More on Existing Home Sales and Pricing Data
From JP Morgan: “…single-family home sales are down 31% from their September 2006 peak. By way of comparison, single-family home sales fell 33% peak-to-trough between December 1986 and December 1990, during the last major housing adjustment…The median price of single-family homes sold fell 6.3%oya, a record low of this series, which goes back to the late-1960s.”
From Merrill Lynch: “The steady sales rate of single-family homes was at the expense of lower prices, with the median sales price of single-family homes falling 1.4% on the month. This means prices are now down 6.3% YoY and 10.1% from their nearby peak this summer. We expect that as we approach the peak period for adjustable rate mortgage resets, the capitulation will accelerate and we look for home prices to fall another 10% in 2008.”
From LEHC: “Median sales prices can be dramatically impacted by changes in the “mix” of homes – both by size/amenities and by region. Earlier this year, the median existing home sales price had been inflated following the subprime mortgage market meltdown, which had a disproportionately large negative impact on lower-priced homes. This summer there was a “perturbation” in both the alt-A and the jumbo mortgage markets, which in some areas hit higher-end home sales in a big way, helping the median sales price “catch up” to reflect actual declines in home prices. Median sales prices are still not very reliable in gauging actual trends in home prices – especially in markets where overall sales volumes are extremely low – and economists believe that “repeat-transactions indexes” based on purchase transactions of the same properties over time (such as those produced by S&P/Case-Shiller) are better (though lagged and still imperfect) measures of home-price trends.”
Fed Vice-Chairman Kohn Softens Message – Signals Fed More Open to Easing
From JP Morgan: “Up until this morning, Fed rhetoric and market pricing of the Fed had been on a collision course. A speech by Vice-Chair Kohn in NY today helped to defuse that tension by moving the Fed closer to the market. Kohn's speech dismissed the moral hazard argument, made no real mention of inflation, and dwelled extensively on the growth risks from the increased turbulence in financial markets. Unlike recent speeches from other FOMC members, Kohn did not declare that he is already factoring in weak incoming data, nor did he discuss risks being roughly in balance. The policy debate between easing and not easing at the December 11 FOMC meeting will likely be animated, but Kohn's speech today suggest the crucial center of the committee is moving toward a 25bp ease. Kohn began his talk by discussing the moral hazard argument that monetary policy accommodation in times of financial unrest may encourage excessive risk-taking. Kohn's responded to this argument by noting that "we should not hold the economy hostage to teach a small segment of the population a lesson." If policy felt constrained by the moral hazard argument from promoting the macroeconomic goals of monetary policy, then "innocent bystanders" would pay the cost. Kohn then went on to discuss the much more central issue for policy in the current environment -- the effect of financial markets on the real economy. Here, unlike his colleagues, Kohn expressed a sensitivity to the recent re-intensification of problems in the financial markets. The relevant passage read: "the increased turbulence in recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses as well." The last topic Kohn discussed was the stresses in bank funding markets, which he attributed to a variety of factors, including counterparty risk, balance sheet risk, and worries about access to liquidity. Kohn saw year-end issues as being only "partly" to blame, suggesting he may see the problems in inter-bank markets as being a more persistent worry for the central bank. Kohn concluded by summing up his speech as one intended "to highlight some of the issues we will be looking at in financial markets as we weigh the necessity of future actions." Discussing the possibility of "future actions" may not exactly be a promise to ease, but it does re-position the Fed rhetoric to be consistent with that policy choice.”
From Bloomberg: “``The degree of deterioration that has happened over the last couple of weeks is not something that I personally anticipated,'' Kohn said in response to a question following a speech to the Council on Foreign Relations in New York. ``We are going to have to take a look at'' the stress in credit markets ``when we meet in a couple of weeks,'' he said…. Federal funds futures show traders see a 92 percent probability of a quarter-point reduction in the benchmark interest rate to 4.25 percent when the FOMC meets Dec. 11. Odds of a half-point cut rose to 8 percent after Kohn's remarks. ``We need to take account of those market expectations, but not follow them blindly,'' Kohn said in response to a question… Kohn said ``uncertainties'' about the economic outlook are ``unusually high'' now, requiring policy makers to be ``flexible and pragmatic'' in setting policy… He added that a ``broader repricing of risk'' that increases the cost of credit and discourages spending ``would require offsetting policy actions, other things being equal.''… Kohn, 65, is one of the most senior members on the Federal Open Market Committee. He was director of the Monetary Affairs Division and special adviser on monetary policy under former chairman Alan Greenspan… Kohn said labor markets remain strong, which provides an important ``pillar'' for the economy. ``On the other side, the spending data have been maybe a little on the soft side,'' Kohn said. ``There has been a noticeable slowing in the growth of consumption.'' Fed officials forecast prices will rise 1.8 to 2.1 percent next year. Kohn said inflation risks remain a priority for the committee.”
