By William Patalon III, MBA | 6 October 2007
The Worldwide Credit Crunch Isn’t Over After All.
Just days after U.S. stocks soared to record highs— and Wall Street upgraded the embattled homebuilding sector— worldwide groups are issuing warnings that there’s likely more pain to come. Investors even bid up the shares of Citigroup Inc. and UBS AG earlier this week— even though the two banking giants on Monday said they would write be writing down $9.3 billion in bad debts between them.
But we said that all this optimism— bordering on euphoria— was premature. And, unfortunately for key economies worldwide, we were correct. [For our free investment analysis, "Avoid the ‘Resurgent’ Homebuilding Sector and Go Global For Profits," please click here.]
Now the key is to find a way to profit, while also avoiding the growing risks complacent investors face from an insidiously expanding international credit crisis.
Let me explain.
Housing and Mortgage Crisis Not Over Yet
When the Dow Jones Industrial Average soared to its all-time record close of 14,087.55 on Monday, it was because investors thought the worst of the subprime mortgage mess and housing slump were behind us, and because the lousy earnings reports at Citigroup and UBS [Generally regarded as the most-conservatively run bank in Europe] allowed investors to define the scope of the credit problems financial institutions faced.
Unfortunately, investors were wrong on all counts.
Just since Monday, additional reports have pointed to a continued slide in the U.S. housing market, which will translate into still more defaults, and still more job losses in the "real" economy. That’s going to impact the ultimate key to U.S. economic growth— consumer spending. Depending on what other mini ‘boomlets’ are under way in the economy, at any given time, consumer spending provides 60% to 75% of the fuel for the economy.
Lately, housing has fueled some of that spending. Rising home prices that translated into growing "equity" enabled many consumers to treat their houses like an ATM machine, extracting cash for big-ticket purposes, further fueling growth. Or, even worse, consumers have regarded their homes as their retirement "savings," meaning they could spend all of their paychecks today, thus also artificially boosting consumer spending.
That’s changing here in the U.S. market already. And it’s going to get worse.
Over the next few months, more than 2 million homeowners with subprime adjustable rate mortgages, or ARMs, are looking at resets— and at much-higher interest rates— a reality that’s likely to deepen and lengthen an already-dismal housing downturn.
More than $50 billion in ARM loans will reset this month alone, a record for a single month, says Economy.com, an econometric firm based in West Chester, Pa.
Even the near-term numbers don’t look that good: On Tuesday of this week, the National Association of Realtors reported that that the pending home sales index fell 6.5% in August after dropping a revised 10.7% in July. The index— a forward-looking gauge of home sales— is at its lowest point since it was created in 2001. [For our full report on this story, please click here].
And when it comes to housing and mortgages, the U.S market is not the only problem area. Mark our words— you heard it here, first— all this negative analysis will soon be true in the United Kingdom, too, where a white-hot housing market looks like an "I Love Lucy" rerun of what happened here in the U.S. market [[actually worse: normxxx]].
Just yesterday in the United Kingdom, in fact, a survey by that nation’s biggest lender said that prices fell 0.6% in September, dragging down the annual rate of price inflation from 11.4% in August, to 10.7% in September.
And that research by Halifax, the No. 1 U.K. mortgage lender, agrees with other market surveys, including reports from rival lender Nationwide, and one from the Royal Institution of Chartered Surveyors, BBC News reported yesterday.
Earlier in the month, the Bank of England said that the number of new mortgage approvals plunged 9% in August from the same month in 2006.
"Evidence is mounting that the housing market is now cooling markedly in the face of financial market turmoil, and the increasing affordability pressure on house buyers," said Howard Archer of Global Insight. "Mortgage rates are rising further as a consequence of the liquidity crunch pushing up money market rates, while the Northern Rock [British banking] crisis may hit confidence and increase consumers’ wariness about buying a house."
In late September, the Organization of Economic Cooperation Development (OECD)— which represents the world’s 33 most-advanced industrial nations— warned that the United Kingdom might need to cut interest rates to keep economic growth from declining sharply. The reason: The global credit crunch and that country’s domestic housing slump were the two key culprits cited.
Nor is Britain the only other problem area besides the United States.
