| |
Crisis or Opportunity - Part 2
|
|
|
The following is extracted from the August 2007 - 1 Issue
Markets continue to be extremely volatile, but seem to have found a base, making it appear less likely that there will be further large declines.
A closer look at what led to the turmoil should help resolve the question of what investors should do now.
Some investors are still dumping stocks on the markets. The selling pressure includes margin calls, fund redemptions and investors concerned that the recent disruptions may lead to a severe economic slowdown.
The selling is equally balanced by buying. While much of the focus has been on the selling, it is instructive to try to understand who the buyers are. I have a sense that the buying includes rational investors with a longer-term perspective who see opportunities at current prices. Among the buyers is Warren Buffet’s Berkshire Hathaway fund, which has been buying banks, including those with big exposure to the US mortgage market.
A recent e-mail from an individual investor may provide some insight into what has been happening on the sell side. That investor stated that “housing has lately been responsible for 20% of US jobs”. That investor’s analysis points out that since the mortgage market has dried up, those jobs will disappear. As a result “bye-bye economy -- hello recession or worse!!!”Anyone who has that outlook on the economy – and I am sure that there are many – would be dumping investments of all kinds.
For anybody who isn’t well aware, the housing industry in the US represents only a tiny fraction of the 20% figure noted by the investor. Secondly, the industry is not going to disappear. Building permits issued in July fell 2.8% from June, but remain at an annual rate of 1.37 million units. Perhaps not all of those permits will be built. However, housing stats in July, while down 6.1% from June, still represented an annual rate of 1.38 million units. Those figures are down from the height of the housing boom a year ago, but it is clear that the housing industry is still in business.
While housing is in decline, manufacturing output in the United States rose at a solid 0.6% in the month of July over the month earlier figure. Overall economic activity continues at a 3.4% annual growth rate. That rate of growth could be impacted by the recent market turbulence. However, it is extremely unlikely that the growth rate would fall to zero. (A zero growth rate would imply that the economy would function at the same pace as last year.)
The turmoil in the financial markets was triggered by concerns with regard to the subprime mortgages in the United States. Investors took flight on the realization that housing loans given to people that could not qualify for regular mortgages were rated at the same level as the top 1% of American corporate debt. Those AAA-rated sub prime mortgages were dispersed into the high quality loan portfolios of financial institutions around the world.
The fact that the top credit rating agencies had given AAA status to subprime mortgages naturally led to questioning of collateralized debt obligations and other asset backed debt instruments across the board. Not surprisingly, financial institutions slowed down the granting of virtually all classes of asset-backed loans, creating a worldwide liquidity crunch. Central Banks around the world stepped in to provide money to keep the financial system liquid.
With liquidity constrained and investors in general scared silly, it was only natural that selling spread into equities and even commodities. Ironically, even gold – the ultimate safe haven investment – suffered in the face of the mass liquidations.
Some of the financial markets were overdue for a dose of realism. For example, enormous amounts of debt were being used by private equity funds to purchase public companies. With the private equity funds competing against one another, the economic rationale for many of the deals seemed to disappear. It is actually a relief that the banking industry will now be exercising a little more discretion.
There was also some over-valuation in the equity markets. Much has been made in the popular press of the fact that equity gains year-to-date were almost wiped out at the bottom of the sell off. However, it is worth noting that the Dow Jones Industrial Average in July was 28% higher than it was 18 months before.
After the recent correction, the Dow still shows a return of about 12% annually over the past 18 months. The other major North American and many overseas exchanges had enjoyed similar gains. The correction brings equity returns back down, closer to long term expectations.
Simply put, many of the major equity markets were due for a correction and the subprime situation was the trigger to re-align values. In the course of mass selling, valuations took a back seat to liquidity. Some of the better stocks were beaten up for the simple reason that there were buyers available.
****
For only $265 US per year, you can be the first to read Lawrence Roulston’s market commentaries and Subscriber-Only company commentaries and alerts. CLICK HERE for more information
|