Financial Stocks Rally – Fannie Mae Has Biggest 1-Day Gain Since 1987
From CNN: “U.S. stocks staged the biggest two-day rally in four years, led by financial shares, after Federal Reserve Vice Chairman Donald Kohn reinforced expectations for another interest rate cut. Citigroup Inc., Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Morgan Stanley rose more than 6 percent… The S&P 500 Financials Index dropped as much as 16 percent this month on concern that subprime-linked losses will sap profit growth. The gauge on Nov. 26 traded at 10.6 times earnings, the lowest since at least 1995, data compiled by Bloomberg show… Citigroup, the biggest U.S. bank, fell 38 percent from Oct. 12 to Nov. 26 and is the second-worst performer in the KBW Bank Index this quarter after Washington Mutual Inc… Freddie Mac and Fannie Mae, the biggest providers of money for U.S. home loans, were two of the three biggest gainers in the S&P 500 after Freddie Mac after the market closed yesterday said it plans to sell $6 billion in preferred stock and cut its dividend in half to shore up capital depleted by record mortgage defaults and foreclosures. Freddie Mac gained $4.72, or 18 percent, to $30.45. Fannie Mae rose $3.80, or 13 percent, its biggest gain since 1987, to
$33.20 after Morgan Stanley said the stock warrants a ``fresh look'' after falling 51 ercent from its peak.”
From Citi: “Relative banks index under performance [versus the broader S&P 500 index] has proceeded the last two recession in the US [in 1990 and 2001, and the same situation appears to be developing now].”
Fundamentals Support Stock Market Decline
From Fortune: “With the S&P down over 10% from its October record high, TV pundits and Wall Street strategists are blaming the most obvious culprits for the sudden reversal of fortune, chiefly the subprime crisis and the looming threat of a recession. But… The real reason is… Put simply, stocks are extremely expensive relative to the daunting risk in owning them. At current prices, earnings can't possibly grow fast enough to give investors the fat returns they covet. There's just one way for equities to get their lustre back -- their prices have to fall substantially so that investors can harvest attractive returns from the modest profit growth that's in the cards… What we're probably witnessing is a massive, irreversible revaluation of stocks based on fundamentals. The repricing machine is now in motion. The smart money says it won't stop, despite feints and lurches, until stocks are a bargain again, a prospect investors haven't seen in years… subprime was the catalyst, not the cause. It wasn't just a crisis that would pass, as the pundits argued, but a flashing red warning that triggered a durable shift in investor psychology. Before the credit crisis, investors took an incredibly blasé attitude toward risk. Yields on junk bonds, corporate debt, and office buildings were at all-time lows. Then subprime struck. Suddenly, investors recognized that the rates on high-risk mortgages didn't come close to reflecting the high probability that homeowners would default on their mortgages. So the prices of subprime paper plummeted. The downward pull on prices spread to all types of fixed income securities, from all types of junk bonds to LBO loans. Now, the fear of risk is spreading to equities with a vengeance. The problem with equities is that the repricing following the bubble of the late 1990s never fully played out. Stocks roared back from their 2001 lows, reaching record levels this fall. The rub is that they were, and still are, extremely expensive. The best way to measure whether stocks are giving you enough juice for the risk you're taking is examining the equity risk premium. This is the ultimate number in corporate finance, what Dartmouth economist Kenneth French calls "the holy grail" of stock investing. Let's run through some simple math. The best measure for the future return on stocks is the earnings yield, the inverse of the price-to-earnings (PE) ratio. Today, the PE, based on trailing 12 month earnings, is around 16. That's not too far above the historic average of 14. Even by that measure, stocks are far from cheap. But the 16 PE isn't the whole story. Earnings are now near a cyclical peak, having jumped more than 60% since 2001. They're now more than 12% of GDP versus an historic average of around 9%. Over long cycles, earnings grow in tandem with GDP. It's likely that they will grow more slowly than national income over the next few years to restore the normal ratio. That prediction makes sense: Many of the factors that led to the earnings explosion are now shifting. Rates for corporate borrowing have increased substantially, companies are being forced to invest far more capital equipment to remain competitive, and labor is demanding a bigger share of the pie. To get a more accurate read on the PE, it's critical to smooth earnings to take out the spikes in the cycle. Yale economist Robert Shiller has developed a profits-smoothing formula that does just. The Shiller model now puts the PE at around 22 or 23, reflecting today's sumptuous earnings. So where does that put the equity risk premium? With a PE of 22, the earnings yield is just 4.5%. So the return investors can expect from equities is 4.5% plus expected inflation of 2.5%, or around 7%. To get the equity risk premium, subtract that expected return from the 10-year treasury rate of 4%. That's the extra lift investors get for choosing the perils of holding stocks over the comfort of owning government bonds. At 3%, the equity risk premium is low by historical standards. The recent decline has helped make it more attractive. But the drop hasn't gone far enough. Over the past 50 years, the risk premium has averaged around 5%. Maybe investors don't need that big a spread today, given the ease of diversifying portfolios and the Fed's ability to smooth economic cycles. So let's say the number is now 4%. To get there, stocks still need to drop an additional 18%. The most dangerous sector is technology… Google's PE now stands at 52. Say you're expecting a 10% a year return from Google (Charts, Fortune 500). Its market cap would have to double to more than $400 billion by 2014. Even if Google kept a stellar PE of 30, it would need to earn $13 billion by then. Today, it earns about $4 billion. So its profits would need to more than quadruple in seven years. It won't happen. For the bulls, the coup de grace is the math -- earnings growth cannot bail out the market. The reason is that what really counts, earnings per share, don't even grow as fast as GDP. That's because companies regularly issue more shares and dilute their current shareholders -- the explosion in stock options is only the most obvious example. Because of the big dilution, earnings per share grow far more slowly than GDP; the best estimate is around 2%, adjusted for inflation. Investors can't get fat returns from profit growth. But they can get good returns from a combination of far higher dividend yields plus modest profit growth. And for dividend yields to rise, prices have to drop. That's the inexorable math we now see playing out.”
