the owners, the SIVs. In essence, this was the same arrangement Enron used with it's ill-fated off-balance sheet transactions. And here you thought Congress was able to legislate this sleight of hand out of business. This summer as housing demand started to cool and adjustable rate mortgages started to reset at higher levels, subprime borrowers were the first to feel the heat. With little or no equity in their homes and unable to refinance at favorable rates, defaults started to mount. Suddenly subprime loans became something of a hot potato, burning whoever ended up holding them. You knew this would happen. You may not have known all the details behind the processes, but you knew making large loans to subprime borrowers would eventually blow up. You also knew that simply repackaging bad debt wouldn't somehow turn it into good debt. That's just common sense, but apparently that didn't occur to the world's largest financial markets' sharpest minds. What you may not have know was the extent of the repercussions. Indeed, as 2008 begins, we're all still finding out. The financial markets were jolted in late February when investors finally started paying attention to the impending crisis. However there was a quick recovery when they were reassured that subprime loans only represented a small percentage of outstanding debt. While borrowers and investors in this area were at risk, the damage was expected to remain restricted to that small corner of the market. Investors were so reassured, they sent stocks to new highs. Unfortunately, subprime's tentacles extended much further. With defaults growing into late summer, financial institutions became fearful of lending to one another. Even if they held no subprime debt, they couldn't tell if their counterparties did. In that situation, the prudent course of action was not to lend at all. As a result, the liquidity that had been driving the financial markets suddenly dried up.
With real overnight rates 0.75 - 1.00% above their stated benchmarks, central banks around the world stepped in to add liquidity. European banks made loans available in almost unlimited amounts and below their stated key rates. The U.S. Federal Reserve cut its benchmark rate, the Federal Funds rate by a cumulative 1.00% starting in September. As the year came to a close, conditions were still far from normal. Perhaps the most unexpected consequence has been the effect on the U.S. dollar. In the past it served as the currency of choice when frightened investors sought a safe haven. This time, however, lower domestic interest rates have weighed on it relative to the currencies of the U.S.'s major trading partners. This, in turn, has helped reawaken what had been the sleeping threat of inflation. Commodities such as crude oil and gold are typically priced in terms of dollars. With the dollar losing value relative to other currencies, the dollar price of commodities has been on the increase just to maintain parity in real terms. As a result, the real price hasn't jumped as much in Europe or Asia as in the U.S. That's little consolation to domestic consumers as gasoline moves through $3.00 a gallon.
It also comes at a time when corporate profit growth is beginning to decline. For the past five years earnings have been on the upswing, but you just knew that had to end at some point. Giddy CEOs and CFOs implied differently right up until the third quarter of 2007 when earnings actually turned down. While it was easy to blame the crisis in the financial markets, that clearly wasn't the whole story. Fourth quarter earnings are now expected to show "negative" growth -- that's Wall Streetese for "decline". Tight credit, slowing earnings, and rising prices have many now fearing a return to the 1970's oddest phenomenon (yes, even odder than disco, shag carpet, and big hair): stagflation. Typically, inflation accompanies a booming economy and it recedes with declining economic growth. Stagflation occurs when the economy succumbs to inflationary and recessionary forces simultaneously. That's rare, but it did happen thirty years ago and some believe it's about to happen again. So the excesses of the past few years have had far-reaching effects. Like ripples reaching out from a small pebble thrown into the center of a quiet pond, they've emanated in all directions. Unlike the ripples in a pond however, these have actually gotten larger the further they go. That small percentage of the credit market has not only hit almost all areas of the domestic markets, it's been felt worldwide. Removing the Band-Aid First of all, it's highly unlikely the subprime crisis is completely over, although it may have reached a turning point in mid-December. When the summer's sudden lack of liquidity first struck, limiting SIVs' ability to receive financing, JP Morgan, Citigroup, Bank of America, and Blackrock proposed creating a $49 billion entity to be known as the Master Liquidity Enhancement Conduit (MLEC) to help provide liquidity to struggling SIVs by purchasing some of the highest quality subprime debt. Not only would they help fund it, they would ask other institutions to kick in as well. After all, everyone would benefit. Cynics among us believed this was nothing more than another ploy to keep SIVs and their failing loans off the guilty parties' balance sheets. Almost everyone saw it as dead on arrival for no other reason than the simple fact that it was (and still is) impossible to know what really constitutes "highest quality" subprime debt. Going into the summer much of it had been highly rated by the major ratings services, yet now those same services are falling over one another to move it to the depths of their scales. Even the bond insurers have seen their ratings cut as well. In essence, "high quality subprime debt" is an oxymoron like jumbo shrimp. As long as the MLEC idea remained even a possibility, institutions could refuse to truly confront the crisis. Like a recovering alcoholic, the first step is to admit there's a problem, not rely on a new derivative entity to bail out other derivative entities. That turning point finally came in mid-December. Following in the footsteps of UBS which a week before announced it was taking its SIVs and their subprime debt back onto its balance sheet, Citigroup did the same. With major banks finally acknowledging their liability and the associated write-downs, the MLEC was truly dead. Progress could now be made. But that doesn't mean the last shoe has fallen. Many (including us) had expected financial institutions to move as much of their write-offs as possible into the fourth quarter. With investors already anticipating them, it seemed like a prime opportunity to clean house. Some even believed the write-offs would be based on the worst-case scenario, thereby paving the way for some surprises on the upside should the charges overshoot the mark. Although that made sense, it doesn't appear to be what happened. The general feeling is that once the bad news is out, the economy will sustain the short-term hit, recover, and resume its upward pace by the latter half of 2008. Given that, banks have decided to limit their write-offs in the hope that the ultimate impact can be delayed until the recovering economy can help limit the losses. As a result, they're minimizing current write-offs and stretching out the process. In common sense terms, they're slowly removing the Band-Aid rather than just ripping it off and getting on with it.
