In Greek mythology, the gates of Hades were guarded by a vicious three headed hound named Cerberus who allowed new souls to enter, but none to return. The stock market has its own version of this hound. But unlike the Greek myth, if the three headed beast of the market gets out of control then Hades is unleashed, causing red to pour out onto all the market monitoring screens across the world. Sounds like a pretty scary myth to me.
Last year, about this time, the three headed beast of the market was composed of oil price fears, inflations fears and interest rate fears. From the months of March through July this beast wreaked havoc on the markets as investors were petrified that Hades would escape. But alas, the markets made a Herculean effort to tame the beast from July to January mounting a 16% rise. About a week ago we got a glimpse of a new and improved beast. This beast has three heads as well: International market jitters, housing/mortgage meltdown fears, and economic growth concerns.
Of the three, I believe international market jitters is the most valid thing to fear. A major Asian sell off acted as an impetus for a meltdown in the US markets. According to the NY Times, last year US investors poured over 22 billion dollars in to international markets, and over the first two months of this year another 7 billion have been added to that. The driving force behind this asset allocation has been the triple digit annual performance of many international markets. The run up of these international markets places many of their values well above that of the US market. The argument has been by some that with growth rates in the 30-40% range these multiples are supported. Anyone who believes that 30-40% growth rates are sustainable should look at a graph of the NASDAQ from 1999 to 2002.
This run up and subsequent overvaluation leaves many international markets vulnerable to a severe correction. Investors seem to have taken light of this and pulled out a massive 8.9 billion out of emerging markets over the last week, according to Emerging Portfolio Fund Research Inc. This is relatively good news, but the precedence of the US markets following an Asian sell off is evidence of intertwined world markets being inexplicably linked and dangerously fragile.
Housing/mortgage meltdown fears have been fanned over the past week due to the eruption of the subprime mortgage market. Let’s try and keep this in perspective; the subprime market, according to Mortgage Banker Association, is about 6% of the mortgage market. Delinquency rates on subprime have risen from about 7% to 12%, but delinquency rates on the entire mortgage market are only 1.4%. To make the math on this easy, the increase of 5% in the subprime delinquency rate is a rounding error on the total delinquency rate, i.e. it’s insignificant.
The concern is that weakness in the subprime market may be a precursor to the rest of the market. I’m not confident we have enough information pointing to a meltdown in the entire mortgage market, in which case it would inadvisable to make decisions based on the subprime market.
Economic growth remains a wild card. Greenspan was kind enough to weigh in on this topic with his guess, which was not accepted well by the markets. Keep in mind when listening to any pundit expound their view on recessions that last time we had one 95% of those surveyed did not see a recession coming. Greenspan himself made the words “irrational exuberance” famous on December 5, 1996 nearly five years prior to the peak of the market. Bloomberg went ahead and asked the Economist (even though they are usually wrong about predicting recessions) last week and the consensus was that growth would be about 3% this year, which happens to be inline with our current Fed’s forecasts. The majority of the arguments for the likelihood that 2007 will be a good year for the market remain intact. I believe that investors should remain cautiously optimistic and look at the current downtrend as a normal market gyration, not the beginning of a sustained sell off.