Recession Risks Unequally Priced Into Various Markets
From Merrill Lynch: “Our proprietary Libor/yield curve model is flashing 60% recession odds right now, up from 50% a month ago. Other metrics we look at suggest that the risk could be even higher, but even at 60%, very few asset classes or equity sectors are priced for that risk. Financials, especially the banks and brokers seem to have already discounted this scenario, but not the asset managers. Ditto for consumer discretionary (homebuilders especially), save for hotels etc. This by no means suggests that these groups have bottomed or that they necessarily have much in the way of visibility but based on prior peak-to-trough moves around recessionary phases, it can certainly be said that a whole lot of bad news has been priced into these segments of the market. Industrials, tech, materials, and even energy meanwhile, have more discounting to do - remember, the historical record tells is that in recessions, everything goes down: it's a matter of magnitude and timing, but no stone is left unturned (outside of special situations). They could be next in this domino game, even if the epicenter of the problem is in housing, consumer and finance. As for the traditional defensives, it would seem as though telecom has priced in more recession risk than health care or staples. In the aggregate, the stock market is priced 37% of the way towards a recession outcome. That is about the odds the consensus now applies to a recession scenario, but our models suggest at least 60%, so we would be more comfortable if the market was already discounting such a probability. Small caps, however, are priced 60% of the way there already - in line with our Libor/curve model. By the same token, corporate bond spreads have also priced in a 44% chances of recession so there is prospect for more widening going forward. Treasuries have 42% recession risks priced in, which is why we continue to favor them. Commodities barely have a 10% recession risk being discounted right now (though today they are priced more on global than just US risks).”
From Credit Suisse: “The rates markets are currently assigning a 60% and 40% probability to a "recession" versus "financial crisis" outcome.”
Could Sub-Prime Fall-Out Match Japan’s Losses in Early ‘90’s?
From The Financial Times: “Goldman Sachs analysts now think that total losses on US subprime mortgages issued in 2006 and early 2007 will be as high as 22 cents in the dollar… If that projection is bad, however, there is worse. As defaults rise on subprime mortgages, other types of debt, such as on credit cards and in car loans, also begin to face defaults. “Investors are now starting to worry that the subprime crisis will broaden out into other forms of consumer and real estate lending,” notes Goldman Sachs in a recent research report, which estimates that in a worst-case scenario non-subprime losses could eventually rise as high as $445bn. If so, this would imply America could be heading for a total credit hit of $700bn or so – and that is without taking account of any losses that might occur if risky corporate loans turn sour too. This is a dramatically bigger shock than investors expected back in August and much larger than the losses in America’s last banking shock, the savings and loans crisis of the 1980s. The Goldman team’s worst case is not far from the scale of losses produced by Japan’s 1990s banking crisis, where bad loans were estimated at $800bn-$1,000bn. A blow of this scale could take years to absorb. But aside from its size, there is a second feature of the credit crisis now spooking investors: uncertainty about how the credit pain will affect the financial system as a whole. In previous crises, credit losses were usually relatively well contained: in the S&L debacle, for example, bad loans were held by a limited group of US banks, which were well known to regulators. But the feverish financial innovation seen this decade has enabled banks to turn corporate and consumer loans into securities that have then been sold all over the world. Until recently it was presumed that this innovation had made banks stronger than before, because they had passed credit risk on to others. Consequently, regulators and investors tended to presume that the main threats to stability in the modern financial world came not from banks but risk-loving players such as hedge funds. Recent events have, however, turned these assumptions on their head. Although some hedge funds have run into problems, their losses have generally not posed any wider systemic threat. Instead, share prices of the banking groups have slid as it became clear that banks had offloaded less risk from their books as investors and regulators had presumed. Indeed, the interbank market is gripped by fears that more banks could soon tumble into crisis, as they run out of capital with which to write off loans. Sectors that had been widely ignored in recent years because they seemed utterly safe and dull – such as bond insurers, money market funds and structured investment vehicles – are also beset by a loss of confidence. The revelations are making investors fearful about the potential for unexpected chain reactions to develop as complex interlinkages break down in poorly understood corners of the financial world.”
Fundamentals Support High Oil Prices
From CNN: “The Energy Information Administration, the Energy Department's independent statistical and analysis arm, thinks strong demand and limited supply - otherwise knows as "the fundamentals" - is why oil is so pricey. "Our view is that the market is tighter [than last year]," said Doug MacIntyre, senior oil market analyst at EIA. "We don't have the inventories now." MacIntyre said inventories in developed countries - crude oil stored at refineries, or in tanks at ports, pipeline terminals and other locations - went from 150 million barrels above their five-year average at the start of the year to 10 million barrels below the five-year average now. "That's a big difference," he said. "There's less slack in the system than there was a year ago." EIA attributed the decline to OPEC production cuts of about 1.5 million barrels a day beginning at the start of 2007, when inventories were so high and oil prices briefly dipped below $50 a barrel. The cuts came despite continued strong worldwide economic growth, which EIA said caused oil demand to rise by 1.3 million barrels a day over the last year. The agency projects an increase in demand of 1.5 million barrels a day in 2008. "High oil prices are not rationing demand,"… EIA said other factors contributing to a doubling in oil prices over the last year include moderate growth in new supplies from non-OPEC countries, the inability to immediately produce much more oil in OPEC countries, a lack of refining capacity and ongoing geopolitical threats.”
