Credit Crunch Revisited

Today, fear seems to be in abundance in our marketplace. The credit crunch has become increasingly risky to the continued growth of our economy as the Real Estate market continues to decline in value. The danger is that this credit readjustment has an impact on the business environment and that companies start to hold back investment and R&D spending. Also, many families are finding themselves with mortgages that reset from fixed rate to adjustable rate at much higher interest rates. With this backdrop, people have growing concerns about their ability to sustain their current lifestyle. It should be noted that adjustable mortgage resets peak in February 2008 at $52 Billion. With the Fed lowering rates, people are banking that all the adjustable rate loans can be refinanced into fixed rate loans like 2001-2005. Unfortunately, credit has been repriced in the market and spreads have widened to compensate for the risk of the borrower defaulting. This means mortgages are between 6.5%-10% depending on individual credit. The widening of interest rates and credit risk has spread to the banking segment of our economy. There are $750 Billion of M&A loans that need to be securitized along with all the real estate loans that haven't been able to be sold in the marketplace. This backlog needs to be worked off before Wall Street starts to make new loans. Credit problems seem to arise in mid-economic cycles as earnings from companies slow. Most of the problems we are seeing today in our markets are due to the lack of information available to the public from the banks and investment community. With time, this will pass and confidence will return to our financial markets. For the last 30 years, the Central Bank has done whatever it takes to get the markets moving again and this time is no different. It is my belief that the Holiday Season will be much better for retailers than expected and that our exports will help offset the Real Estate decline. This is where I differ greatly from most of Wall Street. Our economy is very resilient as exemplified by post 9-11. In fact, the S&P grew it's earnings by 105% from 2002-2007. Mid-cycle slowdowns are scary but a necessary part of a healthy economy. This slowdown is no different from others we have experiened over the last seventy years.

The Economy and Politics

For the last year we have been concerned about the housing market. Today, the hot word is sub-prime, although this buzzword isn't telling the whole story. It can be seen that new Real Estate projects are taking longer to absorb into the marketplace and new projects are still being built. This happened in the late 80's with the S&L's being the home for all the risky loans and junk bonds packaged by Michael Milken & Co. Today, this same process has taken place with hedge funds and European banks being the home for all our risky loans and junk. The Real Estate market still has a way to go before prices make sense and the impact on the economy might actually be pretty large. We see vacancies in our Malls rising to levels not seen since 1992. The Fed is the key to this dilemma but lower rates will not prop up prices. Our Real Estate problems are just the tip of the iceberg. Politically, we have even bigger issues. Iraq is costing over $1 Billion per month. My concern is that Iraq and other external political problems have taken our focus away from terrorism and corporate responsibility. As we approach the elections next year, we should note that having another Clinton in office would make our country much like a Monarchy. Having the Bush's and Clinton's running this country for 20+ years seems a bit too much. The electoral college must go and the popular vote should be used. These are just a few thoughts about the economy and politics.

Credit Rebound?

I began my blog by describing how our housing and securities markets were interacting with each other in ways that might turn out to be disastrous. It should be noted that adjustable mortgage resets peak in February 2008 at $52 Billion. With the Fed lowering rates, one should hope that the adjustable rate loans can be refinance into fixed rate loans like 2001-2005. Unfortunately, risks have been repriced in the market and spreads have widened to compensate for the credit risk of the borrower. That means mortgages are between 6.5%-10% depending on credit. This widening of interest rates has spread to the banking segment of our economy. There are $750 Billion of M&A loans that need to be securitized along with all the real estate loans that haven't been able to come to market. This backlog needs to be worked off before Wall St. starts to make new loans. These credit problems seem to arise mid-economic cycle as the economy slows down a bit. For the last 30 years, the Central Bank and Fed have done whatever it takes to get the markets moving again and this time is no different. It might take some time and new ideas but we can fix the credit situation. I hope it comes in the form of a coordination among Central Banks but you never know how Geopolitics will play into our economic problem.

Credit Crunch?

