I thought I would begin this week's commentary with a quote from Alan Greenspan, taken from his address to the Council on Foreign Relations on November 19, 2002 regarding the risks associated with use of derivatives:

Last week brought about an interesting turn of events; the Russell 2000 Value Index dropped below 20% from its recent peak set in May of 2007. Typically, a 20% drop in an index is one definition of a “Bear Market”. I guess this should be no surprise since Value Indexes as a whole tend to have a proportionately higher percentage of financial stocks than Core Indexes such as the Russell 2000 or the S&P500.

With the Financial and Consumer Discretionary sectors down over 30% from their highs, and together comprising close to 50% of the Russell 2000 Value Index, the relative decline of the Value Indexes is easily understood and amplified in small caps. But now that the Bear has officially arrived, the bigger question is how long it will be here.

Imagine a scenario in which one country, or a group of countries, had a slowing/struggling economy, their banking system was being forced to lower rates while across the oceans things were steaming full speed ahead, growth was strong and the banking system was tightening to slow the expansion. Because we live in a global economy, the weaker economy was being buoyed by the stronger to the point where it may have been its only saving grace. Clearly, we would imagine the weaker of the two economic systems had a currency that was faltering and public perception was that things were going to be bad for quite some time.

As you may have guessed I am describing the US versus the European economies, but I am describing the scenario that existed a decade ago when the Euro was first introduced and promptly dropped to less than 0.90 versus the US Dollar, while the US was propelled forward by the tech bubble and unprecedented productivity gains. The point is, these things are cyclical. Today the shoe is on the other foot but the US economy will not be weak indefinitely and the dollar will not slip into obsolescence. Our relatively weak currency and expansion outside our boarders are buoying the US economy and will likely be the driving forces averting an all out US recession.

A new term has been coined by market analysts to describe how many investors are feeling about the markets right now - “nervous bulls”. Normally, when the market is free falling, we hear the adage, "don’t fight the tape", meaning take your money and run while you still have it, but rarely do we hear this clamor when the market is going up. Sure, there are reasons to worry; the bear case goes something like this: further deterioration in home prices, increases in foreclosures and the lock up in the credit markets will pinch consumers who will slam the breaks on the economy. Short and sweet, but there may be a bull case that is even more compelling.

To begin, we should take a look at the wealth effect, taking note that there is very little data that correlates a drop in housing prices with consumer spending. This is largely because data on falling housing prices has been hard to come by, with consistent nominal gains over much of the last 70 years. So let’s take a look at some numbers on which there have been correlations established. The wealth effect also includes consumers’ reaction to stock market prices. Year-to-date the S&P 500 is up 9.82%, which follows strong years since 2003, a net positive. Other factors affecting the wealth effect: wage growth, 4.1% year over year; consumer borrowing, up 6% year over year; unemployment 4.7%, although it recently ticked up, it is still very low by historical standards, all net positives.

Until last week many people had thought the carnage was contained to the debt markets, but as the week unfolded rumors the sub-prime markets claimed another victim had been confirmed. The latest casualties, market neutral quant funds using statistical arbitrage to determine correlations between equities and debt. Traditionally this has been a relatively safe bet because correlations had been relatively constant, but over the last six weeks correlations have become paired. If something about this sounds familiar it’s because analogous comments were made about correlations in spreads in 1998 when Long Term Capital Management’s stat arb models went haywire and almost took down the whole financial system.

What started out as housing jitters has mushroomed into a credit market revaluation the likes of which has not been seen since 1998. Valuations on some CDO’s are as low as 30 cents on the dollar, if there is a bid to be found. Major Wall Street prime brokers are struggling to determine valuations and risk associated with the leveraged hedged funds they custody. The net take away is the credit revaluation will likely claim more hedge fund victims before all is said and done.

With that as our backdrop, let’s take a look at an interesting development over the last week: The Russell 2000 Value went negative for the year on Friday and is now down 1.2% year-to-date, whereas the Russell 1000 Growth is still up 8.2% year-to-date. This points to a stratification in the equity markets, in general, Growth has outperformed Value this year and the disparity becomes exaggerated as we move down in market capitalization. Note the performance spread in the S&P500 Growth (+3.97%) versus S&P500 Value (+1.83%) is 2.14%, while the performance spread in the S&P600 Growth (+6.18%) versus S&P600 Value (-0.79%) is 6.97%.

In its simplest form, The Fed Model compares the forward earnings yield of the S&P500 to the yield on the 10 year Treasury Note. If the forward earnings yield of the S&P500 is greater than the yield on the 10 year Treasury Note then the market is implied to be undervalued by the percentage of the respective differential; the converse (overvalued) is of course calculated analogously. This gets us one step closer to quantifying the relationship, but not all the way. To more accurately quantify the relationship, let’s take a closer look at the differential between the forward earnings yield of the S&P500 and the 10 year Treasury Note yield versus the actual returns of the S&P500. This can be done by plotting the actual returns of the S&P500 versus the Expected Return as predicted by the Fed Model for multiple rolling periods and then creating a regression to obtain an equation that approximates a normalized Fed Model Return.