From CNN: “Oil prices fell another $3 Wednesday after a healthier-than-expected U.S. inventory report and speculation OPEC will boost production… Oil prices, biting at the $100 mark for the better part of two weeks, fell by more than $3 a barrel Tuesday on speculation OPEC will boost production and the Federal Reserve will hold interest rates steady. Ministers from the Organization of Petroleum Exporting Countries meet Dec. 5 in Abu Dhabi… Oil prices have jumped about 16 percent in a little over a month. Retail gasoline prices, at first shielded from rising crude prices due to slack demand, have caught up - although they appear to be leveling off. The nationwide average price for a gallon of regular gas is now $3.09, up from $2.75 a month ago… Crude oil is now at or near all-time highs, even when adjusted for inflation. The last time oil was this high was in the early 1980s, when it rose to an inflation-adjusted $93 to $101 a barrel, depending on the inflation calculation used and the oil contract cited. Crude oil prices have surged nearly five-fold since trading below $20 a barrel in 2002. Analysts say surging global demand combined with limited new supply is the main underlying factor. The surge in prices has also attracted lots of speculative investment money, further driving prices higher. The impact speculative investment has on prices is hotly debated. Some analysts note that only a small percentage of contracts are held by speculators - investment banks, hedge funds and others who are not end users of oil. They point to rising growth in developing economies when asked why oil prices are so high and also note these investors can cause the price to fall just as dramatically and quickly when the market turns lower. Others say there is plenty of supply and these investors are pouring money into oil because the commodity is easier to buy on margin than stocks. Margin buying is a risky technique that involves purchasing contracts with borrowed money. These analysts say fundamentals - such as rising demand from India and China - have been known for some time, yet note that crude has fluctuated from below $50 a barrel to near $100 just this year. Either way, world oil supplies are currently stretched. That tight supply and demand situation magnifies the effect that geopolitical tensions have on prices, as there is less spare supply available globally to cover disruptions from places such as Iran, Nigeria and Venezuela.”
MISC
From JP Morgan: “…single-family home sales are down 31% from their September 2006 peak. By way of comparison, single-family home sales fell 33% peak-to-trough between December 1986 and December 1990, during the last major housing adjustment…The median price of single-family homes sold fell 6.3%oya, a record low of this series, which goes back to the late-1960s.”
From Merrill Lynch: “The steady sales rate of single-family homes was at the expense of lower prices, with the median sales price of single-family homes falling 1.4% on the month. This means prices are now down 6.3% YoY and 10.1% from their nearby peak this summer. We expect that as we approach the peak period for adjustable rate mortgage resets, the capitulation will accelerate and we look for home prices to fall another 10% in 2008.”
From LEHC: “Median sales prices can be dramatically impacted by changes in the “mix” of homes – both by size/amenities and by region. Earlier this year, the median existing home sales price had been inflated following the subprime mortgage market meltdown, which had a disproportionately large negative impact on lower-priced homes. This summer there was a “perturbation” in both the alt-A and the jumbo mortgage markets, which in some areas hit higher-end home sales in a big way, helping the median sales price “catch up” to reflect actual declines in home prices. Median sales prices are still not very reliable in gauging actual trends in home prices – especially in markets where overall sales volumes are extremely low – and economists believe that “repeat-transactions indexes” based on purchase transactions of the same properties over time (such as those produced by S&P/Case-Shiller) are better (though lagged and still imperfect) measures of home-price trends.”
Fed Vice-Chairman Kohn Softens Message – Signals Fed More Open to Easing
From JP Morgan: “Up until this morning, Fed rhetoric and market pricing of the Fed had been on a collision course. A speech by Vice-Chair Kohn in NY today helped to defuse that tension by moving the Fed closer to the market. Kohn's speech dismissed the moral hazard argument, made no real mention of inflation, and dwelled extensively on the growth risks from the increased turbulence in financial markets. Unlike recent speeches from other FOMC members, Kohn did not declare that he is already factoring in weak incoming data, nor did he discuss risks being roughly in balance. The policy debate between easing and not easing at the December 11 FOMC meeting will likely be animated, but Kohn's speech today suggest the crucial center of the committee is moving toward a 25bp ease. Kohn began his talk by discussing the moral hazard argument that monetary policy accommodation in times of financial unrest may encourage excessive risk-taking. Kohn's responded to this argument by noting that "we should not hold the economy hostage to teach a small segment of the population a lesson." If policy felt constrained by the moral hazard argument from promoting the macroeconomic goals of monetary policy, then "innocent bystanders" would pay the cost. Kohn then went on to discuss the much more central issue for policy in the current environment -- the effect of financial markets on the real economy. Here, unlike his colleagues, Kohn expressed a sensitivity to the recent re-intensification of problems in the financial markets. The relevant passage read: "the increased turbulence in recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses as well." The last topic Kohn discussed was the stresses in bank funding markets, which he attributed to a variety of factors, including counterparty risk, balance sheet risk, and worries about access to liquidity. Kohn saw year-end issues as being only "partly" to blame, suggesting he may see the problems in inter-bank markets as being a more persistent worry for the central bank. Kohn concluded by summing up his speech as one intended "to highlight some of the issues we will be looking at in financial markets as we weigh the necessity of future actions." Discussing the possibility of "future actions" may not exactly be a promise to ease, but it does re-position the Fed rhetoric to be consistent with that policy choice.”
