Halloween Scariness in the Financial Sector
By Frank Barbera CMT. October 30, 2007
Another day, another week, and soon a new month, and the news just continues to fall off a cliff. As investors woke up this morning they were greeted by the headlines of Home Prices falling for the eighth month in a row, with no turnaround in sight. Turns out, Home prices fell in August by 5% from a year ago, recording the biggest decline since 1991 when prices fell 6.3% in April 1991. The Case-Shiller Index showed its lowest annual returns ever recorded in August, with Cleveland down 4.1%, Las Vegas down 7.6%, Miami down 7.8%, Minneapolis down 4%, Phoenix down 8%, San Diego down 8.3%, Washington DC down 7.2% and Tampa, with the biggest loss of all down 10.1%. The picture in the Housing market is bleak, with panelists at a Housing Industry conference in California, Jeffrey Mezger, CEO of KB Homes, and Angelo Mozilo, CEO of CountryWide Financial along with California State Treasurer Bill Lockyer, suggesting to the Wall Street Journal that �home prices in California could decline on the order of 10% to 15% in the year ahead.� After reaching a cycle high of $484,000, the latest September median home price came in at $430,000, already more than 10% off the cycle high.
Of course, none of this news is helpful to the world of Structured Finance, where CDO pricing remains under intense downside pressure. Using the indices tracked by Markit.com, the TABX Index which is a proxy for the world of Collateralized Debt Obligations (CDO�s) has deteriorated 18 to 35% across all tranches in recent weeks, not a pretty picture by any means. None of this is lost on the management of some of the largest SIV�s or Structured Investment Vehicles where SIV�s closely linked with three of this country's largest banks, JP Morgan Chase, Bank of America and Citigroup, need to find $100 billion in fresh investment capital to roll over debts coming due in the next six to nine months. Of course, the large banks are looking to create the SIV Superfund, in an effort to keep these liabilities off balance sheet. Yet the recent disclosures from Merrill Lynch which under-estimated its CDO losses by several billion dollars (4.5 billion original to 7.90 billion final), tell us just how vague and opaque the pricing is on the paper of these CDO and SIV holdings.
Looking ahead, it is very clear that we are far, far away from anything resembling the end of the now global credit crunch. Nationwide, it is estimated that 19% of all subprime loans made in 2005 and 2006 will lead to foreclosure and nearly two million families could lose their homes. To put that number in perspective, 2 million is bigger then the populations of Boston, Seattle and Denver combined. Within the Commercial Paper Market, total CP is down 351 billion in 11 weeks, and within the badly stricken Asset Backed Commercial Paper market (ABCP) the total asset base is down 190 billion in the last two months. These are staggering figures, and to date, we have seen very little appetite for risk taking following the Fed's September rate cut. Of even greater concern is the still ongoing deterioration which is rippling through the banking and re-insurance system where according to Michael Bauer, an executive at Mainsource Financial, �US Banks burdened by loans they promised prior to the recent liquidity shortage will curb their lending practices. Banks now use a tighter lending criteria as a result of losses suffered from defaults in subprime mortgages.� Yet, the damage has most likely already been done, with CDO and other derivatives issues likely dwarfing the Subprime mess. Just look at the downside acceleration seen last week in the shares of MBIA and AMBAC, two of the world's largest bond insurers, both of which reported staggering losses.
Above: MBIA which insures bonds, reported huge losses and the stock plunging to new lows.
Above: AMBAC � a former bluechip now collapsing amid questions regarding whether the company will be able to sustain the kind of losses it could be exposed to if current conditions continue to deteriorate.
To be sure, with the untold number of Banking shares collapsing to multiyear new lows over the last few weeks, the pain in the Financial Sector seems along way from over. For the Fed, the most likely course of action is a long series of 1/4 rate reductions, punctuated with 1/2 rate reductions as secondary credit crises emerge. Yet, the so-called �shock therapy� of additional 1/2 point Fed rate reductions is unlikely to stem the larger tide, which is one of a still building domino style collapse, courtesy of Wall Street Structured Finance and the broad securitization of risk. In fact, unlike past credit problems where the problem was mercifully isolated to one or two offending over indulgent parties, this problem has been packaged and exported world wide and now resides in countless portfolios. Bottom Line: It is simply a long way from over. So what do investors do while trying to make an honest buck? The answer is to expect more turmoil and periodic severe bouts of selling pressure rippling through the financial markets. We are looking at the battle between monetary reflation and debt deflation playing out on the grand stage.