Fast forward to 2006 when earnings of the Fortune 500 were 785 billion on margins of 7.9%. The quick conclusion I drew from these numbers is that we’ve been in a raging bull market for corporate revenue and earnings, but the stock market hasn’t kept pace at the same rate it did during the last cyclical peak. Today’s S&P500 price to earnings multiple is about 17.5x; if P/Es expanded at the same rate they did in the year 2000, the S&P500 would be at over 4,500. Perhaps this is more of a statement of the excesses of the year 2000 than it is about today’s valuations, or perhaps it means the excesses of the year 2000 has made us all gun shy.

Investors point to a slowing economy, inflation fears, housing jitters, energy prices, and currency worries; nevertheless, the market keeps pushing higher. The latest hurdle the market seems to have cleared had to do with Q1 earnings. According to Thomson Financial, 81% of the S&P500 reported earnings for Q1, averaging 8.1% - a far cry from the 3.3% estimate analyst had predicted before the quarter. In all likelihood, when all is said and done, Q1 will probably end up north of 9%, still well above trend earnings growth.

Last year, about this time, the three headed beast of the market was composed of oil price fears, inflations fears and interest rate fears. From the months of March through July this beast wreaked havoc on the markets as investors were petrified that Hades would escape. But alas, the markets made a Herculean effort to tame the beast from July to January mounting a 16% rise. About a week ago we got a glimpse of a new and improved beast. This beast has three heads as well: International market jitters, housing/mortgage meltdown fears, and economic growth concerns.

Some hate housing: The builders are up 13% over the last three months and 24% over the last six.

The outcome was lower interest rates and rising economic activity giving way to wage growth. Given this scenario, it should be no surprise that towards the end of the year housing appeared to have settled, and may even have appeared to bottom. This may, however, change this month when we see the effects of January’s upward interest rate pressures and relatively cold weather.

The table below gives the average weekly return from the end of the previous year to the close on Friday of each of the respective weeks for the S&P Technology ETF (XLK) from 2001 to 2006 (six years):

The real slide started with the warm winter (in most of the country). Natural gas inventories, which influence oil prices, are 18% over historical averages at this time of the year. Another factor contributing to the downward pressure in energy prices has been the rebalance trades in the Goldman Sachs Commodity Index and the Dow Jones AGI. The initial sell off has been compounded by oil prices taking out important technical levels on the way down, scaring the hell out of speculators.

Direction of the markets in 2007

Perhaps it would be worthwhile taking a look at what the Fed is saying and comparing our current economic situation with the last time we stood on the brink of economic turmoil in December of 2000. Luckily, The New York Times was kind enough to cover this topic in an article earlier this week. To summarize what the article said, the Fed sees “moderate growth” with “tight” labor markets. They are expecting a sluggish first half of 2007 with growth picking up later in the year. It also may be of interest that currently Fed Fund Futures are predicting with certainty a rate cut by June. The Fed is trying to balance the risks of slowing growth with inflationary pressures and has made it clear that it prioritizes the later, though the tides seem to be shifting. The NYT published a table comparing figures from Dec 2000 versus November 2006: Unemployment 3.9% vs. 4.4%, Core Inflation 2.5% vs. 2.7%, 10 Treasury 5.53% vs. 4.43%, S&P500 -10% vs. +13%. The last point is the most telling difference.

Even with the slump in housing prices most consumers probably think, "I have a job, I am earning more money than I did last year and it’s less painful to fill up my gas tank than it was this summer, so I might as well spend." The initial reports from the Associated Press confirms this hypothesis with its report on initial Black Friday sales numbers up 6% over 2005.

Housing continued to surprise on the downside with the Commerce Department’s report that new home construction was off 14.6% year over year bringing new home starts to the lowest levels since 2000. The anecdotal information from the industry is that the worst is not yet behind us with both DR Horton Inc. (DHI) and Toll Brothers Inc. (TOL) indicating that cancellations are over double their historical averages. With nearly 50% of the homes sitting empty belonging to speculators, the affect of downturn on the real American family is still undetermined.

The Fed, for its part, seems to be becoming increasingly comfortable with the interest rate policy with Fed minutes and comments made this week suggesting that rates seem appropriate for market conditions and further action is unlikely in the short term. The Fed has continued to make it abundantly clear that inflation is their chief concern and growth will be sacrificed if necessary.

The trend of above average earnings gains appears to be coming to a close as Thompson Financial numbers expect Q4 2006 year over year earnings growth to be 11% and Q1 2007 to be back to trend at 8.4%. The slowing trend has been broadly supported by economic data foreshadowing slower economic growth in the coming quarters led by a softening housing market and an American consumer strapped to find his next source of low interest borrowing to support his spending habits.