From Bloomberg: “``The degree of deterioration that has happened over the last couple of weeks is not something that I personally anticipated,'' Kohn said in response to a question following a speech to the Council on Foreign Relations in New York. ``We are going to have to take a look at'' the stress in credit markets ``when we meet in a couple of weeks,'' he said…. Federal funds futures show traders see a 92 percent probability of a quarter-point reduction in the benchmark interest rate to 4.25 percent when the FOMC meets Dec. 11. Odds of a half-point cut rose to 8 percent after Kohn's remarks. ``We need to take account of those market expectations, but not follow them blindly,'' Kohn said in response to a question… Kohn said ``uncertainties'' about the economic outlook are ``unusually high'' now, requiring policy makers to be ``flexible and pragmatic'' in setting policy… He added that a ``broader repricing of risk'' that increases the cost of credit and discourages spending ``would require offsetting policy actions, other things being equal.''… Kohn, 65, is one of the most senior members on the Federal Open Market Committee. He was director of the Monetary Affairs Division and special adviser on monetary policy under former chairman Alan Greenspan… Kohn said labor markets remain strong, which provides an important ``pillar'' for the economy. ``On the other side, the spending data have been maybe a little on the soft side,'' Kohn said. ``There has been a noticeable slowing in the growth of consumption.'' Fed officials forecast prices will rise 1.8 to 2.1 percent next year. Kohn said inflation risks remain a priority for the committee.”
Financial Stocks Rally – Fannie Mae Has Biggest 1-Day Gain Since 1987
From CNN: “U.S. stocks staged the biggest two-day rally in four years, led by financial shares, after Federal Reserve Vice Chairman Donald Kohn reinforced expectations for another interest rate cut. Citigroup Inc., Goldman Sachs Group Inc., Lehman Brothers Holdings Inc. and Morgan Stanley rose more than 6 percent… The S&P 500 Financials Index dropped as much as 16 percent this month on concern that subprime-linked losses will sap profit growth. The gauge on Nov. 26 traded at 10.6 times earnings, the lowest since at least 1995, data compiled by Bloomberg show… Citigroup, the biggest U.S. bank, fell 38 percent from Oct. 12 to Nov. 26 and is the second-worst performer in the KBW Bank Index this quarter after Washington Mutual Inc… Freddie Mac and Fannie Mae, the biggest providers of money for U.S. home loans, were two of the three biggest gainers in the S&P 500 after Freddie Mac after the market closed yesterday said it plans to sell $6 billion in preferred stock and cut its dividend in half to shore up capital depleted by record mortgage defaults and foreclosures. Freddie Mac gained $4.72, or 18 percent, to $30.45. Fannie Mae rose $3.80, or 13 percent, its biggest gain since 1987, to
$33.20 after Morgan Stanley said the stock warrants a ``fresh look'' after falling 51 ercent from its peak.”
From Citi: “Relative banks index under performance [versus the broader S&P 500 index] has proceeded the last two recession in the US [in 1990 and 2001, and the same situation appears to be developing now].”
Fundamentals Support Stock Market Decline
From Fortune: “With the S&P down over 10% from its October record high, TV pundits and Wall Street strategists are blaming the most obvious culprits for the sudden reversal of fortune, chiefly the subprime crisis and the looming threat of a recession. But… The real reason is… Put simply, stocks are extremely expensive relative to the daunting risk in owning them. At current prices, earnings can't possibly grow fast enough to give investors the fat returns they covet. There's just one way for equities to get their lustre back -- their prices have to fall substantially so that investors can harvest attractive returns from the modest profit growth that's in the cards… What we're probably witnessing is a massive, irreversible revaluation of stocks based on fundamentals. The repricing machine is now in motion. The smart money says it won't stop, despite feints and lurches, until stocks are a bargain again, a prospect investors haven't seen in years… subprime was the catalyst, not the cause. It wasn't just a crisis that would pass, as the pundits argued, but a flashing red warning that triggered a durable shift in investor psychology. Before the credit crisis, investors took an incredibly blasé attitude toward risk. Yields on junk bonds, corporate debt, and office buildings were at all-time lows. Then subprime struck. Suddenly, investors recognized that the rates on high-risk mortgages didn't come close to reflecting the high probability that homeowners would default on their mortgages. So the prices of subprime paper plummeted. The downward pull on prices spread to all types of fixed income securities, from all types of junk bonds to LBO loans. Now, the fear of risk is spreading to equities with a vengeance. The problem with equities is that the repricing following the bubble of the late 1990s never fully played out. Stocks roared back from their 2001 lows, reaching record levels this fall. The rub is that they were, and still are, extremely expensive. The best way to measure whether stocks are giving you enough juice for the risk you're taking is examining the equity risk premium. This is the ultimate number in corporate finance, what Dartmouth economist Kenneth French calls "the holy grail" of stock investing. Let's run through some simple math. The best measure for the future return on stocks is the earnings yield, the inverse of the price-to-earnings (PE) ratio. Today, the PE, based on trailing 12 month earnings, is around 16. That's not too far above the historic average of 14. Even by that measure, stocks are far from cheap. But the 16 PE isn't the whole story. Earnings are now near a cyclical peak, having jumped more than 60% since 2001. They're now more than 12% of GDP versus an historic average of around 9%. Over long cycles, earnings grow in tandem with GDP. It's likely that they will grow more slowly than national income over the next few years to restore the normal ratio. That prediction makes sense: Many of the factors that led to the earnings explosion are now shifting. Rates for corporate borrowing have increased substantially, companies are being forced to invest far more capital equipment to remain competitive, and labor is demanding a bigger share of the pie. To get a more accurate read on the PE, it's critical to smooth earnings to take out the spikes in the cycle. Yale economist Robert Shiller has developed a profits-smoothing formula that does just. The Shiller model now puts the PE at around 22 or 23, reflecting today's sumptuous earnings. So where does that put the equity risk premium? With a PE of 22, the earnings yield is just 4.5%. So the return investors can expect from equities is 4.5% plus expected inflation of 2.5%, or around 7%. To get the equity risk premium, subtract that expected return from the 10-year