The credit market crisis is unprecedented in recent history and is deeply rooted in the bursting of the speculative U.S. housing market bubble and the ensuing supply glut. The housing crisis and its effects may go from bad to worse before getting better. Nationwide, 635,000 foreclosure filings — default notices, auction sale notices and bank repossessions — were reported on 447,000 properties during the third quarter of 2007, a one-third increase from the previous quarter and a 100% increase from a year ago. Construction of single family homes has slumped to a sixteen year low, which will help ensure that the inventory glut eventually recedes. Still, the number of existing homes for sale is rising, even as the dollar value of homes for sale has declined.
Consequently, the U.S. banking system is also experiencing a period of increased stress as large earnings write-offs heighten concerns of capital adequacy among various lending institutions. The standoff between a slow moving Federal Reserve and the intensifying credit crunch dominates the landscape for the global financial markets. The U.S. central bank has been cautious not to overreact and is easing slowly. In the end, the Fed will do the right thing but the process of reflation seems to be more complex than originally thought. This could mean a very volatile investment environment in the first quarter of 2008.
The long running bull market in equities is not dead yet. The U.S. economy is not falling apart, the dollar has cheapened substantially and bond yields remain low. Most important, equities offer good value and the areas most exposed to the subprime crisis are already attractively priced. All of these will provide underlying support for stock prices beyond three-to-six months. Global bonds are in an overshoot stage and there is very little value in most fixed income markets in the G7 universe. In the meantime, the global yield curve should continue to steepen.
Anticipate cooler economic growth in China, as the authorities have intensified their drive to slow the economy. Slower Chinese growth may precipitate a decline in commodities prices as well as a drop in share prices of material and cyclical companies. In fact, commodity prices and gold have already entered a consolidation phase because of softening global growth, the prospect of a steady to stronger U.S. dollar and very overbought commodity positions. The U.S. dollar may be in an extended bottoming phase; expect more dollar strength early next year. The euro is in retreat and further downside is assumed once there is more weakness in the euro area. The Japanese yen will drift higher because of risk aversion.
Expect mediocre economic performance in 2008, but prepare for the worst. Business owners should reexamine their sales trends during the housing crisis of the 1990s in order to predict what may happen this time around. Typically, in a slow growth economy with relatively low interest rates, companies will buy growth through mergers and acquisitions rather than invest internally. Therefore, expect to see a large number of corporate takeovers in the news as well as resultant employee layoffs.
Michael Ashley Schulman, CFA
Hollencrest Capital Management