The Three Headed Monster: Dot-Coms, Housing...Now Credit?

Includes: AXP, MA, V
by: Larry Trefz

Most investors are familiar with a 20+ year chart of the S&P 500 Index. Now that we have reached triple-top territory many are asking which way we go from here. The chart looks like one of the greatest trading ranges in history.

Generally speaking, in the shorter term, the markets are ruled by emotion, sentiment and trend following.

In the longer term there tends to be a greater correlation between the fundamentals and market direction.

I offer the three bubbles below as examples because I see that they share a common factor: a modern central bank, the Federal Reserve, attempting to actively manage each one. This major factor could give us some insight as to how the future could play out and how we might profit from it.

Let's examine the first head of the monster--the dot-com bubble. In 1993 the World-Wide-Web was born with the introduction of the Mosaic Web Browser. This kicked off a boom of Internet start ups that seemingly could do no wrong. As the power of the Internet became apparent, a positive feedback loop developed which fed the bubble. The potential seemed unlimited and investors poured money into internet stocks until the Nasdaq topped out at over 5000, late in the year 2000. The S&P 500 peaked at just over 1500. US 10 Year Treasury Bonds were yielding over 6%. Then the music stopped.

The dot-com bust exposed numerous errors in the growth theory that the positive feedback loop had hidden on the run up. Huge amounts of office space in west coast cities suddenly became vacant. In six months, San Francisco saw 3 million square feet of office space go up for rent. Prices plunged. In mid-2002 the Nasdaq hit bottom below 1150, losing nearly 80% of its value from the peak. As the market collapsed the Fed steadily cut interest rates until they got down to about 1% by early 2003. This helped to give rise to the second head of the three-headed monster.

As we know, the second head of this monster was the housing bubble. This bubble got its start with the end of WWII and the birth of the Baby Boomer generation. Government programs made it increasingly easier to borrow money for housing. As most of us are familiar, cheap credit, Adjustable Rate Mortgages with low teaser rates and sub-prime mortgages fueled the parabolic rise in housing prices in the early to mid-2000s. Once again, a positive feedback loop developed and cheap credit made many people think that housing prices would go up forever and that they should buy not one house but several to function as virtual ATM machines.

The Fed responded to the boom and started raising interest rates in early 2004 and continued to do so until they stopped at 5% in 2007. The rise in housing prices peaked in late 2005 but the S&P did not peak until late 2007 at about 1565. At this point, as mentioned, Fed interest rates were at about 5%.

As the stock market rose past the peak of housing prices, the molten lava of the failing Mortage Backed Securities Market and CDOs boiled under the surface. The Fed became aware that there was a problem in mid-2007 and started cutting interest rates. As the foundations of the financial system shook, the Federal government became the lender of last resort and the concept of too-big-to-fail came to the fore.

As it became clear that the entire financial system was in danger, the S&P 500 thundered downward while the Fed frantically cut rates. The S&P 500 reached a bottom of 666 in March of 2000. The S&P 500 then turned and started to rally as investors became convinced that the majority of credit risk was being transferred onto the Fed and US government balance sheets.

Now the third head--the credit bubble. With interest rates near the zero bound, the Fed put heart and soul into reviving the financial markets and unfreezing credit. Banks were urged to lend and people urged to borrow. Slowly the credit markets thawed and consumers were enticed with previously unimagined low interest rates. Never in known history have so many people been able to have such expensive stuff while making such small payments on said stuff--due to artificially engineered low interest rates. For the first time in history these rates bear little connection with the underlying credit risks. Should credit become more expensive, with rising interest rates, things that appear cheap now because of the low payments could look very different rather quickly.

As has been demonstrated in the dot-com bubble and the housing bubble, the fundamentals are affected by the sentiment of the market participants. While the central banks or the developed world stand at the ready to address any threat that may arise, their firepower has now been reduced to basically one effective tool--monetary easing via asset purchases. Should this tool be used too liberally, inflation could kick in which would cause more of the very problems that the central banks stand at the ready to fight. In other words, the central banks could become their own worst enemy.

Given the weakened position of the central banks and the heavy debt load of their governments the potential for a credit crisis is not out of the question. Interest rates have already started to rise and it appears likely that they will continue to do so. The issue is whether the central banks can engineer a slow steady rise in rates or if rates will get out of control. A potential catalyst for rising rates, would be fixed income investors exiting their positions too rapidly.

Should credit start to freeze up, it would stand to reason that the companies that provide the consumers with credit and those companies that are heavily dependent on the consumer's ability to get credit could face major downturns. Stocks that face the potential of the greatest downside would likely be those that have benefited the most from the last few years of cheap credit conditions.

The tip of the credit spear is consumer credit. Credit card company's stocks have risen dramatically since the 2008-2009 financial crisis. The valuations of most of these companies is also rather rich compared with the S&P 500, which is trading at a 17.17 P/E multiple. The reason I have chosen credit card companies as shorts in this situation is because we have just recently been through a housing crisis.

While it is true that consumers carry the majority of their debt attached to their houses, they have focused on getting that debt under control for the long-term. Adjustable Rate Mortgages are now quite rare and the fixed rate products carry historically low rates. It is quite likely that in the event of a credit stress situation, such as rapidly rising interest rates, people would continue to pay their mortgage and rather default on their credit cards as was the norm prior to the housing crisis.

Mastercard (NYSE:MA) has risen from about $125.00 per share in 2009 to over $525.00 recently. It is currently trading at a trailing P/E multiple of 23.7.

Visa (NYSE:V) has gone from about $45.00 in 2009 to over $160.00 recently. Visa is currently trading a 49.7 trailing P/E multiple.

American Express (NYSE:AXP) has gone from about $10.00 in 2009 to about $60.00 per share recently. While AXP has a trailing P/E of 15.97, which is lower than the others mentioned above, its beta is 1.8 which is more than twice the beta of MA or V.

The stocks mentioned are large companies whose stocks have had an excellent run. Should a credit crisis occur, as mentioned above, I would look at the stocks above as potentially profitable short positions. Given the size and broad-based nature of these companies a stock price downturn could last for some time. Carefully monitoring the health of the average consumer and policy actions that are taken to correct any crisis conditions would be key to determining how long to hold a short position in these stocks

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.