treasury rate of 4%. That's the extra lift investors get for choosing the perils of holding stocks over the comfort of owning government bonds. At 3%, the equity risk premium is low by historical standards. The recent decline has helped make it more attractive. But the drop hasn't gone far enough. Over the past 50 years, the risk premium has averaged around 5%. Maybe investors don't need that big a spread today, given the ease of diversifying portfolios and the Fed's ability to smooth economic cycles. So let's say the number is now 4%. To get there, stocks still need to drop an additional 18%. The most dangerous sector is technology… Google's PE now stands at 52. Say you're expecting a 10% a year return from Google (Charts, Fortune 500). Its market cap would have to double to more than $400 billion by 2014. Even if Google kept a stellar PE of 30, it would need to earn $13 billion by then. Today, it earns about $4 billion. So its profits would need to more than quadruple in seven years. It won't happen. For the bulls, the coup de grace is the math -- earnings growth cannot bail out the market. The reason is that what really counts, earnings per share, don't even grow as fast as GDP. That's because companies regularly issue more shares and dilute their current shareholders -- the explosion in stock options is only the most obvious example. Because of the big dilution, earnings per share grow far more slowly than GDP; the best estimate is around 2%, adjusted for inflation. Investors can't get fat returns from profit growth. But they can get good returns from a combination of far higher dividend yields plus modest profit growth. And for dividend yields to rise, prices have to drop. That's the inexorable math we now see playing out.”
Recession Risks Unequally Priced Into Various Markets
From Merrill Lynch: “Our proprietary Libor/yield curve model is flashing 60% recession odds right now, up from 50% a month ago. Other metrics we look at suggest that the risk could be even higher, but even at 60%, very few asset classes or equity sectors are priced for that risk. Financials, especially the banks and brokers seem to have already discounted this scenario, but not the asset managers. Ditto for consumer discretionary (homebuilders especially), save for hotels etc. This by no means suggests that these groups have bottomed or that they necessarily have much in the way of visibility but based on prior peak-to-trough moves around recessionary phases, it can certainly be said that a whole lot of bad news has been priced into these segments of the market. Industrials, tech, materials, and even energy meanwhile, have more discounting to do - remember, the historical record tells is that in recessions, everything goes down: it's a matter of magnitude and timing, but no stone is left unturned (outside of special situations). They could be next in this domino game, even if the epicenter of the problem is in housing, consumer and finance. As for the traditional defensives, it would seem as though telecom has priced in more recession risk than health care or staples. In the aggregate, the stock market is priced 37% of the way towards a recession outcome. That is about the odds the consensus now applies to a recession scenario, but our models suggest at least 60%, so we would be more comfortable if the market was already discounting such a probability. Small caps, however, are priced 60% of the way there already - in line with our Libor/curve model. By the same token, corporate bond spreads have also priced in a 44% chances of recession so there is prospect for more widening going forward. Treasuries have 42% recession risks priced in, which is why we continue to favor them. Commodities barely have a 10% recession risk being discounted right now (though today they are priced more on global than just US risks).”
From Credit Suisse: “The rates markets are currently assigning a 60% and 40% probability to a "recession" versus "financial crisis" outcome.”
Could Sub-Prime Fall-Out Match Japan’s Losses in Early ‘90’s?
From The Financial Times: “Goldman Sachs analysts now think that total losses on US subprime mortgages issued in 2006 and early 2007 will be as high as 22 cents in the dollar… If that projection is bad, however, there is worse. As defaults rise on subprime mortgages, other types of debt, such as on credit cards and in car loans, also begin to face defaults. “Investors are now starting to worry that the subprime crisis will broaden out into other forms of consumer and real estate lending,” notes Goldman Sachs in a recent research report, which estimates that in a worst-case scenario non-subprime losses could eventually rise as high as $445bn. If so, this would imply America could be heading for a total credit hit of $700bn or so – and that is without taking account of any losses that might occur if risky corporate loans turn sour too. This is a dramatically bigger shock than investors expected back in August and much larger than the losses in America’s last banking shock, the savings and loans crisis of the 1980s. The Goldman team’s worst case is not far from the scale of losses produced by Japan’s 1990s banking crisis, where bad loans were estimated at $800bn-$1,000bn. A blow of this scale could take years to absorb. But aside from its size, there is a second feature of the credit crisis now spooking investors: uncertainty about how the credit pain will affect the financial system as a whole. In previous crises, credit losses were usually relatively well contained: in the S&L debacle, for example, bad loans were held by a limited group of US banks, which were well known to regulators. But the feverish financial innovation seen this decade has enabled banks to turn corporate and consumer loans into securities that have then been sold all over the world. Until recently it was presumed that this innovation had made banks stronger than before, because they had passed credit risk on to others. Consequently, regulators and investors tended to presume that the main threats to stability in the modern financial world came not from banks but risk-loving players such as hedge funds. Recent events have, however, turned these assumptions on their head. Although some hedge funds have run into problems, their losses have generally not posed any wider systemic threat. Instead, share prices of the banking groups have slid as it became clear that banks had offloaded less risk from their books as investors and regulators had presumed. Indeed, the interbank market is gripped by fears that more banks could soon tumble into crisis, as they run out of capital with which to write off loans. Sectors that had been widely ignored in recent years because they seemed utterly safe and dull – such as bond insurers, money market funds and structured investment vehicles – are also beset by a loss of confidence. The revelations are making investors fearful about the potential for unexpected chain reactions to develop as complex interlinkages break down in poorly understood corners of the financial world.”
