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The Hard Road Ahead

Fri, Oct 12 2007, 07:46 GMT
by Comstock Partners Team

Comstock Partners Inc.

The current market rally is based a number of dubious assumptions that are not likely to hold up. The bulls make the case that the credit crisis is over, a hard landing in the economy is not likely, the Fed will continue easing and the market is reasonably valued, if not cheap. Let’s take a look at each of these assertions.

In our view it is far from certain that the credit market problems are over. While it’s true that tensions have eased and companies are not blowing up every day, it’s still unlikely that the markets can return to where they were before the crisis. Confidence between borrowers and lenders remains low while continuing new highs in Euro interbank rates indicates that liquidity has not returned. Longer term, the task of cutting back on risk, reducing debt levels and repairing balance sheets is only in the early stages. In addition, although many analysts believe that financial companies are writing off the kitchen sink in the current quarter, we’re not so sure this is the last of it. We remember too well that after the collapse of the dot-com bubble, technology companies took sequential writedowns despite assuring everyone that they were finished. Furthermore the housing industry will probably be reporting atrocious numbers over the next few months, and that could uncover even more financial companies with serious problems. Also remember that the people who are saying the crisis is over are mostly the same ones who never saw it coming in the first place.

It is also unlikely that Fed ease will prevent a hard landing. A careful reading of the Fed minutes for the last FOMC meeting indicates that they are actually quite bearish about the economy. The staff marked down their GDP forecast for both the 4th quarter of this year and for all of 2008, stating that lower housing wealth, slowing gains in employment and reduced consumer confidence would restrain consumer spending. They also anticipated a scaling back of capital spending.

Participants referred to the outlook for economic activity as characterized by particularly high uncertainty with risks skewed to the downside. Although they recognized that the August drop in employment overstated the weakness, they said that growth was slowing down even before then and that further slowing was likely. Recognizing the potential for a negative feedback loop, they added that if the decline in housing were to dampen consumption that could feed back into employment and income, thereby further reducing the demand for houses. Some participants also felt that the further tightening of terms for equity lines of credit and second mortgages would weigh on consumer spending. As for capital spending, their contacts indicated business executives in some parts of the country had become more cautious and were delaying investment outlays. Given these bearish views by the FOMC it is no wonder that they turned around and slashed rates by 50 basis points only six weeks after viewing inflation as the greater risk.

Although the Fed’s minutes are couched in careful language and there are the usual economists’ "on the one hand and on the other hand" references, there seems little doubt that the Fed is worried, and with good reason. September foreclosures have doubled over a year earlier with no end in sight. This dumps even more houses on the market with increased pressure on prices. Today’s Wall Street journal front page article shows that subprime mortgages are even more widespread than we thought both with regard to geography and price points. Subprime together with Alt-A mortgages accounted for about 40% of mortgages issued in 2006, and this demand has now been removed from the market. Aside from the direct effects of the housing slump, let’s not forget the indirect economic impact on such items as cement, wood, construction equipment, appliances, school building, roads, sewers and shopping centers. Today’s reports from retailers indicate that consumer spending is weakening as well while core new durable goods orders are down 2.2% from year-end.

Although there seems to be a widespread feeling (at least on bubble TV) that the Fed could wave a magic wand and cure anything, this is not the case. On January 3, 2001, when the Fed cut rates by 50 basis points in an emergency telephone meeting the S&P 500 jumped 5% that day and 7.8% by the end of the month. The index then proceeded to plunge 44% over the next 21 months and the recession continued for ten months following the cut. Although the market seems reasonably valued on overhyped forward-looking estimates of operating earnings that may never be met, the S&P 500 sells at an historically high 23 times trendline earnings, higher than in any year before the late 1990s boom. In our view neither the market nor the economy is out of the woods.

Published on  Fri, Oct 12 2007, 07:43 GMT