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February 13, 2007
Stocks Absorb The Ominous In Stride...For Now
With corporate profit margins threatening to contract after rising for 18 straight quarters, and profit growth likely already having peaked, 2007 is shaping up to be a challenging year for US stocks. To make matters even worse, the rays of sunshine leading into 2007 – falling commodity prices and the expectation of Fed rate cuts – have temporarily vanished, which could potentially isolate the clouds gathering over corporate profits story.
As challenging as the future might seem, stocks have yet to succumb to any serious incident of selling. Rather, investors have, apparently, concluded that the profits picture is not all that bad and/or that growth “should revive in the second half of 2007”.
As for potentially menacing events, they have generally been ignored. For example, last week ‘the two biggest U.S. mortgage lenders to high-risk home buyers warned that costs from delinquent loans were swelling faster than they had expected’ and over the weekend there was enough material written on the potential for a subprime mortgage catastrophe to fill many libraries…and yet for most of yesterday the Dow was stuck inside a 40-point trading range. In short, despite all the headlines foretelling of doom and gloom, the total decline on the S&P 500 since last Wednesday’s high has been a mere 1.1%, or basically unmentionable.
Unshakable Investor Confidence?
The lesson that has been learned since 2003 is that the potential for negative events to spread in the marketplace is not enough to severely impact market prices. To be sure, be it the GM/Ford downgrades, multiple Fed rate hikes, Amaranth (& others), or subprime, whatever the scaring story market participants are not buying into it, at least not for very long.
In other words, it will likely take tangible carnage to spook investors; carnage that negatively impacts economic activity, causes job losses, spawns multiple defaults, etc. Until then weakness in home/mortgage related stocks simply compels capital to rotate into other areas of the marketplace. And yes, in an environment where the S&P 500 has not corrected by 15% in more than 4-years, a 1.1% decline in 3-trading sessions is considered terrible news…
What Will Cause Fear To Return To Equities?
While Kass and others are talking about the potential for a $40+ billion total blow-up, it is important to remember that the subprime market is tiny when contrasted against the many trillions in housing wealth since 2000. Quite frankly, the US consumer was hooked on extracting wealth from their homes for many years and now they are being weaned-off – this is the tangible story worth monitoring going forward, not whether or not a major lender blow-up will spark chaos in the financial markets.
And while the US consumer has withstood a softer housing market well so far, there is reason to believe that the housing market slowdown is only just beginning. For example, assuming no rebound in January, the decline in ‘new houses for sale’ has lasted all of 6-months, while the average correction since 1963 has spanned 37-months.
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The rational individual may ask: But isn’t a decline in ‘houses for sale’ potentially good news? After all, if fewer new homes are on the market wouldn’t the prospect for higher homebuilding margins presents itself and/or the expectation of stable home prices? The answer is yes, but with a mighty big BUT:
Given that new lending schemes allowed once sidelined buyers to become homeowners and investment dollars herded into real estate in 2005-early 2006, there is reason to suspect that the average decline of 37-months could be bested this go round, and declining new homes for sale means only 1-thing: softer price appreciation.
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When you read about the US housing market recovering remember that the housing market strengthened during the last recession and has been booming ever since, and that we are currently only in month 6 of the correction.
In short, rising US home prices are no longer padding the consumers pockets and corporate profit growth is slowing down as margins get crimped for the first time in a long time. Although stock prices continue to walk down pleasant street, these trends are ominous and unlikely to go away quietly.
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