Fragile, Handle With Care

This was the title for the U.S. Macro Outlook from Mark Zandi, Chief Economist and co-founder of Moody's Economy.com, Inc. released today which seems quite appropriate. Just when everything looks like clear skies ahead with the Dow Jones Industrial Average pushing through the 14,000 milestone, things turn on a dime and volatility and uncertainty predominate as risk is re-priced. Excerpts from Mr. Zandi's U.S. Macro Outlook are provided below:

The catalyst for the global financial turmoil is investors coming to terms with the reality of the massive losses on their housing and mortgage-related investments. Of the approximately $2.5 trillion in subprime, Alt-A, and jumbo IO and option ARMs outstanding--equal to almost one-fourth of all mortgage debt outstanding--some $1.3 trillion is at serious risk of default (see chart). These at-risk loans were originated between late 2004 and early this year with less than 10% equity at time of origination. House prices are expected to decline 10% from their late 2005 peak to their nadir later next year. Of those at-risk loans, nearly $425 billion worth will actually default, ultimately resulting in losses to investors who purchased securities backed by those mortgages of well over $100 billion.

Figure 1

Source: Mark Zandi, Moody's Economy.com

Mr. Zandi goes on to mention the fragility of the markets where it may only take one more financial mishap to lead to a credit crunch. One suggestion for what the next shoe that drops may be is the commercial banks. Commercial bank exposure to residential real estate surged in 2002 as did the share of residential real estate assets to total assets.

Figure 2

Source: Moody's Economy.com

The subprime issue is far from contained and may next spread to the commercial banks. This despite the financial media consistently saying it was contained (much like their constant housing bottom calls) and ignoring the issue and its implications, though the information was available a year ago.

Appearing often on CNBC is Peter Schiff, President of Euro Pacific Capital. He has consistently pointed to the weakness in the dollar and the over-priced housing market, and has been both ignored and laughed at during interviews. Mr. Schiff's comments in his July 27th newsletter (What a Difference a Week Makes!) are given below:

This week however, the preponderance of bad economic news on the U.S. economy finally trumped the good news coming from abroad. Perhaps the hardest pill for the market to swallow was Countrywide's admission that its earnings had been negatively impacted by late payments on its PRIME loans. This threw cold water on Wall Street's self-induced delusion that the problems in subprime had been contained. This notion had been so universally accepted that the very word 'contained' has been conspicuously paired with subprime with almost every utterance.

However, from the onset I have repeatedly warned that subprime was just the tip of the iceberg. I have been writing about the dangers of the housing bubble for years. Here are some excerpts from my recent commentaries regarding subprime:

• December 22, 2006, Subprime Disaster in the Making

• March 9, 2007, The Worst is far from over

• March 14, 2007, From the subprime to the Ridiculous

• March 22, 2007, Don't Uncork the Champagne Just Yet

• June 28, 2007, Subprime Shoes Continue to Drop

We are already seeing the subprime issue spread to other areas of the fixed-income market, however there are still financial pundits preaching a 'goldilocks' economy, though not everyone is in agreement. Mark Zandi commented on the spill-over of the subprime and housing mess to the general economy in another article he wrote (Investors Reconsider Risk, 07.30.07), with excerpts provided below:

The U.S. economy will not be able to avoid some ill effects. There is only downside for the housing market, as mortgage credit will now be even less ample and more costly. Weaker stock prices, assuming they remain so, when combined with falling house prices will cut into household net worth and equity withdrawal, inducing a more significant negative wealth effect. Evidence is mounting that consumers are already turning more circumspect in their spending, particularly in parts of the country where housing has been hit especially hard, such as in California and Florida.

Echoing Mr. Zandi's comments on a spill-over to the economy from a weakened consumer is Paul Kasriel, Sr. Vice President & Director of Economic Research at The Northern Trust Company. Mr. Kasriel's comments on the spillover into the economy from housing are provided below:

More Evidence of Spillover from Housing to Consumer Sector

We have been forecasting that the housing recession would have a negative knock-on effect on discretionary consumer spending. Six successive months of declining light motor vehicle sales is corroborating evidence of this. If J. D. Power has got its numbers correct, July is on course to mark the seventh consecutive month in which car and truck sales decline. This organization said that U.S. auto (and presumably, truck) sales were down 20.4 % from year ago in the first half of July. This sales decline comes with a 28% jump in cash rebates by auto makers. What is more discretionary than a Harley Hog? Harley Davidson reported that its U.S. sales in the latest quarter were down 5.5% from year-ago. Another discretionary consumer item is a pleasure boat. To that, Brunswick Corporation, the world's largest maker of recreational boats, today cuts its 2007 profit and boat sales forecast.