Fundamentals Support High Oil Prices
From CNN: “The Energy Information Administration, the Energy Department's independent statistical and analysis arm, thinks strong demand and limited supply - otherwise knows as "the fundamentals" - is why oil is so pricey. "Our view is that the market is tighter [than last year]," said Doug MacIntyre, senior oil market analyst at EIA. "We don't have the inventories now." MacIntyre said inventories in developed countries - crude oil stored at refineries, or in tanks at ports, pipeline terminals and other locations - went from 150 million barrels above their five-year average at the start of the year to 10 million barrels below the five-year average now. "That's a big difference," he said. "There's less slack in the system than there was a year ago." EIA attributed the decline to OPEC production cuts of about 1.5 million barrels a day beginning at the start of 2007, when inventories were so high and oil prices briefly dipped below $50 a barrel. The cuts came despite continued strong worldwide economic growth, which EIA said caused oil demand to rise by 1.3 million barrels a day over the last year. The agency projects an increase in demand of 1.5 million barrels a day in 2008. "High oil prices are not rationing demand,"… EIA said other factors contributing to a doubling in oil prices over the last year include moderate growth in new supplies from non-OPEC countries, the inability to immediately produce much more oil in OPEC countries, a lack of refining capacity and ongoing geopolitical threats.”
From CNN: “Oil prices fell another $3 Wednesday after a healthier-than-expected U.S. inventory report and speculation OPEC will boost production… Oil prices, biting at the $100 mark for the better part of two weeks, fell by more than $3 a barrel Tuesday on speculation OPEC will boost production and the Federal Reserve will hold interest rates steady. Ministers from the Organization of Petroleum Exporting Countries meet Dec. 5 in Abu Dhabi… Oil prices have jumped about 16 percent in a little over a month. Retail gasoline prices, at first shielded from rising crude prices due to slack demand, have caught up - although they appear to be leveling off. The nationwide average price for a gallon of regular gas is now $3.09, up from $2.75 a month ago… Crude oil is now at or near all-time highs, even when adjusted for inflation. The last time oil was this high was in the early 1980s, when it rose to an inflation-adjusted $93 to $101 a barrel, depending on the inflation calculation used and the oil contract cited. Crude oil prices have surged nearly five-fold since trading below $20 a barrel in 2002. Analysts say surging global demand combined with limited new supply is the main underlying factor. The surge in prices has also attracted lots of speculative investment money, further driving prices higher. The impact speculative investment has on prices is hotly debated. Some analysts note that only a small percentage of contracts are held by speculators - investment banks, hedge funds and others who are not end users of oil. They point to rising growth in developing economies when asked why oil prices are so high and also note these investors can cause the price to fall just as dramatically and quickly when the market turns lower. Others say there is plenty of supply and these investors are pouring money into oil because the commodity is easier to buy on margin than stocks. Margin buying is a risky technique that involves purchasing contracts with borrowed money. These analysts say fundamentals - such as rising demand from India and China - have been known for some time, yet note that crude has fluctuated from below $50 a barrel to near $100 just this year. Either way, world oil supplies are currently stretched. That tight supply and demand situation magnifies the effect that geopolitical tensions have on prices, as there is less spare supply available globally to cover disruptions from places such as Iran, Nigeria and Venezuela.”
MISC
From The Telegraph: “Forget inflation and the manufacturing figures. Stop looking at the latest existing home sales figures or the data on non-farm payrolls. One of the most accurate indicators of an imminent recession is in and Americans should start tightening their belts. Winnebago, the makers of the famous recreational vehicles so prominent on the highways of the US, is expected to post a decline in sales this year for the first time in six years. Buying a motor home is seen as the ultimate discretionary item, and over the past three decades, declines have always heralded a rapid slowdown in the US economy … Motor home sales have already declined 7.1pc in the first nine months of 2007 year, including a 20pc plunge in September.”
From Business Week: “Some 5,400 Harley-Davidson Inc. workers are out of work this week as the motorcycle maker cuts production because of falling sales… The company cut bike shipments and earnings expectations in September. Shipments were down 10.8 percent to 86,535 units in the most recent three-month period.”
From Handelsbanken: “The Fed’s regional survey of economic activity found that the national economy expanded at a “Reduced Rate”. The glut of available homes on the market was a key factor identified by the report and was credited to a lack of demand as well as to previous over building. Builders remain pessimistic and not expecting a pick up in demand until well into 2008. Mixed reports on manufacturing provided less of an offset to the drag from housing in the latest survey. Consumer spending was reported as generally “downbeat” while an easing in labor markets was identified as dampening wage demands. Prices, outside of those that rely on food and energy, were also seen as stable.”
From Business Week: “Some 5,400 Harley-Davidson Inc. workers are out of work this week as the motorcycle maker cuts production because of falling sales… The company cut bike shipments and earnings expectations in September. Shipments were down 10.8 percent to 86,535 units in the most recent three-month period.”
From Handelsbanken: “The Fed’s regional survey of economic activity found that the national economy expanded at a “Reduced Rate”. The glut of available homes on the market was a key factor identified by the report and was credited to a lack of demand as well as to previous over building. Builders remain pessimistic and not expecting a pick up in demand until well into 2008. Mixed reports on manufacturing provided less of an offset to the drag from housing in the latest survey. Consumer spending was reported as generally “downbeat” while an easing in labor markets was identified as dampening wage demands. Prices, outside of those that rely on food and energy, were also seen as stable.”
