A while back we suggested that October was going to treat markets badly. We were not too far off the mark: the start to November has not been stellar.
Last night, we attended an unusually hands-on dinner during which a very mature economist of a leading financial group (sorry, we cannot disclose who) was telling us about the sub-prime mush. He was able to tack numbers onto it - and to give us a feel for when Wall Street well could crack.
1. How deep is deep?
We are led to believe that the sub-prime [SP] mortgage market is "worth" about USD 1.3 billion.
But that figure is misleading: it is only the tip of the iceberg.
Here is how such mortgages have been chopped and diced:
1. The SP mortgages have been combined into Mortgage Backed Securities [MBSs];
2. These MBSs, in turn, have been packaged into Collateralized Debt Obligations [CDOs];
3. These CDOs have then been divided into tranches, whereby 80% are rated "AAA" and so on, with 4% being parked in the "BBB" lot;
4. These "BBB" CDOs have been re-packaged into CDOs to the power of 2 [CDO2s] instruments;
5. These CDO2s, in turn, have been carved into various tranches: 75% of them are designated as being of "AAA" quality, and 4% have been rated as "BBB".
If you are not yet confused, re-read the above alphabet spaghetti and get confused!
Logically, how can 75% of the CDOs rated "BBB" in step three all of a sudden get a "AAA" rating in the CDO2 instrument?
All that this means is that nobody can measure just how deep this dormant volcano is.
2. When will the crack occur?
We had forecast this October. Well, we were not too far off the mark, given the end of month gyrations on Wall Street. But it was hardly a crash. So we have toned down our stridency to "crack".
I asked when would all of this sub-prime mush turn into reporting realities. The economist hosting the dinner suggested that the Q407 results would become public knowledge within three to four months, i.e. from February - March 2008. My guess is that the first quarter of 2008 will be particularly messy. Once we get the first wounded companies reporting the extent of their damages, Wall Street will go wildly bearish. Add to this our view that this will worsen the The Economic Time™ in America even more, and you have plenty of downhill runs...
3. How to Save Money Off This Idea
Lighten-up on your US exposure, except for tech stocks. As a Chinese friend of mine taught me at lunch today, these are like "consumer staples" - people need tech such as search engines, regardless of what the economy does. You could argue that when things head south, search engine traffic heads north...
By sector, we keep advising to avoid banks. Also add to this: mortgage-related finance companies.
While we do maintain that America will fall strongly, buy on dips in China, Hong Kong, India and Malaysia: there, The Economic Time™ is all right.