15 Feb 2008 “Negative Waves”
In the star-studded 1970’s comedy war film Kelly’s Heroes, Donald Southerland’s character ‘Oddball’ constantly admonished the dreary nature of his tank driver, Moriarty, played by Gavin MacLeod with the phrase “always with the negative waves Moriarty.” The steady pounding of dour economic reports continues with little positive relief in sight. The juggernaut US and global economies seem to have changed course almost overnight. The change in mood is due both to qualitative and quantitative forces.
Infinitely available information, a product of our time, has been mostly negative these last few months. People buy into the fear and uncertainty (perhaps faster than in the past because of today ubiquitous barrage of analysis) that the economy could slow, they naturally become more conservative in their investing and spending. A second and equally powerful driver is the virtual drying up of credit. The flow of capital required to sustain this monster global expansion has been perilously restricted by fears, both real and imagined.
A month after dramatic cuts of 1.25% by the Federal Reserve, both companies and homeowners are paying MORE to borrow money than before the cuts. Rates on jumbo mortgages (those above $417,000), have actually increased in the past month, making it tougher to sell properties and risking further price declines on homes. The stimulus bill signed by President Bush this week raises the jumbo limit for purchase by Fannie Mae to $729,750, which should help. But, banks and investors are demanding greater compensation for offering credit as their losses mount on subprime-mortgage securities. Driving those concerns are huge uncertainties over what will happen if bond insurers loose their high credit ratings.
Bond Insurance companies have become the focus of the problem and the potential solution. They include names like MBIA, Ambac, and FGIC. They were formed to insure bond investors against unforeseen interruptions in the payment of principal or interest on bonds – municipal bonds, primarily. In the last few years these companies, chasing growth, branched out from municipal bonds into student loans and the ill-fated collateralized debt obligations, or structured mortgages.
As rates rose and housing growth slowed a ‘slice’ of these CDOs started going bad (sub-prime) and no one really knows yet how big the ‘slice’ will get. That’s why the rating agencies like Standard and Poor’s, Fitch, Moody’s are threatening to lower their AAA rating. They have already done so for AMBAC. Most analysts agree that bond insurers will fail over the long-term without triple-A ratings. That’s because municipal insurers will typically only buy insurance from a triple-A guarantor. The near-term market effect of lowering their ratings reduces bondholders’ confidence that they are adequately covered against loss. The bonds insured by these companies accordingly drop in value. Banks own lots of bonds that are declining in value as the “potential” ratings reductions hang over bond insurers. We are in a highly leveraged downward spiral that ends when confidence in bond insurance can be restored.
Today, the Federal Reserve of NY reported that its general business conditions index tumbled to negative 11.72, falling below zero for the first time since May 2005. It dropped from a level of 9.03 in January. It suggests recession in that state and perhaps throughout the nation as a whole.
The Reuters/University ofMichiganindex of consumer sentiment dropped to 69.6, the lowest since 1992, from January’s 78.4. It suggests that consumers are getting very scared, but these measures have failed to accurately predict consumer behavior in the recent past. On Tuesday in a rare moment of good news the government reported that US retail sales actually jumped .3% in January after a surprising decline in December. Another surprise came yesterday when Japan reported that its economy grew 3.7% last quarter, twice the pace economists forecast.
But talk is negative from the most influential speakers. Fed Chairman Ben S. Bernanke gave his honest assessment of the economy when he said yesterday that the world’s largest economy is “clearly on the edge” of a recession. He further said that he believed we would avoid recession and that the Fed “will act in a timely manner as needed to support growth” Former Fed Chairman Alan Greenspan said yesterday in Houston that the economy is at “stall speed” and the odds of a contraction are “50% or better. “Always with those negative waves.”
While things look pretty bleak for the economy the stock market remains attractively valued with a pretty solid floor. Corporate earnings for companies in the S&P 500 have dropped 15% on average, but that’s mostly from the financial sector’s record losses. Analysts have lowered expectations for US corporate earnings in the first two quarters of 2008, after results for the fourth quarter showed conditions much worse than initially expected, according to a weekly survey by Reuters Estimates. They expect S&P 500 companies’ first-quarter earnings to grow just 2.8% year-over-year in the first quarter and 3.5% in the second quarter, after falling 20.7% in the fourth quarter. For the full year, analysts forecast earnings in the financial sector to recover 21% in 2008 after falling 48% in 2007. The technology sector is seen as the most resilient to the US slowdown, with analysts expecting earnings growth of 23% in 2008.
We have increased cash in the face of mounting evidence that recession is upon us, but we are reticent to go down the road of market timing. While we bent our strategic allocation in each model to carry more cash, we believe it prudent to maintain equity exposure, albeit more conservative exposure. We lightened our technology weightings in recent weeks and months as volatility reached extremes, but we still believe it remains an attractive place to be in 2008. The US stimulus package will help drive demand at home while a global thirst for competitive advantage will drive demand abroad. While our profits persist in our Wachovia holdings, we were a bit too early in global financials. Regardless, we sense that Federal and state regulatory agencies as well as the banks themselves will reach agreements in the coming weeks to restore confidence in the credit markets. Further, rate cuts from the Fed and effects of the Federal stimulus package should provide some positive energy for the market in the spring.
The financial markets and our office will be closed on Monday in observance President’s Day. Have a good weekend.