Full-Fledged Market Repricing May Now Be In Place

 |  Includes: DIA, QQQ, SPY
by: Andy Greig, CFA

Let's take a moment and review what is going on with the stock market. The first issue is the widening of the credit-spread from historically low levels to more normalized levels. The higher cost of credit is causing a slowdown in the private equity sector which had provided substantial liquidity to the public markets.

Now, I don't believe private equity is dead. The deals will just have to be done with more equity and at lower prices. This is the first factor in why equity prices are now lower than they were just a few weeks ago. The private equity "bids" underneath the markets are now lower and the excitement of the next deal are behind us.

Part and parcel to the repricing due to higher credit spreads is the increase in the equity risk premium. When one asset class - high yield - reprices, it will cause a repricing in all asset classes, including equities. When investors demand higher returns from a risky asset class they will demand a higher return from all risky asset classes. Now this does not have to be a linear relationship, and it is not in this case.

The final interlinked piece is the worry that the default rate on subprime mortgages is filtering to prime and near prime paper. This is a biggie. American Home Lending just came out and wrote down a bunch of prime and near prime paper. I am a bit surprised at this. If the prime market starts to unravel we have the very real possibility of falling into a recession. The reason is simple: When quality credit risks can not pay their mortgage it is easy to see that consumer spending will be drying up. The consumer makes up 2/3 of the GDP and a moribund consumer is a recipe for trouble.

CNBC is having a field day with this. Now, instead of trumpeting every new high in the market, they are showcasing the walking dead in hedge fund land. A former golden boy from Harvard's endowment fund just blew his fund into a million pieces. Sowood Capital, a 3 billion plus, fund took losses exceeding 50% in the past month and had to sell its positions to Citadel. Oops.

It is too early for me to tell if this is the start of a bear market. I doubt it. I think American Home Lending was an isolated incident due to poor underwriting. I think the repricing is about over (yeah, don't remind me I said that 200 points ago) and we are at an attractive buy point.