I wanted to name this week, "The Week of Reckoning," but could not resist the obvious title tied to the start to the NCAA's annual tournament, which by the way is also fitting in our view. The week really is critical in deciding the direction of the market for the rest of the month and possibly for a while longer. Leading up to this week, U.S. equities fell and have since bounced. Now, the market must find its true direction. After all the reactionary fund flows have settled, money must find reason to flow somewhere. Unfortunately, we view catalysts in place for true March Madness that portends to turn buyers into April fools.
Last week, Alan Greenspan told us that we had a one in three chance of experiencing recession this year, while Hank Paulson said everything was just dandy. I have a tendency to believe the guy who is less impacted personally by the outcome. In this case, if Paulson's rosy view is wrong, he's in trouble. So, I'm going with Greenspan this time around.
I have noticed a lot of headlines these days repeating warnings I have already issued, and it's frightening that more and more people are agreeing with some of my greatest concerns. An article in Barron's this week raises the red flag about investor complacency amid escalating world conflict, a point we have harped on time and again. Also, a loyal reader recently sent me an Associated Press article about Tyson Foods' plan to pass through its higher cost of feed, with hikes in the prices it sells proteins to consumers to result. Recall, we voiced concern about the threat that food inflation poses to the Fed's ability to boost the economy through rate cuts, and we pointed to the broader impact of grain demand as the catalyst. It's just harder to cut rates in an environment of stagflation.
We warned on Friday that the weekend would bring a slew of new articles in the popular press that would highlight concerns about the subprime lending space, and low and behold, Businessweek was chock full of articles on the subject. Now, we know the politicians are reading this stuff, as evidenced by presidential candidate Hillary Clinton's statement on the risk of China's interest in our nation's debt just a few days after an article on the topic was published. I do not know what's scarier, the topic itself, or the fact that politicians, sometimes not so bright ones, are basing policy on it without considering all sides of the issues.
Last week provided signs, bad bad signs. Last week provided signals that the subprime loan issue is not limited and has not yet peaked. Susan Bies reinforced some of that concern with her statement that, while "limited to a narrow sector, the subprime problem had just begun." She said that short term teaser rates were just beginning their adjustment phase, meaning rates for many borrowers were about to go higher. Businessweek highlighted that same concerning topic, reminding us that many subprime borrowers would not be able to refinance into long term fixed rate loans, especially now that lending standards are tightening. So, borrowers are going to find themselves with a much higher rate and monthly payment necessary to keep their homes, and if they want to sell, they are likely to find that the value of their homes has declined, perhaps to below the amount necessary to cover their mortgage in some instances. So, guess how far Businessweek estimates this risk extends... Businessweek says the size of subprime loans in aggregate that are set to readjust in 2007 is $265 billion.
Susan Bies says the risk is limited to the subprime sector, but we have to disagree. You see, as foreclosures increase, inventory in the housing market rises, and this risk was estimated last week at 500,000 homes. That's big and likely understated in our view. It's about one-twelfth the number of annual existing home sales, if we go by the most recent sales rate. So, if inventory increases, despite home builder efforts to reduce inventory, it means home prices could fall some more. That reduction in equity for all homeowners takes away a portion of an important liquidity source, home equity funding.
But that's not where the risk ends. Last week, we saw a light productivity number. Here's how we read this in simple English. If productivity is lacking, it most likely means we have too many workers providing products and services, which means the employment environment could be about to weaken. Hey, we know the Fed expects this to happen. It's kind of counting on it to reduce wage pressure on inflation. But, if employment weakens and liquidity dries some, then the reliability of the previously stalwart consumer to save our economic growth comes into question. And if the consumer stops spending, then my friends, it seems recession is likely. From where we stand today, this is not good news for stocks in our view. Considering the valuations of emerging markets, we could then be in store for a very significant global correction. We had an indication last week that consumer confidence is slipping. Also, February same-store sales were weak, and we think it had little to do with weather, which is where most of the reporting companies placed the blame.
This week is really a week of reckoning, as retail sales data will be reported for February. We think it's too early yet for business inventories to provide a sign of weakening, and should in fact look decent. But, CPI and PPI data will add their usual drama, giving indication of inflation. Capacity utilization portends to be weak in light of the productivity figure of last week, and March Michigan sentiment should prove frightening. On top of this, we will receive earnings reports from many major investment banks, and while the results themselves are expected strong, all eyes will be seeking indication that subprime troubles are spreading. Thus, while the direction of the investment banks might be difficult to determine, volatility is likely, in our view. There is risk to investors in securitized loans and that includes the banks and some big hedge funds that have thus far withheld information on the burden they have perhaps bourn.
Monday starts the week off quietly on the news front, but the weekend's doom and gloom articles portend to seriously hurt equities. Ears will be listening intently to Federal Reserve Governor Randall Kroszner, who will address the National Association for Business Economics on the dynamics of inflation on Monday. Also, the Treasury will release the federal budget balance for February, which is estimated by the Congressional Budget Office to be $123 billion in deficit.
On the corporate front, Jo-Ann Stores is scheduled to report earnings while several water companies present for investors at a Janney Montgomery Scott conference. Also, Texas Instruments will provide a mid-quarter update, while JDS Uniphase makes a commercial lasers presentation. Finally, Fidelity Research Institute will announce its findings on the outlook of retirement in the U.S.
At 8:30 EDT Tuesday morning, investors will get a first-hand look at how the consumer is faring, as February retail sales are reported. The consensus expects retail sales to show an increase of 0.3% in February, according to a Bloomberg survey. This report is critical, as any perceived weakness in consumer health could be the catalyst to drive a sustainable decline in equities. Retail sales were reported flat in January, and last week provided poor February same-store results, in our view. At 10:00 a.m., January business inventories are expected to be reported 0.1% higher, versus no change in December. A reading on the high side here could threaten stock stability as well, but we think the chances of this are smaller and the potency is weaker than the retail data.
Also on Tuesday, Treasury Secretary Paulson will tell a conference and the market about all he's learned recently on the issues affecting the competitiveness of the U.S. capital markets. President Bush will certainly grab some headlines as he travels to Mexico as part of his Latin American tour. In other international news, the OECD will provide an economic outlook for Europe, the U.S. and Japan.
Chevron is scheduled to meet with analysts on Tuesday. On the critical corporate earnings list, look for Goldman Sachs to report. Joining Goldman, expect reports from Kroger and Gymboree Corp. The reaction to Goldman's report could set the tone for the week for the investment banks and some commercial banks, as investors look for any signs of spreading of subprime woes.
Wednesday's news will include the 8:30 reporting of the current account deficit for the fourth quarter. Bloomberg's consensus expects the deficit to narrow to $203 billion, from $225.6 billion in the third quarter. Also, import prices are expected to have increased 0.6% in February, partly on higher energy prices.
ConnocoPhillips is scheduled to meet with analysts on Wednesday, while the Bank of America Consumer Conference will include presentations from Petsmart and Playtex. Reporting earnings, look for Lehman Brothers, Stage Stores, Hibbett Sporting, Pep Boys, General Communication, Cambrex, Hot Topic, Browne & Co., Biolase Technology and Miva Inc.