In Australia, the credit crisis is affecting non-bank lenders so much that financial advisors and debt-recovery specialists are urging home borrowers to consider refinancing their mortgages with major banks. Non-banking financial-service firms have raised their rates to avoid the credit crisis fallout, the Australia Herald Sun reported in its edition today (Friday).
Other Problems Abound
Nor is housing the only problem facing investors. Here in the United States, the dollar has weakened to near-historic lows against other major currencies, and the expectation of additional interest-rate reductions by [the Fed] will likely lead to an even weaker dollar. That’s great for exporters— such as Boeing Co. (BA), the No. 1 U.S. exporter— but is highly inflationary for consumers, and for companies that depend on raw materials, sub-assemblies or ingredients sourced from, and purchased from abroad.
The U.S. jobs report due out today is expected to pave the way for another interest-rate reduction by U.S. Federal Reserve policymakers. All these issues rule out most banks and financial institutions in the United States and other key financial markets as investments. Definitely avoid the homebuilding sector, even though Citigroup’s equity-research unit upgraded many of the shares earlier this week.
Then there’s China, perhaps the world’s most alluring profit opportunity for the long haul. But stock prices have been on a near-vertical ascent of late, meaning the chances of a near-term correction are fairly substantial. Look to buy in after a dip makes valuations more reasonable.
The Plays to Make Now
There are four ways to beat the credit crunch and profit from the still-positive global growth trends that remain in place. Our strategy calls for you to:
- Invest in agricultural commodities.
- Invest in gold.
- Invest in Japanese small-cap stocks, which are domestically focused and which therefore will benefit from that country’s highly liquid economy.
- Benefit from Asian growth, and from the promising Korean economy, with a strong telecommunications play from that country.
No matter what the mortgage market looks like, how many cars General Motors Corp. (GM) sells or doesn’t sell, or what the price of a gallon of gasoline is at the pump, people will always need to eat. Indeed, as wages rise in such places as China, India, Latin America and emerging Eastern Europe, people will be able to afford more and better food. And that bodes well for agricultural commodities.
And a great way to play commodities is via an exchange traded fund, or ETF. One that we like is the Deutsche Bank’s PowerShares Agriculture Fund (DBA)— intended to reflect the performance of four commodities in the agriculture sector— soybeans (31.13%), wheat (28.87%), corn (23.43%) and sugar (16.58%). These include some of the key commodity plays that investment guru Jim Rogers advocates as great long-term investments. And we agree. [To see what famed author and investor Jim Rogers has to say about wheat— and other agricultural commodities— please click here.]
Commodities are also a good play when financial markets are unpredictable and when inflation is expected to remain in the picture. And the best of those commodities are precious metals, such as gold.
If you think the central banks will continue to print money to solve the credit crunch— they already are, and will continue to do so— you really need an inflation hedge, which means the StreetTracks Gold ETF (GLD). Gold is currently trading in the range of $740 an ounce, and some analysts, including our own Director of Global Investing Research, Martin Hutchinson, think that a price of $1,000 an ounce is indeed likely in the next 6 months [[that's the sort of panicky thinking that presages a likely near term reaction in the gold price: normxxx]].
Despite our near-term concerns about China, Asia is still a highly promising market. [In fact, if you aren’t yet a Money Morning subscriber, sign up now and receive— free of charge— our 6,000-word research report, "The Three Best Investments in Asia Today," by clicking here.]
Two of our four plays benefit from Asia’s rapid growth, but in very different ways.
First, invest in the streetTracks SmallCap Japan ETF (JSC). It focuses on smaller Japanese firms, which are more domestically focused. That means the companies will benefit from Japan’s highly liquid economy, and are also somewhat insulated from the worldwide credit foolishness we’re trying to help you avoid.
Second, invest in SK Telecom (SKM), Korea’s largest cell-phone company, which has international operations in China, Vietnam and the United States, although the U.S. market is only a small part of its operations. With 18 million subscribers, this $15 billion growth company has a 52% share of the South Korean wireless phone market.
With these four picks, you’ll be able to boast how you beat the global credit crunch, and profited some hefty profits in the process. And these days, how many investors can truthfully say that?
Bad-news bulls
From The Economist print edition
Stockmarkets are breaking records again as if the credit crisis were ancient history. If only it were.
