The bulls have a definite case. My former professor at the Wharton School, Dr. Jeremy Siegel, is right. The valuations in the market are cheap. The S&P 500, which constitutes 80% of the total market value of US Stocks, is selling at 16.5 times earnings. Corporate earnings have been solid if not spectacular this quarter.
The markets are awash in cash that still needs to be put to work. By some estimates, the private equity funds have 20 trillion dollars in cash to put to work. There are unfounded fears that the buyout craze of private equity has come to end. These buyouts have partially fueled the bull market by reducing the supply of available stock.
The crisis in private equity is a temporary situation. The high yield bond market has risen 100 to 150 basis points in yield. Investors nixed financing the buyout of Chrysler. To paraphrase Mark Twain, “reports of its demise are exaggerated.” The princes of private equity may have to accept lower returns. But they will continue to buy companies.
The bears can also come out of hibernation. A barrel of light crude oil hit $78 a barrel this week. The public has yet to express any concern. Where are the protests against the oil companies? Eventually, Joe Public is going to wake up and notice less money in his pocket due to increased fuel costs. This consumer fueled market rally may pause then.
The depressed real estate market is only a minor concern. Although for most people their home is a major investment asset, most of us are living in our homes and not planning to sell them anytime soon. So we are prepared to wait out what they think is a temporary dipping in price.
What keeps my up at night is the collateralized and mortgage backed securities owned by hedge funds and major financial institutions. As soon as the first warnings about sub prime mortgages were sounded in February, I took much money out of the market and became more bearish.
Unfortunately, I saw first hand the havoc that mortgage backed securities can do to an investment portfolio in the 1990’s. The rocket scientists can sit in front of their computers and project the pricing etc of securities in various interest rate and real estate environments. I learned from bitter experience that their predictions were as under water as the bonds that I sold.
The rocket scientists forget to factor in the human factor. In a rising interest rate environment, mortgage back securities are the hardest hit. Some of that was due to the proliferation of new mortgage products. Interest only, principal only, negative amortization mortgage bonds were new inventions. Although we thought we understand them, it turned out that we did not.
When sellers panicked and stampeded out of the bonds, there was no orderly market or specialist system like on the New York Stock Exchange to handle the sales. The Federal Reserve refused to step in. Prices plummeted.
It seems that neither the investing public nor the Federal Reserve learned a lesson so history is repeating itself with sub prime mortgage bonds. The rating companies also fell asleep at the switch. They did not even blink when the first warnings of a crisis in sub prime debt were sounded. They are only downgrading their ratings on these bonds now. It begs the question, how many other credit debacles are they missing.
This current collapse of the mortgage market is even scarier than its predecessor. The savviest professionals in the mortgage business are literally going out of business. American Home Mortgage (AHM), not even a sub prime lender, announced last week that it could not continue to fund existing obligations. The Sub prime lenders like Novastar (NFI), New Century (NEWCQ), and Accredited Home Lenders (LEND) made similar announcements earlier in the year.
One of the savviest players in the mortgage market, Bear Stearns (NYSE:BSC), has three hedge funds in serious trouble. Six months ago, the funds were priced at full value and now two of them are practically worthless. One is refusing to accept any investor redemptions this month.
It is scary to me to think that a fund could be valued at 100 in April and now be worthless. Mortgage back securities have become the black hole of investing.
Another hedge fund, Sowood, lost half of its value, a total of 1.5 billion dollars this month. Harvard University lost 350 million dollars of their endowment’s money in this fund. The fund was forced to sell to Ken Griffin’s Citadel Investment in Chicago.
The credit worries are not limited to the United States. Australia’s Macquarie Bank announced that one of its funds lost 25% of its value last month. This fund does not hold any American sub prime mortgage debt.
I do not know how to quantify the losses in the current mortgage crisis. Neither does anyone else. Without some clarity, I am keeping my investment powder dry. I will not be adding any new positions and am staying on the sidelines. The market will continue to volatile until this credit crisis is resolved.
I am monitoring the stocks that are battered by credit woes. There will be survivors among them. But it is still too early to buy them.