Market Leaves Investors With That Sinking Feeling

Investors were reminded last week of why October has the well-deserved reputation of being the most treacherous month for the stock market.

Last week, the S&P 500 was hit for 4%, with financial stocks leading the way lower (both the bank and broker/dealer groups dropped over 7%). Third quarter earnings reports for the largest U.S. banks provided an unsettling window into the unfolding credit correction.

Despite large write-downs related to mortgage finance and other credit excesses, the impression left with investors was that of a problem of indeterminate magnitude closer to its beginning than its end. As a case in point, Citigroup's (C) write-offs of bad debts were half a billion dollars more than the bank had forecast only two weeks earlier.

Aside from unequivocal evidence that the credit correction is far from over, there were a number of other worrisome developments last week concerning the economic outlook. Oil prices surpassed $90 for the first time last week, before closing at $88.60, and there continues to be no end in sight for the residential real estate recession.

The National Association of Home Builders Confidence Survey fell to another record low (in over 20 years of data), and the stock prices of home builders plunged to new bear market lows. Housing data reported out of California were particularly alarming, with home sales in September falling to the lowest levels in 20 years, and southern California home sales down 48% in September from year-ago levels.

The CEO of MGIC, the largest U.S. mortgage insurer, which reported last week its worst quarterly performance since the company came public in 1991, predicted that real estate prices may drop 10% nationally over the next 18 months. This magnitude of decline in the median U.S. house price is consistent with the expectations implied by the Case-Schiller housing futures markets. The correction in housing and in credit markets is clearly rattling confidence and dampening expectations for the economy.

CEO confidence in the U.S. economy, according to a Conference Board survey, has fallen to its lowest levels since the 2001 recession, and industrial bellwether Caterpillar (CAT) warned last Friday of the prospects for U.S. recession in 2008.

The tenuous economic outlook and last week s renewed financial markets turmoil have predictably ratcheted up expectations for another rate-cut from the Federal Reserve when it next meets on October 31.

By late Friday, markets were placing a 90% probability on a quarter-point rate cut at Wednesday's FOMC meeting, up from a 30% probability at the start of last week. We wonder how the Fed can cut interest rates again with the U.S. dollar under extreme pressure and commodity prices soaring.

Moreover, the evidence clearly indicates that the Fed's rate cuts in August and September have done little to accomplish their purported objective - to stem the unfolding corrections in the residential real estate and mortgage credit markets. Financial stocks and anything related to housing have been the worst performing stock market groups since the August 16th discount rate cut. Homebuilding stocks have fallen to fresh cycle lows, and banking stocks are flirting with new lows. Meanwhile, the Fed's ease has sent the U.S. dollar tumbling to record lows, creating a destabilizing run on the world s reserve currency, and has stimulated huge rallies in commodity prices. Commodity-related areas of the stock markets, which the Fed most certainly was not aiming to stimulate, have exploded to the upside over the past two months.

Hopefully, the Fed will realize when it meets next week that cutting rates further is not the answer to the mortgage credit mess (where losses on bad debts simply have to be recognized), or the conditions of excess supply and inflated prices in residential housing.

Last week's market developments demonstrated that this is far from a low risk environment. We don't profess to know whether last week's drop will turn out to be a relatively short-lived correction of an overbought market or if we are setting up for a more extended replay of the July/August swoon. What we do know is that risks in the economy and financial markets appear particularly high at present, arguing strongly for a cautious approach.