The news seems to go from bad to worse. In late September, figures showed that the American housing market was in free fall, with both sales and prices plunging. On October 1st Citigroup and UBS, two of the world's biggest banks, said they were writing down $9.3 billion of debt between them because of the credit crunch.
Global stockmarkets have reacted not with dismay but with euphoria. Wall Street marked the Citigroup write-downs by driving the Dow Jones Industrial Average to a record high (see chart). The MSCI emerging-markets index has soared to new highs. This summer's turmoil seems to have been completely forgotten.
What explains this apparent insouciance? It seems that investors reckon they cannot lose. "Take your pick," says Gerard Minack, a strategist at Morgan Stanley: "Equity markets are either behaving as if the worst is over for credit and housing problems or they remain convinced that the [Federal Reserve] can offset whatever bad news may unfold." In other words, bad economic news means the Fed will cut interest rates and good news means recession will be avoided. There are some signs to support the idea that the worst might be over in the credit markets. After strenuous effort, banks have managed to find buyers for $9.4 billion of the $24 billion needed to finance the takeover of First Data, a payments processor, by Kohlberg Kravis Roberts, a private-equity firm. According to JPMorgan, even the structured products that caused so much disquiet during the summer are moving again— $6.2 billion of collateralised-debt-obligations were issued in the last week of September.
Risk appetite is resurfacing in currency markets, too. The "carry trade", the borrowing of low-yielding currencies to buy higher-yielders, is back in full swing; the Australian and New Zealand dollars have been surging. Having reached a 27-year high on October 1st, gold (often seen as a safe haven for nervous investors) suddenly lost 2.5% of its value in a day.
The bullish case seems fairly simple. The American economy may be slowing but the rest of the world, particularly emerging markets, can make up for it. As a result, corporate profits can continue to be strong. Profits forecasts are being revised down, but not dramatically so. Ian Scott, a strategist at Lehman Brothers, says that in America there have been just 71 profit warnings after the third quarter, compared with 114 warnings at the same stage in 2005 and 173 in 2004. The dollar's decline has added impetus to the earnings of American exporters and multinationals with overseas subsidiaries.
In this light, the credit crunch seems like old news. Even bank write-downs can be spun in a good light. Much of the panic in August was caused by fear of what banks had on their books; now the bad news is out, investors can relax.
In addition, many investors are looking back to 1998 when the Fed cut rates in response to a previous crisis in the finance industry— the collapse of Long-Term Capital Management, a hedge fund. The markets recovered quickly and the dotcom bubble reached its apogee. This time round, emerging markets (or even alternative energy stocks) might be the big winners. And in the short term at least, money that was pouring into the credit markets is now being invested in shares.
But not everyone buys the bulls' arguments. Experienced observers of the debt market, such as Tom Jasper of Primus Guaranty, a credit insurer, think the crunch is far from over. According to Moody's, a rating agency, the spread (excess interest rate) of high-yield debt over Treasury bonds has fallen from the crisis peak but is far higher than it was in June.
In the quick-to-rollover money markets, there is still a much wider spread than normal between the rate governments must pay to borrow money and the rate which big banks have to pay. That indicates investors remain nervous about the extent to which banks are exposed to losses from subprime mortgages, or large private-equity borrowers.
Problems in the housing markets are far from over, too. The latest gloomy statistic to emerge was a 21.5% annual fall in pending American home sales, a figure that is a leading indicator for actual sales. House prices will surely fall further and defaults increase, as homeowners struggle to cope with higher mortgage rates from "teaser" loans taken out in 2006.
That may well have a depressing effect on consumer sentiment, something which the Fed's rate cut last month may do little to help. Normally, interest-rate moves take 12 - 18 months to work their way through the economy. In any case, mortgage rates are barely lower than they were a month ago. The American economy could yet slip into recession, an event on which Goldman Sachs now places a 40% probability.
Even the argument that corporate profits are still strong does not look completely convincing. American profits are close to a 40-year high relative to national output, according to Longview Economics, a financial consultancy. That suggests they should return to the mean, especially as the profit numbers taken from national-accounts data look a lot weaker than those reported by quoted companies. The last time such a gap appeared was in the late 1990s, an era of much creative accounting.
