Very little has changed this week on the broad market price front. The front line indexes were largely unchanged for the week, barring Thursday's fierce sell-off partly fueled by events in Pakistan. In this relative quiet of the holiday season, investors and analysts alike are likely to be unsure of what to make of any news flow.
The week also saw the release of a flurry of housing data... and to put it mildly, they were ugly. Sales of new homes dropped 9% in November to a 12-year monthly low of 647,000, far below the consensus estimate of 720,000. On a yoy basis, sales were down 34%, the largest annual drop since the 35.3% free fall in January 1991. New home sales are down 53% from their July 2005 peak. Although the actual number of homes of sale decreased ever so slightly, the inventory of unsold homes still represents almost 9.3 months at the current sales pace. The outlook for 2008 is not very bright either, with Fannie Mae, the largest US mortgage buyer, recently estimating that sales of new houses will tumble 8.9% in 2008 on the back of the 25% drop this year. Factoring in the rising cancellation rates, Calculated Risk estimates that new home sales are probably overstated by about 100,000 and the months of supply would balloon up closer to 11.3 months.
The S&P/Case-Shiller report was even more dire; home prices in 20 metropolitan areas fell a massive 6.1% in the 12 months to October, the most in at least six years, raising fears that Americans will walk away from properties that are now worth less than what they owe. This is the 10th consecutive month of negative annual returns, the 23rd consecutive month of decelerating returns and the biggest decline in this down cycle.
On the back of shrinking sales and slumping prices, foreclosures registered a 68% surge in November from a year earlier. Foreclosures are more likely to increase than decrease from current levels as subprime adjustable rate mortgages (ARMs) reset.
The housing market slump has the potential to undermine consumer spending in a major way. The holiday sales postmortem began in earnest this week with several data points confirming retailers' worst fears: 2007 witnessed the weakest holiday spending in five years. MasterCard's (MA) SpendingPulse, that tracks purchases made by more than 300 million debit and credit card users, estimates that the period between Thanksgiving and Christmas Eve saw nominal sales gains of 3.6%, the lowest in three years. However, excluding food and energy (supermarkets, restaurants, gasoline sales), back of the envelope calculations suggest that sales would have risen approximately 2%... a tad below the core rate of inflation. To put it differently, real sales may have actually declined over last year despite the longer shopping calendar in 2007.
We are entering 2008 with significant headwinds. Martin Feldstein, head of the National Bureau of Economic Research, which determines the dating of economic recessions, put the probability of a recession at 50% in 2008! But the turmoil has also unearthed opportunities for savvy investors. Warren Buffett, often criticized for not deploying his $45Bn cash pile more effectively, is moving quickly. In just a week, Buffett spent $4.5Bn to gain control of Marmon Holdings - a motley collection of 125 diverse businesses, agreed to a $440M purchase of a reinsurance unit of ING Groep NV and revealed plans to enter the $400Bn+ a year municipal bond insurance business. It suffices to say that if Buffett smells an opportunity, his track record suggests that there is indeed one!
With the support from the Santa Claus rally gone, would the indexes have the resilience to hold on to the recent gains? Earnings season kicks off next week; blended earnings growth rate for the S&P 500 in 4Q (combining actual numbers for companies that have reports and consensus estimates for those yet to report) are a dismal -3.8%, a far cry from the 11.5% estimated at the start of the quarter. Once the holiday hiatus comes to an end next week, traders are likely to take stock of the state of affairs in the equity markets and hopefully provide further clues that would help predict the short term course of the front line indexes.
Speaking of taking stock, this is a year that saw both extremes of greed and fear and all the shades of gray in between. Forecasting the roller-coaster ride in the financial markets has been a challenging exercise. In the next few paragraphs, we present a recap of the hits and misses this year and how we kept pace with the developments all through.
