Stocks Reel From Heightened Recession Risks

Includes: FMCC, FNMA
by: J.D. Steinhilber

U.S. stocks posted a third consecutive weekly drop. Despite Friday's bounce, the S&P 500 is down 7% for the month, which ranks as the fifth worst November drawdown in the history of the S&P 500. Year-to-date, the total return on the S&P 500 is 2.8%, less than the return on T-bills and money markets.

Stocks have been reeling this month due to heightened recession risks and the continuing credit crisis. The latest major shoe to drop in the mortgage finance fiasco came last week from Freddie Mac (FRE), whose stock price plunged 30% after disclosing a $2 billion loss in the third quarter and announcing the need for a capital infusion to shore up its balance sheet and meet its regulatory capital requirements.

As "government sponsored enterprises (GSEs)", Freddie Mac and its counterpart Fannie Mae (FNM) are considered liquidity providers of last resort to the $12 trillion U.S. mortgage market. Given that as recently as last month, proposals were being advanced by politicians, mortgage industry participants, and Fed Chairman Bernanke himself for the GSEs to expand their activities to support the mortgage market, news that Freddie Mac was liquidity-constrained as a result of mortgage losses fueled expectations that the housing downturn is likely to get worse before it gets better and that the unraveling from the subprime crisis is far from over.

The combination of a glut of housing inventory, persistent home price overvaluation, and tightening mortgage credit is in and of itself sufficient to ensure a weak housing market with downward pressure on prices in 2008. The additional element of looming mortgage resets, whose numbers just began to spike last month, only exacerbates the problems.

Over the next 15 months, approximately $50 billion in adjustable subprime mortgages will reset each month. Such resets will typically result in monthly mortgage payments increasing by 20% or more. As a result, delinquencies, defaults, and foreclosures are virtually certain to rise in 2008, which will add to the over-supply of homes for sale, drive prices downward and further increase losses on pools of mortgage backed securities. The Mortgage Bankers Association estimates that 1.35 million homes will enter the foreclosure process this year and another 1.44 million in 2008, up from 705,000 in 2005. The projected supply of foreclosed homes is equal to about 45% of existing home sales and could add four months to the supply of existing homes, which is already over 10 months.

Given the deflating real estate and credit bubble, it is no surprise that a variety of financial market indicators are signaling heightened recession risks. Credit spreads, which had narrowed in September after the initial Fed action and investor hopes that the credit crisis would quickly pass, have now widened to their widest point for this cycle. Two-year Treasury yields have plunged to 3.1%, versus a current fed funds and commercial paper rate of 4.5%. The stock market is breaking down, with several broad segments - financials, small-caps, retailers, and real estate stocks - now trading at 52-week lows.

The growth rate in the leading indicators we track from the Economic Cycle Research Institute is at its lowest level in 14 months, but has not yet fallen to a level that would point to a recession. ECRI, which had been in the slow-growth rather than recession camp, is now suggesting it could tip either way. Our own sense is that the odds of recession have increased to above 50%, but it is still quite possible that a successful reflation effort from the Federal Reserve, combined with the usual systematic under-reporting of inflation, will keep the official GDP growth figures in positive territory in the coming quarters.

Given the recession scare currently gripping financial markets, expectations for further Fed easing are rising. Futures contracts on the Chicago Board of Trade now show a 96 percent chance that the Fed will lower its target rate a quarter- percentage point to 4.25 percent on Dec. 11. The shape of the yield curve also indicates that bond investors expect a rate cut from the Fed. Maturities from 2 years to 10 years range from 3% to 4%.

It will be interesting to watch Fed rhetoric over the next two weeks for signals that the Fed may be preparing to disappoint markets by leaving rates unchanged on December 11. Due to near-$100 oil, the dollar tumbling to new lows, and headline CPI inflation set to come in at 4% or higher for 2007, the Fed was hoping to pause in its rate cutting campaign, but equity and bond markets may force their hand towards additional easing sooner rather than later.

On a short-term basis, stocks are very oversold and the sentiment indicators we track are back to the pessimistic extremes reached in mid-August. That proved to be a favorable buying opportunity in stocks, and we may be at another favorable long-side entry point here, especially looking out over the next two months given that December and January are historically the strongest months of the year.

But given that we are in the midst of a credit crisis/contraction and real estate bear market that in all likelihood will continue through much of 2008; given that oil prices are threatening to move above $100/barrel and that the dollar is sinking to new lows; given that recession risks are at their highest levels in this cycle; and given that valuations on stocks are a long way from cheap when earnings are normalized for the economic cycle, the risk/return profile on the stock market is not favorable enough to entice us to increase out stock exposure even if a seasonal bounce is in the offing.