End-of-Day Market Update
From JP Morgan: “Financial markets are rallying today. Equities are posting big gains, Treasury prices are weakening, and the dollar is strengthening (as seen in sharp losses in EUR and JPY), as are many fx carry trades. The oil price is down hard for the second day in a row, with nearby WTI trading below $92/bbl.”
From Deutsche Bank: “Having failed to break down through the 5-year uptrend on Tuesday, the S&P500 has taken encouragement and surged 3% at the time of writing. Financial stocks have again led the way, probably continuing to benefit from the Citigroup funding deal announced on Monday night. A sharp decline in the price of crude hasn't hurt the cause. Understandably, the VIX has fallen, credit spreads have narrowed and the carry currencies have caught a further bid.”
From UBS: “Treasuries went into a free fall late this morning, and the 2s30s curve flattened more than 8bps… TIPS took a hit today as energy prices fell, with crude dropping more than $4/barrel intraday. Breakevens narrowed across the board, with January 2009 breakevens in 10bps… Spreads narrowed across the board, particularly in the front end, where 2-year swap spreads were in as much as 10bps intraday. Agencies saw very little flow, but FFCB today announced $2 billion of a new 3-year note. Agencies lagged swaps by 2-3 bps. Mortgages saw solid buying with the Street being caught short, tightening 15 ticks to Treasuries and 12 to swaps at one point.”
From Lehman: “The treasury market got whacked again on Wednesday despite mediocre economic data, as a fairly dovish speech by fed vice-chairman Don Kohn seemed to offer great comfort to risky asset markets, which exploded today. S&P's rallied 45 points on the day, or over 3%, and credit, ABX and mortgages all had great days. Treasuries sold off hard, but tens are only back to where they traded Monday morning before that day's monster rally. As more than a few people pointed out, the ten year performance was not bad given the equity market rally, as one could only imagine what would happen to the bond market on a day that equities fell 3%. Volumes remained high… While that might be counter-intuitive, the front end has generally been pricing a worst-case scenario (just in case you didn't notice the 2.89% 2 year note on Monday) and some relief comes from the knowledge that the fed is sensitive to financial market stress and is on the job.”
Three month T-Bill yield fell 11bp to 3.03%.
Two year T-Note yield rose 10bp to 3.17%
Ten year T-Note yield rose 8bp to 4.03%
Dow rose 331 to 13,289
S&P 500 rose 41 to 1469
Dollar index rose .08 at 75.18
Yen weakened 1.19 to 110.2 per dollar
Euro unchanged at 1.483
Gold fell $7 to $805
Oil fell $2.84 to $91.60
*All prices as of 4:25pm
S&P 500
From JP Morgan: “Financial markets are rallying today. Equities are posting big gains, Treasury prices are weakening, and the dollar is strengthening (as seen in sharp losses in EUR and JPY), as are many fx carry trades. The oil price is down hard for the second day in a row, with nearby WTI trading below $92/bbl.”
From Deutsche Bank: “Having failed to break down through the 5-year uptrend on Tuesday, the S&P500 has taken encouragement and surged 3% at the time of writing. Financial stocks have again led the way, probably continuing to benefit from the Citigroup funding deal announced on Monday night. A sharp decline in the price of crude hasn't hurt the cause. Understandably, the VIX has fallen, credit spreads have narrowed and the carry currencies have caught a further bid.”
From UBS: “Treasuries went into a free fall late this morning, and the 2s30s curve flattened more than 8bps… TIPS took a hit today as energy prices fell, with crude dropping more than $4/barrel intraday. Breakevens narrowed across the board, with January 2009 breakevens in 10bps… Spreads narrowed across the board, particularly in the front end, where 2-year swap spreads were in as much as 10bps intraday. Agencies saw very little flow, but FFCB today announced $2 billion of a new 3-year note. Agencies lagged swaps by 2-3 bps. Mortgages saw solid buying with the Street being caught short, tightening 15 ticks to Treasuries and 12 to swaps at one point.”
From Lehman: “The treasury market got whacked again on Wednesday despite mediocre economic data, as a fairly dovish speech by fed vice-chairman Don Kohn seemed to offer great comfort to risky asset markets, which exploded today. S&P's rallied 45 points on the day, or over 3%, and credit, ABX and mortgages all had great days. Treasuries sold off hard, but tens are only back to where they traded Monday morning before that day's monster rally. As more than a few people pointed out, the ten year performance was not bad given the equity market rally, as one could only imagine what would happen to the bond market on a day that equities fell 3%. Volumes remained high… While that might be counter-intuitive, the front end has generally been pricing a worst-case scenario (just in case you didn't notice the 2.89% 2 year note on Monday) and some relief comes from the knowledge that the fed is sensitive to financial market stress and is on the job.”
Three month T-Bill yield fell 11bp to 3.03%.
Two year T-Note yield rose 10bp to 3.17%
Ten year T-Note yield rose 8bp to 4.03%
Dow rose 331 to 13,289
S&P 500 rose 41 to 1469
Dollar index rose .08 at 75.18
Yen weakened 1.19 to 110.2 per dollar
Euro unchanged at 1.483
Gold fell $7 to $805
Oil fell $2.84 to $91.60
*All prices as of 4:25pm
S&P 500
2 Year Treasury Yield
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