February 2008
Market Minefields
Turmoil within financial markets became noticeable nearly one year ago with growing numbers of defaults on subprime mortgages. Since then, credit problems have widened. Similar quality issues and increases in mortgage delinquencies have subsequently invaded the alt-A, prime, insurance and more recently the usually stable municipal bond market. Today credit markets are, for the most part, dysfunctional with billions of dollars of unmarketable loans parked on the balance sheets of major corporations in spite of the billions having already been written off. In the week, UBS rattled the market further by saying that losses in financial institutions could reach more than $600 billion as problems spread not only through asset classes but also across boarders.
The world’s largest insurer, American International Group, announced an $11.1 billion write-down in assets and posted a $5.3 billion loss for the fourth quarter of 2007, marking the largest loss in the company’s long history. AIG points out that companies are being forced to mark assets to market at a time when credit markets are dysfunctional and that its write-downs are “unrealized” and may never actually result in a real charge to the company. [The argument for pricing to market is to hopefully avoid a Japanese-like situation in which Japanese banks carried defunct loans on their books for years.]
The current situation is pushing some credit markets to extremes. This past week, two hedge funds received margin calls on poor bets and were forced to liquidate billions of dollars in municipal bond securities. This push yields on muni-bonds and other tax-exempt issues higher to unprecedented levels.
Finger pointing has become an off-season sport around Washington with calls for massive government bailouts within the banking and housing industries and increased government regulations amounting to nothing more than additional layers of wasteful bureaucracy, which have proven to be un-attentive to date. Federal Reserve Chairman, Ben Bernanke, offered these candid comments during his recent testimony before the Senate banking committee “I don’t know how to fix it, ... I don’t know what to do about it.” Of course, the real culprit will always remain at large and resurface whenever and wherever opportunities present. The culprit is greed. In our opinion, the housing/credit problems are likely to continue for an extended period, allowing consumers ample time to relearn the lost art of “belt-tightening”.
Prevailing uncertainties are not contained to the financial sector alone, however. The dimming earnings picture for 2008 and beyond is now starting to get more ink. Stock prices, as we previously pointed out, appear to be adjusting to a lower earnings outlook for 2008 and maybe beyond. At current, some technical indicators may appear attractive by historical standards, i.e. P/E ratios, however if earnings are to be adjusted downward in a weakening economic environment, stock prices in general certainly do not look cheap. Helpful fiscal and monetary policies will help to temper any economic downturn but we doubt that either will be able to deflect a recession entirely. Our outlook for the market over the next few months is for continued downward pressure on stock prices, albeit volatile from time to time. With economic, monetary and political uncertainties mounting, 2008 on may be a year of just avoiding market minefields, read capital preservation.