Credit crisis obliterates Bear Stearns

Through March 31st, S&P 500 declined 9.4% YTD and the NASDAQ declinded 13.9%. 

Stocks looked into the abyss on March 17th.  As is well known, Bear Stearns was driven to the brink of insolvency and was taken over by JP Morgan bank with the help of some powerful guarantees from the Federal Reserve.  Bear Stearns, the 5th largest broker dealer, was the most aggressive prime-broker to hedge funds, not only selling all kinds of exotic securities but also arranging for financing.  As a number of credit hedge funds have had a particularly tough quarter, failing at the rate of nearly one/day, a lot of the collateral ended up back on Bear Stearns' balance sheet.  In a shockingly short period (less than a week,) Bear Stearns found itself unable to borrow funds to finance this inventory.  Counterparties began cutting credit lines and withdrawing assets, and that crisis of trust was the end of the 85 year old firm. 

As news of the takeover broke Sunday afternoon, March 16th, stocks plummeted 6% in Asian markets, 3% in European markets, and opened down 3% in the US on the 17th.  However, reassuring words from the Federal Reserve Bank cut that loss to 1% by day's end and set off a subsequent short-covering rally in financial services (Federal National Mortgage nearly doubled from a low of $18.25 on March 17th to $35.50 on March 20th, which is ridiculous for a mature company with a $30 billion market cap.)  The S&P 500 fell as low as 1257 on the 17th (down 19.7% from last October's record,) but rallied smartly over the last two weeks.  The S&P 500 finished the month down just 0.4%, and the NASDAQ gained 0.4%.  At present, the S&P 500 is off 13.1%, the NASDAQ off 17.4% from the mid-October 2007 highs.

Biggest risks to short-circuit a new rally in stocks

The S&P 500 declined 12.5% over the past two quarters, the worst performance since the second and third quarters of 2002 when the S&P 500 declined 28.3%.  In 2002, earnings of S&P 500 companies collapsed following the bursting of the internet bubble and the mild recession following the 9/11 attacks.  As stocks were overvalued by 110% in January 2000, there was no support for stocks whatsoever.  At present, stocks are undervalued by 30% according to the Fed Model.  Morningstar has a new model for checking fair value.  The data extends back only as far 

as 2000 and is an average of the ratio of Morningstar's estimate of 5000 companies' fair value and their current stock price.  Although, the ratio is not at the extremes of 2002, it does confirm that stocks are cheap right now.

Corporate earnings are hanging in there, with expected growth for Q1 2008 in the range of 5%.  Earnings for financials, reflecting continued write-offs, are expected to plunge 37%.  Excluding financials, S&P 500 earnings should grow in the 8-10% range.  Earnings growth is expected to improve moving further into 2008.  However, that expectation is tempered by the thought that the US is either in or about to enter a recession.

What would convert the slowdown in US growth to a full blown recession would be a substantial decline in US consumer spending (business spending remains strong based on international demand but accounts for only 1/3 of GDP.)  Unemployment rates remain low (currently 4.8% versus the peak of 6.3% in 2003) but could rise.  Home price are down 10.7% year over year, down 12.5% from the July 2006 peak, and back to levels last seen in early 2005.  The biggest worry is that the home foreclosure rate, which has surged to a15 year high of 2% of outstanding loans, continues to surge as mortgages with low "teaser rates" reset to market levels.  The bulk of these mortgages were issued in the last two years.

Although the Federal Reserve has taken a lot of criticism for "allowing" the crisis to develop, in fact the Fed has done a reasonably good job of containing the damage.  No one at the Fed held a gun to management at Citigroup, Merrill Lynch, Bear Stearns and forced them to invest in CDO's.  By luck or skill, management at JP Morgan did not make significant investments in those securities and is now able to take advantage of the situation.  As in the days after the October 1987 stock market crash, or in September 1998 during the Long Term Capital Management Crisis, the Fed has worked flexibly and pro-actively to protect the whole financial system while allowing individual firms to fail "pour encourager les autres."  Bear Stearns was an integral counter-party in the $10 trillion OTC derivatives market - to have that market seize up would do far more damage than the $232 billion written off so far on mortgage backed securities.

What could go right?

After doubling from $55/barrel in January 2007, and quintupling from the November 2001 low of $18/barrel, oil has settled back 9% from the March 14th record of $110/barrel.  Gold has fallen 14% from March 16th's $1033/oz to $880/oz.  Commodities in general are down 9% from recent highs.  The sudden drop reflects a rotation from commodities back to equities, and more importantly reflects strength in the US Dollar, which is up 6.5% against the Japanese Yen, 6.6% against the pound, and is pushing higher against the Euro (by 1.9% compared to last week's record low.)  Lower currencies and a stronger dollar means that the Fed needs to worry less about inflation, and can keep rates at current levels or even lower them further if need be.

While we have little expectations that housing will revisit 2006 levels anytime soon, a couple of reports suggest that the rate at which prices are falling will moderate and perhaps level off by the end of 2008.  We note with interest that the stock price index of the home-builders industry group is UP 24.5% YTD.

Probably the biggest piece of good news is that stocks are way under-owned in the US with Americans pulling $98 billion out of equity mutual funds in January-March 2008 and equity oriented hedge funds holding aside another $65 billion.  US money market funds now total $3.5 trillion versus US stock market capitalization of $24 trillion.  Eventually that cash will make its way back to stocks, boosting prices. 

Strategy

Last month we wrote, "Although the stock market is currently undervalued by at least 25%, we need to see what banks say about their credit losses in April...If losses diminish for the 1st quarter reports coming out in April, we'd feel comfortable that the worst was past.  However, if the losses accelerated in April (a 10% probability we estimate), then there would be no support for the stock market whatsoever."  At this point, Goldman Sachs, Morgan Stanley, and Merrill Lynch have released earnings reports with CDO write-downs that were less than worst case expectations.  Merrill Lynch reports April 17th and is expected to write down $5 billion; Citigroup on April 18th is expected to write down $15 billion.  Lehman stock was pressured last week by rumors that it would follow Bear Stearns into insolvency, but those rumors would put to bed yesterday when Lehman raised $4 billion from a convertible preferred offering. 

We'll probably wait to see the Merrill Lynch and Citigroup earnings reports.  Still, if this week's rally is any indication (S&P 500 up 3.6%, NASDAQ up 4.0%,) this quarter could be very positive for stocks.

                                                                                    Yours sincerely,
                                                                                 

The Heron Capital Management client letter is published immediately following month end and when market conditions require comment. The views expressed in this letter represent HCMI opinion and strategy as of the date published and can change at any time upon receipt of new information. Data quoted in this letter are from sources deemed reliable, but no guarantee of such data is implied.