Inexorably, the tentacles of the housing recession are strangling the U.S. economy. Despite mounting evidence to the contrary, the Fed keeps saying that the housing recession is quarantined. Does it really believe this or is it so terrified about what might happen to the dollar if it were to cut rates to prevent a recession that it keeps up this Orwellian newspeak that there does not appear to be much negative spillover from housing to the rest of the economy.

Despite the presence of a vast array of negative developments from a housing recession, subprime debacle, hedge fund blowups, and tightening credit, there are still 'goldilocks' preachers. These preachers are sighting low inflation and world economic growth that continues to benefit many Dow Jones Industrial Average companies due to foreign sales exposure. Thus, we have a tug-of-war between the permabears and the permabulls, hence the fragile state of the markets.

We may have reached a bottom of temporary or significant importance as signaled by Westpac Strategy Group's economic surprise index, which is designed to track the evolution of economic data surprises over time. The Westpac Positive Surprise Index measures the percentage of releases beating Bloomberg consensus estimates in the previous eight weeks, presented as a percentage and is bounded by 0% and 100%, and shows a clear positive correlation to the S&P 500.

The Westpac Positive Surprise Index turned sharply lower preceding the March and July corrections of this year, heralding a possible turn in the markets. The index is currently at a reading of 41.01 as of last Friday and is near the range of previous bottoms, with bottoms in the index corresponding with bottoms in the markets. Thus, it is not surprising to see a bounce in the S&P 500 this week.

Figure 3

Data: Bloomberg

The S&P 500 also tracks the Westpac Positive Surprise Index on a rate-of-change (ROC) basis, with its three month ROC displaying a close relationship to the Westpac index. On a ROC basis, the S&P is near the realm of previous bottoms which also leads support to the market's recent snapback rally.

Figure 4

Data: Bloomberg

Neither the permabulls nor permabears can declare victory as of yet, at least determined by the markets. Victory will be determined by the sustainability of the current recovery rally. The global economy continues to expand with many U.S. multinational companies benefiting, adding support to the bull camp, though we are still climbing the mountain of ARM resets which are expected to peak later this year into next, adding support to the bear camp. With the market outcome uncertain, continued volatility is to be expected.

TODAY'S MARKET

Stocks rose throughout most of the day aided by news yesterday that Cisco Systems Inc. posted a 25% rise in quarterly profit and raised its revenue forecast for the year. However, a 190 point surge in the down was completely erased in late afternoon trading on rumors Goldman Sachs was going to make a potentially troubling announcement after the close, dipping briefly into negative territory. A quick release by Goldman that denied the rumor led to a sharp recovery rally into the close.

The Dow added 153.56 points to close at 13,657.86 (+1.14%), while the S&P 500 fared slightly better, rising 20.78 points (+1.41%) to close at 1497.49, with the NASDAQ closing at 2612.98, up 51.38 points (+2.01%).

The rally in equities led to a sell off in Treasuries with yield on the 10-year note rising 11.7 basis points to close at 4.86%. The dollar index was down on the day, falling 0.13 points to close at 80.35. Advancing issues represented 70% and 67% for the NYSE and NASDAQ respectively, reflecting a broad rally in the markets.

Oil prices were down on the day despite bullish petroleum inventory release, with Brent crude falling __spamspan_img_placeholder__.81/barrel to .99/barrel, though Henry Hub spot natural gas was up 4.42% to close at .38. Precious metals were up with gold adding .10/oz to close at 4.50/oz (+0.31%), and silver up __spamspan_img_placeholder__.04/oz to close at .13/oz (+0.31%). Base metals were mixed with tin putting in the strongest performance (+1.94%), while nickel displayed the weakest performance (-3.25%).

The rally in the markets was broad based as nine out of the ten S&P 500 sectors were up on the day, with the materials, financials, and energy putting in the strongest positive performances, up 2.36%, 2.15%, and 2.14% respectively. The only declining sector was telecommunication services, down 0.34% on the day.

Overseas markets had a big day with many indices up more than 2%. The Taiwan Taiex index led the charge, up 2.68%, followed by the Brazilian Bovespa and Korean Kospi indices, up 2.67% and 2.34% respectively. The weakest performance came from the Chinese Shanghai index and Japan's Nikkei 225 index, down 0.26% and 0.64% respectively.