First, this should be taken as a personal explanation for the financial problems that have engulfed our credit markets since last February. It began with the risky lenders going bankrupt in February (although the underlying bonds representing their loans were never priced appropriately). This was caused when Bankers\Hedge Fund Managers and Portfolio Managers stretched for return and had no bearing of risk over the last few years when volatility was low. Over the last three months, most short term leverage (i.e. commercial paper and medium term notes) have been called by Banks/Wall Street Brokers and investors (or never rolled). This caused massive selling on the parts of leveraged Hedge Funds/CDO and CLV's. One positive note is that most of the assets that had been liquidated are high in quality due to the lack of bid for esoteric derivatives and mark to model non-rated debt held by these entities. This means that the Hedge Funds had to sell their stock positions and Treasuries to raise capital for margin calls and redemption's. In due time, the credit markets will begin to measure risk in in a prudent manner and the young managers will loose their jobs just like previous credit crunches. Times seem to repeat themselves. This time the global economy is in full swing and corporate profits look healthy. During this fallout, an overweight in high quality equities (especially International) as well as some corporate/AAA Mortgage Debt that has dropped in price during the credit crunch should be tactical. In the coming weeks, more news might hit like Countrywide or some small regional banks like Vineyard Bank might have further short term cash needs. This will cause more panic but these are just short term movements. Just remember that in 2002 many un-failable companies declared bankruptcy. This is not the end of the world. Just unraveling of a bubble. The market still looks poised to rebound this small correction and continue higher by year end. Again, 14,000 has been already crossed over. Remember, stay away from leverage a major correction in Residential Real Estate seems to be setting in.

Dow 14,000?

Even with the Subprime mess, companies are continuing to surprise the street with exceptional earnings. Most likely the Fed will keep interest rates steady even though most strategists think they will lower. Inflation is still a persistent problem even though China and other up and coming countries are making the world more competitive. One important aspect that most people don't pay attention to is the "pipeline" of M&A activity. That means the Investment Banks will have a windfall of profits this year. Couple that with a wide "crack" between crude oil and unleaded gas and you can see how profitable the energy companies will be again this year. Both those industries will surprise everyone. That is why they are all trading close to 10 times earnings. Another sector ripe for great gains is Technology. As people upgrade to Windows Vista (only 15% of computers are upgradable today), this will cause another spending boom that is long due. The last cycle was in 98' to 99'. These are important undercurrents that will help the market reach new highs. The S&P is fairly valued at 1700 and I see the Dow crossing the 14,000 mark by year end. Of course these are just predictions but let's see if I am right.

International

Given the decline in the dollar over the last year, it is a great idea to keep between 15-40% of your portfolio in overseas companies. One might also include Mulit-national corporations like GE or Coke because they derive over 50% of their revenues from countries other than the US. This should help balance the value of your dollar denominated assets with other assets that generate the revenues in other currencies like the Euro. For many, one idea is a Global Fund that allows the manager to decide where to invest. Emerging markets should only be a small percentage of the International allocation due to the risk inherent with their economies. Just remember what happened to Brazil and Russia in the 90's. There are many ways to make money investing and having a portion overseas will help with diversification.

Investment Market Outlook

The last few weeks have finally shown the world that volatility still exists and will suprise even the most sophisticated Hedge Fund Managers. What most people don't understand, is that the market looks forward about 6-8 months. This initital decline over the last few weeks is most likely an indication of things to come (mainly that China is overvalued and will not continue to grow it's GDP the way it has). I also believe that people are worried about our low savings rate, high debt, unbalance budget and that a decline in Housing Values will crimp the consumer. That means less electronics and clothing that is imported from overseas thus slowing the world economy. What has interested me for the last four months is the spike in premiums with the credit default swaps. Investors now believe the probability of a major financial institution collapse has grown. I think we have had 6 Subprime Lender bankruptcies in the last two months. It always begins in a far flug market, the subprime mortgage market this time and Malaysia in 97. Like Mr. Buffett says, expect what is unexpected and you shouldn't loose you shorts. Perception is the key to the market (albeit the manipulation being done by the large players of moving prices to make a quick buck) that will drive the price of all free markets. Riskier Assets will now be out of vogue as people shift to higher quality assets and Indexing becomes less advantages. I am not a dume and gloom investor but rather pointing out the negatives.

On the other hand, corporate profits are at new records and productivity seems to defy odds. The S&P's P/E is still trading under 20 and cashflow is at an all time high. I think stock picking is very important at this time and Munipal Bonds offer the greatest value for the yield. For the most part, our economy is in a great position but risks still might arise. In fact, there might even be some investment value's in the Real Estate sector when this all unfolds.