And while the weak dollar may be good news for American exporters, it is bad for European companies. Having been strong in the early part of this year, the latest data on European economies have weakened sharply; Nicolas Sarkozy, the French president, is not the only one concerned by the euro's strength. There is the potential for turmoil in the currency markets, either because Europe takes a stand against the rising euro at the Group of Seven finance ministers' meeting on October 19th, or because international investors, who have to finance the American trade deficit, become alarmed by the weakness of the dollar. Stockmarkets might be able to rise above the problems of the credit markets. But whether they could gain ground in the face of foreign-exchange market turmoil as well seems a lot more doubtful.
To Infinity And Beyond
From The Economist print edition
Contrary to popular belief, stocks do not always go up
If american investors have learned any lesson in the last 25 years, it is to buy shares on the dips. The slide in 2000-02 may have been longer and deeper than they were used to, but normal service was eventually resumed, driving the Dow Jones Industrial Average to a record high on October 1st.
Among American financial commentators, it is almost universally accepted that shares always rise over the long run. And this perception does seem to be backed up by evidence; if you take any 20-year period, Wall Street has always delivered positive real returns. In addition, one ought to expect shares (which are risky) to deliver a higher return than risk-free assets such as government bonds.
Nevertheless, investors ought also to remember the lesson of the world's second largest economy, Japan. Its most popular stockmarket average, the Nikkei 225, peaked at 38,915 on the last trading day of the 1980s; this week, nearly 18 years later, it was still only around 17,000, less than half its peak. Buying on the dips did not work either. By 1994, the Nikkei had fallen to 21,000— at which point a technical analyst, after poring over his charts, told this columnist that it had to be one of the great long-term buying opportunities [[it subsequently fell below 8000: normxxx]].
Investors who suffered through the Depression, when American stocks fell almost 90% from their peak, at least had a decent dividend yield to hold on to. But the Japanese market has offered a paltry yield throughout this period.
Japan might seem to be an exception. Arguably, America is just as much of a special case. Think back to the start of the 20th century when investors might have picked Russia, China and Germany as the rising stars of the next 100 years. Within the next half-century, investors in the first two saw their holdings wiped out by revolution while world wars and hyperinflation ruined the portfolios of those who backed Kaiser Wilhelm II's empire.
Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School examined* the record of 16 stockmarkets which were in continuous operation over the course of the 20th century. In itself, this selection showed survivorship bias by excluding the likes of Russia and China. The academics found that only three other countries could match the American record of having no 20-year periods with negative real returns.
Other investors were far less lucky. Japanese, French, German and Spanish investors all suffered instances where they had to wait 50-60 years to earn a positive real return; in Italy and Belgium, the waiting period stretched to 70 years. It was no good following the famous advice to "put the shares in a drawer and forget about them"; the furniture would not have lasted that long.
Besides survivorship bias, there is another problem with the belief that stockmarkets must always go up; the very existence of the belief is likely to lead to its falsification. Investors will keep buying until prices reach stratospheric levels. That clearly happened in Japan in the late 1980s and with the technology-heavy NASDAQ index in the late 1990s; the latter is still, after seven years, not much more than half its peak level.
A significant proportion of the return from equities in the second half of the 20th century came from a re-rating of shares [[increasing P/E ratios: normxxx]]; investors were willing to pay a higher multiple for profits. But re-rating cannot continue forever. Although ratings have fallen significantly since the heady days of 2000, that is in large part due to the remarkable strength of corporate profits, now close to a 40-year high relative to national output. If profits revert to the mean, that could act as a drag on stockmarket performance. And, as with Japan, American investors no longer have much in the way of income to fall back on; the dividend yield on the American market is just 1.7%.
If investors want a simple parallel with share prices, they need only turn to the American housing market. Back in 2005, Ben Bernanke, then an economic adviser to the president, was asked about the possibility of a decline in house prices on CNBC, a financial-television channel. He said, "We've never had a decline in housing prices on a nationwide basis. What I think is more likely is that house prices will slow, maybe stabilise."
Lots of people took the same view and were willing to borrow (and lend) on a vast scale on the grounds that higher house prices would always bail them out. They are now counting their losses. Investors in equities should beware of overcommitting themselves on the basis of a similar belief. Just ask the Japanese.
Normxxx
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