In the end, the rapidly escalating downhill slide of the US Dollar may very well be the straw which breaks the proverbial camel's back. In its efforts to save the US Housing sector, and mitigate a building US Recession, neither one of which is likely to be effective, the US Fed has told the rest of the world that the Dollar is their problem -- to be sure, a message resonating loudly in the board rooms of Daimler Benz, Toyota and Hyundai. As the Dollar continues its steady path lower, the ongoing signs of Stagflation become overwhelming even in daily life within the US. Sure, for many who pay no attention to the prices paid, the skyrocketing movement of food prices may not be clearly evident. Yet, it is prices across a broad front of consumer products which are moving up at a real world rate often in excess of a 10% annualized rate of change. With Crude Oil and Heating Oil at new all time highs and winter approaching, we are sure to see gasoline prices surge come the spring of next year. Perhaps $5, $7 or $10 per gallon gasoline will finally grab hold of the public's attention, as the mainstream lack of questioning on the CPI data beggars the mind. How, How, How can reported energy costs be up 5% year to date when Crude Oil, Heating Oil and Gasoline prices are all up 40% YTD? Some pretty fancy math to achieve that end result, which at the end of the day simply puts untenable strain of the budgets for the Middle Class. Of course, a key verdict on this note might come from the market with a major break below long time support on Wal-Mart Stores at $42.
Perhaps we can see still more evidence of the current economic recession playing out in the share prices of formerly highly popular retailers at the local mall. You know the names -- Coach, American-Eagle, Bebe, Guess, Urban Outfitters, Jones Apparel, Chico�s, Hot Topic, Pacific Sun, Abercrombie, Liz Claiborne, etc� Not a pretty picture and a sprawling bearish divergence visa vie the DJIA. Certainly, no second round of new highs in 2007 for this bunch, as they somehow seem to have missed their Fed servings of KoolAid. A few more percentage points from here and we could readily be talking new multi-year lows by February.
So where does an investor go during periods of stagflation? Well, you have to go where there is earnings leverage through stronger pricing power. Put another way, you need to play the �things� that are inflating. Of course, it would be entirely self serving of me to point the way toward precious metals, but among many sectors where there is strong upside leverage, certainly agricultural commodities are creating solid EPS growth in a number of situations, while in addition, Energy in all its many forms is also providing many an interesting opportunity. It's that �Back to the 70's Show� all over again, courtesy of Uncle Ben. In this vein, we note that during today's stock market sell off, some of the Energy names were hit especially hard with money rotating �out of energy� and into �technology.� Bad move from our viewpoint, as Technology has already started showing major cracks in the CAPEX damn. And have a good look at those PEG Ratio�s why don't you; nothing really cheap in the Tech Sector.
In fact, Tech Sector investing and recession simply don't mix, but Energy, especially in the world of Putin, Chavez and Ahmadinejad, Energy Stocks, well, are in many cases, still plenty cheap and thus ripe for potentially bigger gains ahead. As a final note to those willing to do some hunting, we throw out the following bone relative to the Energy Sector. Consider the Energy Majors which have moved to new highs and which have largely enjoyed a huge advance. As in many areas of the Natural Resource world, most of these larger companies need to continue to grow reserves, and to that end, in today's world growth through acquisition, even with nice takeover premiums is still far cheaper than originating homegrown organic growth. As a result, we perceive an industry trend that will continue on the path to greater consolidation wherein smaller and mid-sized companies probably sport the best EPS leverage around. In the chart below, we show our basket of secondary Oil Stocks (about 30 names) visa vie the large cap dominated XOI. You can see that on the very bottom clip, Small Cap Energy is down in the basement and appears to be trying to turn the corner. Bargain Hunter�s � let loose your best truffle sniffing hogs, as there is much fertile ground in this corner of the world -- a corner far, far removed from all that weeping and gnashing of teeth taking place in the dark recessed ugliness of the financial space.
At the close, the DJIA ended down 77.79 on Tuesday to close at 13792.47, with the S&P 500 down 9.96 at 1531.02, and the NASDAQ Composite virtually unchanged, down .73 at 2816.71. Nearby Gold ended at $785.60, down $7.00 per ounce with the 10 Year Bond Yield finishing at 4.38%. That's all for now,
© 2007 Frank Barbera