Stocks Break Down As Credit Crisis Continues

The stock market suffered one of its worst weeks of the year. The Dow fell 4.7%, the S&P 500 lost 3.7%, and the high-flying Nasdaq 100 was clipped for 8.1%. The technical condition of the stock market, which was already in a tenuous state due to poor breadth, deteriorated further last week. The S&P 500 (SPY) broke decisively below important support at 1490, a level that had been tested repeatedly over the past month, and also closed the week below its 200-day moving average line, signaling a potential change in the primary longer-term trend.

Bear market action continues in a number of stock market sectors that reflect the problem areas in the economy, including financials, real estate, and consumer discretionary/retailing. The small-cap averages are back in negative territory for the year, and are close to breaking below their August correction lows. Given that the Dow has plunged over 600 points in the past three sessions, stocks are quite oversold on a short-term basis, but these technical breakdowns argue for a defensive market approach.

Troubling geopolitical developments, near-$100 oil prices, and persistent weakness in the U.S. dollar are obviously contributing to current anxieties and heightened volatility in the stock market, but the recent downturn in stock prices is principally the result of rising recession risks stemming from the unfolding credit crisis and housing bust. Bond market indicators are signaling heightened recession risks, as yields on the short end of the Treasury yield curve have plunged to below 3.5%, and corporate bond spreads have widened by over one percent in the past month.

The record level of unsold housing inventory combined with tightening credit availability virtually ensures that home prices will continue to fall well into 2008. Given the wealth erosion in housing (including the demands of servicing heavy mortgage debts in an environment of falling prices), inflation pressures in non-discretionary spending such as energy, food and medical costs, and now the threat of stock market losses, pressures are consumer spending are intensifying. It is no surprise that the latest University of Michigan Consumer Sentiment survey, reported last Friday, registered its lowest reading since October 1992 (excluding the Katrina and Iraq war declaration episodes).

With respect to the unfolding credit crisis, no one really knows where the CDO/mortgage securities debacle will lead because we don't know how far housing prices will fall. Financial institutions don't know what their mortgage backed securities are worth in part because of the lack of liquid trading markets for the securities and in part because the value of the securities will be a function of the extent of future mortgage defaults. A number of analysts have recently estimated that losses on mortgage-backed securities will total in excess of $200 billion before all is said and done.

As we have noted repeatedly, the Fed's ability to do anything productive about the credit and housing debacle is limited. Given the recent surge in oil and gold prices, and the 5% drop in the U.S. dollar to record lows since the Fed starting easing policy in August, the Fed may be forced to the sidelines to defend the dollar and prevent a destabilizing rise in inflation expectations.

Our portfolios are conservatively positioned, so we do not feel the need to take defensive measure at this point in response to the recent deterioration in market action and the economic outlook.