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Markets: The Smartest Guys in the Room?
New York: September 03, 2007
By John R. Stephenson

 

Pride goeth before a fall

Proverbs - XVI.18

Optimism has been riding high for a while, buoyed by the view that the U.S. Federal Reserve will ride to the rescue by cutting the fed funds rate and injecting some badly needed liquidity into the global financial system. With this prospect hanging in the air, stocks have been oscillating higher — but will it last? Possibly. But if the Fed disappoints and doesn't cut rates dramatically, the risk then becomes another sell off in the market. But if they do cut rates in response to what the stock market is saying, then the Fed risks a weaker U.S. dollar at a time when the dollar is already under pressure. For our money, we think that the Fed will chose to sit this one out and markets will then move lower — for a while.

But what set the recent down moves in the market in motion had nothing to do with the stock market itself, it was the debt markets and, in particular, the drying up of liquidity in the asset backed commercial paper portion of the market. What makes this crisis different from all others, is that so few people have been responsible for creating such havoc for so many.

Like the mythical story of Icarus who flew too close to the sun, this is a crisis that was created by a select few, who believed so vehemently in their own genius that they felt they could value, package and offload pools of largely U.S. subprime home mortgages to the masses. So successful have they been that 99% of all the AAA rated credit in the U.S. is based on financially engineered products rather than good old-fashioned solid companies with steady cash flows. The problem? With liquidity suddenly unplugged, no one knows what these things are worth and there are trillions of dollars of this paper floating around out there. This is a big problem for the financial services firms that hold this paper on their balance sheets.

Life is nothing but ironic. After the shenanigans at Enron, all this financial hocus-pocus was supposed to be a thing of the past. And yet it's not. Banks and other financial institutions who needed to find a way to keep growing and paying out healthy dividends needed to find a way to make more and more loans and to keep these assets from showing up on their balance sheets where they could be detected by savvy analysts. To do this, they created bank sponsored asset backed paper that was sold through conduits. By taking these pooled loans off the balance sheets of the major banks, these shaky assets would be out of sight and out of mind — or at least until something happened.

Before long, other financial players had entered the game and were doing what the banks had been doing and so the market for these asset backed securities (many of these were backed up by subprime U.S. mortgages) exploded. But then something did happen. The default rates on these mortgages started going up and investors started to panic. What were these things really worth? Is there anyone who will buy these securities and for how much? No one seemed to know the answers to these questions.

With lots of uncertainty out there, the markets and, particularly the stocks of the big banks, have been under pressure lately. Investors are uncertain as to what it is that the banks really own. The likelihood that this problem goes away in the short-term is small, since the principal catalyst for the subprime meltdown is far from over. Mortgage rate resets on roughly $850 billion worth of mortgages are still due to reset in 2007 and 2008 with a peak occurring in November of this year. That's not bad news for the stock market and for the PhD's in Greenwich Connecticut that created the vast majority of these funky new products that have been wreaking havoc with our retirement plans. With a strong likelihood existing that the news from the U.S. subprime housing market gets worse before it gets better, there could be further pressure to come on the markets and on bank stocks in particular in the days and weeks ahead.

Figure 1: Banks Stocks Have Sold Off Harder Than the Broad Market

But in spite of the leverage used in the commodity markets, commodities themselves have held in rather smartly during this period of uncertainty in the stock market. The CRB index is down only 6% from its July high and down only 1% from the start of the year. Commodities, or the stuff in the ground, are among the most basic of all investment alternatives and when the crisis occurred in the high flying financial services stocks, all of a sudden what is basic and boring seemed to make a whole lot of sense.

Figure 2: Commodities Have Held in Well

The hubris that led to the creation of these problems is the same sort of hubris that led to the collapse of Enron. The sort of thinking that leads you to think that the laws of the universe don't apply to you and that you, being the genius that you are, have come up with a better mousetrap. Enron tried to fool the market by telling investors that they were better and more profitable than other companies. It's the same kind of thinking that led to the subprime mess and the manufacturing of toxic debt that has been exported around the world and sold on the basis of misleading ratings and academic models that only worked in a best-case scenario.

Where it will end, no one knows. With interest rates on many of these loans set to reset (higher) in the next 12 to 14 months, the likelihood that we are out of the woods yet, is probably too much to hope for. The financial services sector is getting walloped in the days when the market sells off and justifiably so. Commodities, on the other hand, have been hanging in there.

Figure 3: The Shanghai Market Continues to Move Higher

For our money, the financial services sector is one to avoid — at least for now. The stocks of commodity producers have been hard hit of late, yet this could represent an outstanding buying opportunity. Unlike past cycles, the strength in the commodities is coming from non-traditional regions.

In the past, America has been the engine of global economic growth. Now, global economic leadership is in the process of changing. While America still accounts for 22% of global GDP growth, it is sapping up 75% of global savings. Isn't it about time you put a bet on global growth, rather than U.S. economic leadership, by buying gold, energy, base metals and agri-businesses and avoiding the sectors where the smartest guys in the room have led us astray again?

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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