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Sunday, August 05, 2007

Market correction - Aug 2007

For anyone who has been following the sub-prime lending fiasco the failure of funds with exposure to the sub-prime market and stockmarket weakness comes as no surprise. Why:
1. The US market was at dangerously high levels of debt
2. Nominal US interest rates are still very low - making little allowance for current inflation, let alone increases
3. The risk-premium implied in current nominal interest rates is excessively low.
4. The ARM-type 'no doc' loans offered in the US were destined to result in failures. Offered at times when people cant remember bad times, and when interest rates were extraordinarily low. Rates are rising, and the 'concessionary rates' that baited lenders are about to reset.

Sub-Prime Lending Fiasco
There are 3 issues that can sink this market:
1. The prospect of a bird flu epidemic
2. Inflation taking off or market recognition that inflation is higher than we know
3. Debt liquidation

Bird flu
Well there is currently no sign that no sign that bird flu will turn into a pandemic. Its plausible that authorities have improved the levels of animal husbandry in China and other developing countries to an extent that it might be avoided. For now its 'all quiet on the eastern front', but I suspect work practices in Outer Mongolia are a little harder to administer, or people simply dont bother. The wild bird population is spreading the virus to these farflung areas. The question is whether a mutation arises which combines some of the bird flu virility issues with the communicability of the common flu.

Inflation
I have long argued that inflation is a broad measure of price variance, and thats not what the 'core CPI' measures in western countries. This is political distortion. The exclusion of housing prices, energy prices, food prices for the sake of volatility is equally invalid. The inclusion of qualitative adjustments is a subjective distortion, and the inclusion of rent is a distortion too because rents are suppressed by the high levels of home buying. Clearly you can't have your cake and eat it...unless you are a bureaucratic manipulator. Its interesting to ponder why business accepts this state of affairs. My assessment is:
1. They have derivatives contracts to protect themselves
2. They benefit from the sustained growth in global consumption
At current nominal interest rates there is little adjustment for inflation, so the current Fed interest can be regarded as stimulatory...say 2.5% when a neutral (real) rate would be around 4-5%.

Debt Liquidation
The other aspect of this market correction is the threat of credit liquidation. Just as global consumption has been fuelled by credit expansion, any contraction of credit growth (from higher interest rates) and even credit defaults (liquiation of existing outstanding loans) poses a significant threat to the market. There is a snowballing effect as well since we are likely to see higher interest rates and the resetting of ARM rates causing even more failures in the USA.
Consider the facts emerging today.
1. More than 2 million subprime adjustable rate mortgages (ARMs) are poised to reset at much higher rates in coming months according to CNNMoney.com. Based on current proportions we might expect 5-10% of these to fail. But when you consider that these problems will cause weaker housing prices, we are looking at a significant problem.
2. Borrowers who took out ARM loans in 2004 and 2005 based on concessional rates for the first 1-3 years can expect their monthly mortgage payments to climb by 35% or more.
3. In October alone more than $50 billion in ARMs will reset - so there is alot more failures coming.
4. The threat is that as the number of subprime ARMs underwritten reached a high, the quality of loans was hitting a low. Since the lowest quality loans were made through to 2006, we migh expect the US property market to remain subdued until late 2008 I believe.
5. Another threat is the prospect of a huge increase in the sale of homes in the USA, as home owners drop out of the market. In 2005, about 40% of all purchases were for second homes and investment purposes. Expect alot of these owners to bail out, increasing the listing backlog and depressing prices.

So how bad is the problem?
Well its not good. According to AIG, the world's largest insurer and one of the biggest mortgage lenders, residential mortgage delinquencies and defaults are becoming increasingly common among borrowers in the category just above subprime. As it stands AIG has said that 10.8% of subprime mortgages were 60 days overdue, compared with 4.6% for loans just above subprime. What does this mean? Well I think it means 50% of the loans in the higher quality bracket might not be sound since at the same point in time, 50% of those loans are doubtful. that loans indicating that the threat to the mortgage market may be spreading.
AIG said delinquency rates for first mortgages had risen from a low of 3.08% in Jul'05 to 3.56% in Apr'07 and 3.98% in June'07. First mortgages represent 90 percent of AIG's domestic mortgage business, so its possible that the broader market is fairing better.

The good news is....
The good news is:
1. Equity markets have not woken up to the fact that more bad news is coming. This is not unxpected since we have become so accustomed to the good times
2. The good news is that whilst credit expansion has ballooned over the last 10 years, inflation has been greater than stated by the media-promoted statistics. The bad news is that there is still a significant correction required to bring markets back to equilibrium. Since money supply has grown so much more than output, prices and credit liquidation both have to rise to bring those markets back into equilibrium.
But the bad news is...if you own a property, you are about to loose a significant amount of money. Why?
1. Deflation will occur most in those markets where there was the greatest inflation.
2. Prices are set at the margin, so they will fall quickly as buyer interest evaporates. You wont have time to sell.

Equity Market Correction
Its hard to make informed decisions on these issues since the information to assess the market is not readily available. Up until a few weeks ago I was thinking that the market had enough momentum to keep growing, that the US housing market was turning around and the amount of money in the global economy would sustain a stronger market, with also the remote prospect of Fed stimulus in the form of lower rates. I was particularly heartened by the fact that copper inventories are very tight and copper and tin prices are very high. But thats a precarious position to hold as well.

From the market I gathered several points that prompted me to question my previously positive judgement:
1. Credit risk: The snowballing impact of the sub-prime loan. The news just keeps getting worse
2. Technical weakness: The failure of the Dow Jones Industrial Average (DJIA) to continue its uptrend
3. Affirmation of weakness: The fact that recent price action has suggested further weakness.
4. Commodity markets: I think the impact on commodity markets is lagging because of strike shocks to supply and because China is expanding inventories unaware of the market realities.

I was originally expecting a fall back to the 12,800-12,900 level in the Dow Jones, but I actually would not be surprised if we see a fall to 11,700 pts as its a much stronger support, particularly as I think there is more bad news looming.
Dont expect fund managers to spread news of an impending implosion - look at what the market is telling you. Understand that if you are a fund manager it takes time to unload stock. They dont want you thinking their is a meltdown, otherwise you will be jumping in queue ahead of them to unload your stock. So instead they tell investors 'all will be fine in the long run', 'nothing to worry about'. Of course in the long run the Dow Jones has risen exponentially for 100 years. But why would you want to wear a loss if you dont have to. So if you want to be ahead of the pack, you need to see trends before the rest....so you are ready to react when you see statistics that carries bad news.

Its seems likely that the Dow Jones is about to fall to its trend support of 12800-12900 points. Given that the collapse in the sub-prime market is a US phenomena, you might think this is a US-only phenomena. Well the rationale is that the US consumption has been fuelling the global economy, so a contraction there will have a significant impact on the global economy. I have recently become pessimistic on a US recovery until late 2008, and I see a short recession caused by the housing slump, with the prospect of an inflation-fuelled slum next year, which could make the forthcoming recession about 4-5 years long. I suspect it will take this long for the asset inflation to work its way out of the market and for production capacity to be re-adsorbed.
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