The Panic Of 2007
In better times (read: start of 2007), most pundits would have considered the Panic Of 1907 to be a bolt from the past - an episode depicting the great excesses and venality of the era, shattering of business expectations by a cataclysmic disaster in California, manipulation of financial markets by unscrupulous hands and the eventual restoration of faith in the nation's banking system by one man, John Pierpont Morgan. Only the uber bearish would have imagined that a panic of that magnitude would ever repeat again in today's infinitely more sophisticated financial markets. But as investors realized this year, not much has changed in the financial markets... to paraphrase Mark Twain, history does not repeat itself, but it sure does rhyme! The more sophisticated we have become, the greater the opacity and hence the higher propensity for a 'black swan' to throw the entire pecking order into disarray.
Although many anticipated a fall in American house prices in 2007, few would have contemplated the scale of ramifications for financial markets as a whole. Few would have predicted the world of structured finance to go upside down and unravel faster than a ball of wool in a basket of kittens. When the subprime demons started surfacing, policy makers believed that the problem would be contained... as one commentator remarked, the problem was indeed contained... only on Planet Earth! In an increasingly intertwined and interdependent world of finance, symptoms in one part of the globe can quickly spread to infect the entire financial ecosystem. Going back in time, we have seen this several times already in the last two decades: the Latin American crisis in the 1980s, the Asian currency crisis in 1997 and the Russian default a year later.
The late Rudi Dornbusch had remarked that in economics 'things take longer to happen than you think they will and then they happen far faster than you thought they could.' So has it been this year. On the back of a protracted period of cheap credit, it was hard to ignore distinct, yet similar, patterns of a bubble brewing in the housing markets and the excessive complacency that had seeped into the credit markets. However, the cracks took longer to appear than many observers believed and now have proven to be far more damaging than anyone feared. The high (or is it low?) points of the year in business and finance can probably be summed up in one word : subprime. The story of 2007 will be recounted by an entire generation: how the non-payment of mortgage interest by a homeowner in Florida ballooned up into an international credit crisis, heaping losses running into tens of billions on Wall Street that necessitated its biggest banks to run scurrying for capital overseas.
History suggests that economic contractions driven by falling asset prices and problems in the credit markets are recognized relatively late and tend to be quite protracted. The most startling examples are the Great Depression after 1929 and the Japanese experience through the 1990s. The last two recessions in the United States were driven respectively by the bursting of the Savings & Loan real estate bubble in the early 1990s and the tech-bubble collapse earlier this decade; although, the actual duration of these recessions were quite limited, it took several years before satisfactory rates of economic growth were restored.
Lets recap the events thus far:
1. Subprime? What's that?
In February this year, the word subprime entered the mainstream lexicon with more than 25 subprime lenders declaring bankruptcy, announcing significant losses or putting themselves up for sale. HSBC fired the head of its US mortgage lending business as losses reached $10.5Bn. Just a few weeks later, New Century Financial, the largest US subprime lender filed for Chapter 11 bankruptcy. Ben Bernanke, the Fed Chairman, expected the problems in the subprime lending industry to 'be contained', while ruling out a broader economic impact from the growing number of mortgage defaults. The tremors, however, were felt on Wall Street with Bear Stearns pledging $3.2Bn in June to bail out two of its hedge funds that had made bad bets on subprime mortgages.
2. Contagion spreads
S&P and Moody's, under flak for their inability to predict this crisis earlier, downgraded over $12Bn worth of bonds backed by subprime mortgages. In a testimony to the Congress, Bernanke finally woke up and smelt the subprime coffee, warning that the crisis could cost up to $100Bn. Bear Stearns meanwhile filed for bankruptcy protection for its two disgraced funds with investors standing little, if any, chance of getting their money back. Short term credit markets froze up completely after French banking major BNP Paribas suspended three investment funds worth €2Bn citing its inability to value these assets accurately as the market for these assets had disappeared. Equity markets took a major tumble on fears that the largest US mortgage lender, Countrywide Financial, could go bankrupt after drawing on its entire $11.5Bn credit line. The Dow Jones Industrials fell over 10% in just a matter of weeks.