So as long as they prolong the process, you just know it will encumber economic growth. If it takes until the second half of 2008 to finally wash out all the bad debt, it will also take that long before earnings can recover. Equities might react sooner in anticipation of the turnaround, but it's always risky trying to call the bottom. Along the way, the Federal Reserve will be called upon to help stabilize the credit markets. But think about it: With the benchmark Federal Funds rate ending the year at 4.25%, can they really aggressively lower it much further? Ten years ago you probably never thought you'd see rates this low. Twenty years ago you were certain you wouldn't. But here we are in 2008 with relatively low interest rates and rising inflation. Does it make sense to expect the Fed to ease much further and fuel inflation only to help prodigal financial institutions manage their Band Aid? You just know there are times when you simply have to take your medicine -- no matter how bad it tastes -- so you can get on with life. The Fed's done all that can be done from a monetary policy standpoint although they may still be forced to go further. Congress and the administration have some fiscal policy remedies that are equally distasteful and potentially quite harmful. Congress wants to regulate lenders. More government regulation in the free market is rarely a good thing, but at worst it's simply inefficient and wasteful. We've grown used to that. The administration's solution, however, can be downright harmful. In this election year, President Bush is encouraging legislation that would freeze adjustable rate mortgages at current levels for several more years. Purportedly this is to buy more time for subprime borrowers and hopefully enable them to keep their homes. But think about it: This will help them buy time for what? Will they suddenly receive more income? Will all their other debts magically disappear? Will the lenders (and investors who own the debt) suddenly just say, "Oh, never mind," and keep the current rates in place forever? You just know that all this can accomplish is to delay the inevitable. This is yet another Band-Aid that will eventually have to come off now matter how slowly and painfully you try to remove it. In an election year -- and God help us all, 2008 is an election year -- this sort of solution plays well on the campaign trail, but truth be known, the best fiscal solution is a tax cut which would potentially raise everyone's income and ability to service existing debt. That, however, isn't a populist alternative given the class warfare that dominates the current campaign. What You Know Now But that's not the whole story. In the third quarter when earnings growth on the 500 was collectively falling 11%, healthcare, tech, and telecommunications were actually increasing 18%, 17%, and 11%, respectively. In fact, aside from the financials, only consumer discretionary (-22%) and energy (-7%) saw growth decline, the other seven sectors enjoyed increases. For the fourth quarter, analysts expect only basic materials to join financials with negative earnings growth. Given the deep decline anticipated for the financials, the other sectors are expected to again be overshadowed, with earnings for the overall index predicted to fall by 2%. Although we often refer to "the market" as a singular entity, it's actually a compilation of very different sectors which are not homogeneous. This is why stocks have been able to hold up as well as they have despite the turmoil in the financials. It's also why at least some sectors will be able to weather the ongoing credit crisis in 2008 as well. The dollar is a better gauge of overall economic health. Globalization has helped hold back inflation. As a nation of net importers, lower cost goods from overseas, particularly China, have helped damp prices domestically. But now the falling dollar more than counterbalances these benefits, particularly in regard to crude oil. Rising prices from a weak dollar are not demand driven but rather currency driven. Until the dollar at least stabilizes, inflationary threats will persist. As long as the Federal Reserve is pressured to lower interest rates, inflation will be a concern. Further declines could well push commodity prices higher and production and earnings lower. As odd as it sounds, easier monetary policy could actually push the domestic economy closer to recession. Stagflation, however, is much less likely. If the economy slows due to higher producer prices, demand will also decline. Although the U.S. economy does not have the global weight it once enjoyed, exports into this country are still a major engine of worldwide growth. A slowdown here would almost certainly have an impact around the world, particularly in Europe and possibly even in China. This could be what it takes to slow the rising price of crude oil, not artificial quotas set by OPEC. So if you want one indicator to keep an eye on in 2008, watch the dollar. Market watchers will refer to all sorts of indicators and signs, but you know economics really isn't rocket science. The signs that have been there in the past are still there now. There really isn't anything that's all that different this time. Investors will almost always come out ahead if they simply rely on their gut feelings because in most instances, you just know. TOLD YOU SO -- In reviewing this year's annual outlook, here's a glance back at 2007's: It's our sense that U.S. stocks are poised for a mid to upper single-digit gain, slightly less than the historical average annual return. It wouldn't be surprising to see volatility increase from the current low levels. It's also possible that there will be another mid-year selloff, possibly the slightly overdue 10% correction. The second quarter is the likeliest timeframe. Aside from calling the sell-off one quarter too early, the rest was right on target. It's encouraging to occasionally have a better record than the weatherman. Search this site! Just enter you key word or words:
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T'S SOMETIMES SAID THAT what you don't know can hurt you. Actually what you do know can, too, especially if you ignore it. To a certain extent, that's what happened to the financial markets last year.
