Our Take On What's Going On In the Markets, Vol. II
22 August, 2007
Last week was another wild ride in the stock market as the subprime mortgage mess came to a head. After falling 3.2% in the first three days of the week the S&P 500 then rose 2.8%, most of it in a dramatic surge on Friday. And so, as happened the week before, last week’s stock market was a roller-coaster ride that ended up very near where it started.
Nonetheless, at the low point last week the S&P 500 had declined 9.5% from its high on July 19. If you round that up to 10% it qualifies as a “correction” in stock prices, something we haven’t had in the four-and-a-half years since stocks emerged from the epic bear market in March of 2003.
So you could argue we were overdue for a correction. Because our outlook is driven by stock valuations and the fundamentals of the economy, we didn’t see this coming. We remain positive on both (more on this below). The problems last week arose rather as a result of financial gimmickry gone awry. If you’ll bear with us we’ll explain how below.
The problems arose over the past couple of weeks in an arcane sector of the bond market known as collateralized debt obligations or “CDOs.” These bonds are backed by various kinds of loans-mortgages, credit card debt, car loans, etc. CDOs were created by Wall Street as a way for lenders like banks and mortgage companies to package and sell some of their loan portfolios. This allows the lenders to transfer the risk of these loans to the bond market while raising cash that allows them to make more loans (and so collect more origination fees).
The buyers of these CDOs have tended to be large, supposedly “smart” institutional investors (a.k.a. hedge funds) who liked the bonds’ higher yields. Being crafty types, they often bought the CDOs with money borrowed “on margin” to further boost returns.
Over the past two weeks professional bond buyers, wary of exposure to subprime mortgages, turned their backs on the mortgage-backed securities market. This quickly caused the “bid” side of the market to evaporate and with it all pricing for these securities. With no pricing available, the CDO market ground to a halt.
This caused big problems for all sorts of financial players. Countrywide Financial, one of the largest issuers of mortgages in the US, had to tap an $11.5 billion credit line as they were no longer able to sell loans into the CDO market. French bank BNP Paribas suspended investors’ ability to get their money out of three of its funds because CDO holdings made it impossible to value the funds’ shares. And Goldman Sachs, the bluest of blue chip Wall Street firms, had to put $2 billion of its own money into some of its hedge funds to keep them afloat in the face of margin calls.
In short, the financial markets were hit by a liquidity squeeze. One of the main ways those afloat on borrowed funds dealt with the crisis was by selling assets they COULD get a bid for. Like common stocks. And so problems in the bond market fed into the stock market and selling begat more selling in a classic panic.
That’s when the Fed stepped in. Last Friday the Federal Reserve took the unusual step of cutting its so-called “discount rate” by 50 basis points. This is the rate at which the Fed directly lends to other financial institutions. It was both a symbolic and a substantive action whereby the Fed signaled it would provide the liquidity that had so suddenly disappeared from the markets.
The same day the S&P 500 rose 2.5%, its largest one-day gain since 2003.
The Fed’s action by no means constitutes an “all clear” signal. But it was powerfully reassuring on two fronts.
First, financial crises if left unchecked can feed back into the real economy. If mortgages are harder to come by there are fewer home buyers, housing prices suffer, construction falls off and carpenters lose their jobs. So the Fed breaking the logjam in the financial markets isn’t just a matter of bailing out hedge funds (Goldman Sachs’ largest global hedge fund fell 30% last week.)
Second, the Fed has also signaled that it’s ready to gun the engines on the real economy (lowering interest rates) should growth slow to a worrisome pace. As we’ve argued recently, this is the ace in the hole, if you will, with regard to recession risks. At 5.25% the current Fed Funds Rate can be lowered A LOT if need be in order to stimulate the economy.
While we don’t know if the economy will slow further, we are confident that if it does the Fed will cut interest rates. Either way, we don’t expect a recession. If we’re right then what we’re experiencing is a classic mid-cycle slowdown such as occurred in 1985 and 1995. In both cases there were financial crises, the Fed cut interest rates, recession was avoided and the stock market did well-quite well, in fact.
This isn’t to say that stocks can’t fall from here. They could easily revisit the lows made last week. But with stock valuations at their lowest levels since 1995, short of recession we don’t see much downside from here. Indeed, we expect just the opposite.