3. Credit markets continue to simmer
German regional bank Sachsen Landesbank received a €17Bn lifeline and was rapidly sold off to Germany's biggest regional bank Landesbank Baden-Wuerttemberg after a near-collapse under the weight of its subprime burden. Northern Rock was, however, not so lucky with the latter having to resort to emergency financial support from the Bank of England. The bailout took on humongous proportions with this being the biggest single loan ever advanced by any government to any private company anywhere in the world. But this was insufficient to prevent the first run on a British bank in decades. Complete aversion to risk led to a 'flight to safety' sending treasury bonds soaring and pushing the yields to a two year low. TED spread widened to its highest in years. Traders actively unwound risky carry trade bets sending the yen soaring against several currencies. Banks announced a cumulative $40Bn in write-downs in October alone. The liquidity crisis metamorphosed into a crisis of trust with banks refusing to lend to each other fearing the extent of hidden subprime losses. The US Treasury supported 'Super SIV' aimed at preventing a fire-sale of good assets stuck in SIVs received only a muted reaction before a quiet burial.
4. Central banks open up the liquidity taps
In August, the European Central Bank pumped in over $200Bn of liquidity into the European banking system within a matter of days to ease the credit crunch. Other central banks followed suit. The US Fed promised to inject as much overnight money as would be needed to combat the crisis. The Fed also cut the discount rate by a half percentage point in a rare overnight move, signaling its seriousness in handling the crisis. Equity markets rejoiced in anticipation of a series of rate cuts, best remembered by Jim Cramer jumping in joy on national television. The Fed reduced the Fed funds rate by a cumulative 100 basis points and the discount rate by 150 bps over the next three meetings. Total intervention by the ECB tallied to $300Bn in just a month. The resurgence of the credit crunch in November after a brief hiatus forced the Fed and other central banks to think out of the box and come up with a creative solution to the problem at hand. In a rare concerted move, a clutch of central banks decided to set up swap arrangements to offer dollars to banks in their own countries in an attempt to tide over the liquidity crunch. Importantly, the Fed also revealed a new tool in its arsenal, the Term Auction Facility, targeted at pushing liquidity into the corners of the financial system where its needed the most.
5. Economy takes a tumble
Even in the wake of a severe liquidity crunch, the economy remained reasonably resilient. GDP grew a healthy 3.9% in the third quarter. Digging deeper, however, revealed that an exceptionally low price deflator artificially inflated the numbers. The unemployment data has been erratic with large month on month revisions. Initial estimates of non-farm payrolls in August suggested a dramatic contraction, sending the equity markets into a tailspin. But the numbers were significantly revised upwards subsequently. Our dislike for the 'core' inflation methodology is well-known to our regular readers. We had suggested at the beginning of the fourth quarter that inflation could be expected to rebound significantly towards the end of the year due to a combination of surging crude oil prices and the low base effect due to very low readings in the fourth quarter of last year. Our contention was subsequently proved right with inflation for the month of November surging phenomenally...S&P 500 earnings in 3Q slumped to a 2.5% decline driven by the massive write-downs for the first time in several years. The 12.4% sequential decline in earnings was the worst performance for almost two decades, rivaling similar earnings declines in 4Q 1989 and 4Q 2000, that preceded the previous two recessions. With 4Q earnings also likely to decline, we are standing at the brink of an 'earnings recession'.
As we head into 2008, a presidential election year, we are greeted with dysfunctional credit markets, stark possibility of a full-blown recession, continuing housing meltdown, inflation above the Fed's target range, oil approaching $100 and geopolitical risk with Al Qaeda and Iran. But markets being the discounting machine that they are will look to shrug off the past and discount the future. In the business of managing portfolios, one must be forward-looking at all times. We can only fall back on history for guidance. In the words of George Santayana, 'those who cannot remember the past are condemned to repeat it'. The co-ordinated effort from the world's central banks has the potential to stave off the credit crunch. But it will surely be an uphill battle. 2008 promises to be an exciting year.
Happy New Year!!!