It’s been a terrible opening for the markets in 2008. While the new year is supposed to bring hope of god things to come, the markets have instead dropped like stones. Citigroup and Merrill Lynch announced massive writedowns in their respective portfolios, everyone from Congress to the Fed is talking about some type of stimulus plan and there is hope for rate cuts from the Federal Reserve. Finally, there is more and more talk about a recession – which is defined as two quarters of negative economic growth. So, the question on everybody’s lips is what the hell is happening? Are we in a recession? Why are the markets tanking so hard? Below I will explain what is going on. I will caution up front this will be a long and fairly involved article.
Let me start with something I wrote in August 2007:
Since the beginning of 2001, the US consumer has accumulated a great deal of mortgage debt. According to the Federal Reserve, total mortgage debt outstanding increased from $4.9 trillion in the first quarter of 2001 to $9.8 trillion in the first quarter of 2007. To facilitate the creation of this debt, the US financial system has developed a system called "securitization", which I explained in this article. Central to this system is the willingness of certain financial parties such as investment banks, mutual funds and other large investment pools to buy and sell large pools of mortgage debt. This system has been around for about 20-25 years and has worked very well over that period.
However, over the last few years lending standards have deteriorated. In the past for example, a borrower had to put down 5% or more of the purchase price, the mortgage payment couldn't be more than x% of the borrowers income and the borrower had to have a decent credit history. These lending standards were lowered by a sub-section of the mortgage market called the "subprime market". "Subprime" simply means a person was not a prime risk, but instead was riskier to lend to.
The system of buying and selling mortgage securities and the mortgage underwriting business worked against themselves for the last few years. As the system of buying and selling mortgages wanted more mortgages to buy and sell, mortgage underwriters were happy to oblige by writing more mortgages. This was partially responsible for the lowering of lending standards. Because there were so many mortgage investors, it was thought the risk of the less credit-worthy borrowers was spread out among enough buyers that a default wouldn't seriously hurt anybody. However, we're learning that isn't exactly true:
"For years, people have taken the view that the strength of the modern financial system was that risks were widely spread, and so when something went wrong everybody had a small piece," says Lou Crandall of RH Wrightson & Assoc. "The problem now is, everybody's got a small piece, but those pieces are actually big enough to pull some players under, which means the fact that the risks are so diffused in the system means everybody is a suspect, and that's the flip side of what we saw as the strength."
Everything changed in late July. Bear Stearns announced that two hedge funds that invested in mortgage derivatives which had previously been worth about $6 billion were now worthless. I have publicly criticized the fund's manager before and I am doing so again. He was a fool. His fund was heavily leveraged and his investments were risky. So long as the market is going up, he was a genius. But the market turned against him, forcing margin calls and essentially bankrupting the fund in short time. He deserved to lose on his bet.
The Bear Stearns situation was the first in series of announcements from three continents (Australia, the US and Europe) where funds or investment managers announced their respective funds were losing value because of their investments in subprime mortgages. Since Bear made their announcement in late July a week has not gong by without another announcement of a problem at an investment fund, bank or financial company.
The Bear Stearns announced was the start of a process that continues to this day. According to the Wall Street Journal’s Marketbeat:
According to figures calculated by MarketBeat, some $100 billion-plus in positions have been written down for 2007, as the world’s investment banks recognize, en masse, that nobody wants this paper, not even made-up vehicles that have no choice but to buy it. Susanne Craig, David Reilly and Randall Smith reported in today’s Wall Street Journal that banks are going back to basics, reducing risky loans as a result, but that requires that they set aside more capital on their balance sheet, which will hurt earnings.
In other words, the US markets have now experienced a continual drumbeat of negative news from the financial sector that has lasted about six months. This has created a growing concern about the health of the financial sector and the economy as a whole, which in turn negatively impacts investor sentiment. Hence, investors are selling securities. I wrote about the overall problem in more detail here.
Let's take a look at the markets to see what exactly is going on.
Since their top in late September around 156, the SPYs have fallen 15%.
Since their top in early November at 54.50, the QQQQs (NAASDAQ) has fallen 16.8%
Since their top in mid-Septemter around 84, the Russell 2000 has fallen 20%.
All of these charts are extremely bearish. Prices are below the 200 day simple moving average (SMA), the shorter SMAs are below the longer SMAs, all the shorter SMAs are moving lower and the 200 day SMAs are starting move lower as well.
But now in addition to concerns about the financial sector’s health there is concern about a recession developing. Recent economic news has not helped in this matter.
The most devastating piece of news was the most recent employment report:
The unemployment rate rose to 5.0 percent in December, while nonfarm payroll employment was essentially unchanged (+18,000), the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Job growth in several service-providing industries, including professional and technical services, health care, and food services, was largely offset by job losses in construction and manufacturing. Average hourly earnings rose by 7 cents, or 0.4 percent.
Before this report, the bulls strongest argument was employment gains would continue to fuel consumer spending. This report basically blew that argument out of the water. Here is a chart of the year-over-year change in employment, which shows a clear downtrend over the last few years:
Then there was the disappointing retail sales report from the Census Bureau:
The U.S. Census Bureau announced today that advance estimates of U.S. retail and food services sales for December, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $382.9 billion, a decrease of 0.4 percent (±0.7%)* from the previous month, but 4.1 percent (±0.7%) above December 2006. Total sales for the 12 months of 2007 were up 4.2 percent (±0.4%) from 2006. Total sales for the October through December 2007 period were up 4.9 percent (±0.5%) from the same period a year ago. The October to November 2007 percent change was revised from +1.2 percent (±0.7%) to +1.0 percent (±0.2%).
And retailers are reacting thusly:
The retail industry appears to be skidding toward its first big wreck in 17 years.
Chains are slamming the brakes on store openings, cutting back on inventory and girding for leaner times as consumer spending chills. The speed with which sales slowed during the holidays caught even cautious retailers off-guard, prompting a flurry of profit warnings.
Considering that consumer spending is responsible for 70% of US GDP growth this news adds to the "Wall of Worry."
There are several reasons for the decline in retail sales. The first was mentioned above – weakening job growth. The second is the continued increase in gas and food prices. Here is a chart of oil for the last few years:
And here is a chart of agricultural prices:
In other words, the price of necessary expenses is hampering the consumer’s ability to purchase non-necessary goods and services. These price increases are also hampering the ability of the Federal Reserve as they indicate inflation is rising. And inflation is now at multi-year highs:
US inflation for all of 2007 hit the highest rate for 17 years, as surging energy and food costs pushed up prices, official data has shown.
Consumer prices rose by 4.1% for all of 2007, up sharply from a 2.5% increase in 2006, the US Labor Department said.
While there has been some talk of stagflation recently (high inflation and slow growth) I think it’s way too early to be making that call. If year-over-year inflation hits 7-8% then stagflation talk is warranted, but not until then.
So, the basic overall economy situation is not good.
-- The employment report indicates that employment growth is slowing. This indicates businesses are not confident about the future.
-- Christmas sales were OK, but not great.
-- The consumer is hemmed in by rising oil and food prices
-- The Federal Reserve is hemmed in by high gas and food prices.
-- The financial sector is still dealing with the fallout of the sub-prime mortgage mess and probably will be for the foreseeable future.
In short, things do not look good right now.
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