Saturday, August 11, 2007
I'm not convinced that the stock market is going to go south en masse in a drastic way. I do expect a pretty strong redistribution of values. What I am wondering about is these big funds. For one thing, I suspect some have commercial short-term debt tucked away in money market funds, etc. I wouldn't want to be holding it. For another, Lord only knows what the real valuations of some of these ABS (Asset Backed Securities) are
Look, I calculate this stuff all the time, and I'm good at it. But right now I would be hesitate to value paper, because the likely fate of many adjustable mortgages depends on two things:
1) What FNMA does. I can't believe they won't tighten by dumping some of their risk-layered products, and they do have them. If they cut back, the ability to refi is cut back. They have already raised their rates for the riskiest mortgages signficantly, and it is pushing a lot of would-be buyers out of the market temporarily.
2) Where rates go. Average rates as reported by HSH moved to almost exactly where I calculated they needed to be a while ago. I expect some moves to continue. The jumbo mortgages are adjusting upward, but in many areas a rational, risk-based pricing would dictate that. Overall mortgage rates have not yet been impacted by the events of the last few days.
As for defaults, if a person has a non-resetting mortgage and has been paying on it for a few years, that person's risk of of default is not that high, but then you have to adjust for the possibility that a person loses so much money in the home from property devaluation that the person will walk away from it. This is already happening in some markets.
As for loss severity (how much is lost per defaulted mortgage), in this environment average loss severities are doomed to rise for all classes of mortgages, including PRIME CONFORMING pooled on a national basis. We are overbuilt and those who have to sell must cut pricing to move the home in a majority of markets. That fact alone tells me that housing prices will continue to go downward on average even if interest rates don't rise any more. But since loss severities are doomed to increase, in a rational pricing environment interest rates would have to rise somewhat; ergo, interest rates will continue to go up somewhat more.
When you offer rates on mortgages, you know that a certain proportion of them will default. You try to calculate the expected losses (loss severity) from defaults (percentage of defaults), and then compensate for those losses by raising your rate to cover those losses (plus a little) to get the final rates you will offer borrowers. The base rate is dictated by the yield investors are willing to accept. Since investors are nervous, offering rates will have to go up somewhat, because an investor now believes that there is some risk of loss and so must have a higher yield to compensate. Since loss severities will be higher, rates must tend to rise on average.
The one countervailing rate factor is that T-Bill yields are moving lower, but I believe that the heightened risk environment is producing the rise in Treasury pricing (yield is inverse to price). Therefore I would calculate the drop in yields to produce 1/2 - 1/3rd of the normal drop in rates. At this point, additional risk expectations should overwhelm the effect of lower T-Bill yields.
As for stocks:
Howard at Oraculations wrote about the perils of black-box investment models and buying stocks held mostly institutionally. But in general, if you have a good stock with strong management that has not been loading up with debt, I would hold that stock. Even if stock prices go down, over a few years you are likely to make a good gain on the stock, because it probably will grow its business in a difficult environment whereas weaker competitors will lose.
So how do you know the stock is a good one? There is no substitute for reading financials for stocks you buy or hold. None. If you are not willing to do this, you probably will be better off having a professional manage your money, with the proviso that you still must check their logic.
The stock market is a place to invest for long term gains. At any given time, stock prices could be up or down. What matters is not the stock's price today, but the long term performance of the stock. So if you like a company, pay attention to what the company is doing, and see the stock falling because of causes that do not seem intrinsic to its basic business or its management, a period of falling stock prices is the time to buy more. No guts, no glory, but do your homework. This is one reason for selling out before the top - then you have more money to buy later when things go down. Over decades this maximizes your returns.
Risk factors for companies (and thus their stock):
1) High debt in relation to cash flow. Believe it or not, debtors expect to be paid in real money. Real money comes from income or sale of assets. If the company has to sell off pieces of itself to pay down their debt on a more or less consistent basis, they are eroding the fundamental value of their business and thus your stock.
2) Been doing stupid things like buying back their stock with borrowed money while their overall cash flow/profits go south. Sell, sell, sell, almost always.
3) The company doesn't seem to make any actual money from anything but arbitrage. Think Tyco and Enron. Yuck. Bad cash flow plus great capital gains plus high debt is often a sell signal. Like Howard says, if you don't understand it, stay away from it.
4) EPS (earnings per share) goes up, but overall profits/cash flow go down and the company is buying back their stock. For this one, if the company is low-debt and decent cash flow, you can discount it. But otherwise, they are playing dingbat games to get dingbats to buy their stock.
Risk factors should make you spend more time reading a company's financials to figure out what is going on. Then you make your buy/sell/hold decision. Sometimes management is actually making a prudent move and has a decent rationale for what they are doing. Sometimes they explain this in calls, and if it makes sense to you, go with it.
Most people do have some acquaintance somewhere who knows something about the particular business the company is in. Ask your buddies about the basic business environment. Remember - if a company is doing pretty well and has good cash flow and profit when entering or in the middle of a down business cycle, buying it then can make you good returns later. On the other hand, if the company is not doing so well at the top of a business cycle, what do you think is going to happen when the business environment worsens?
California is following the Florida recipe. For July CA sales tax revenues to be 3.4% LESS than last year is going to be a disaster. Govt hiring was the #2 creator of new jobs last year in CA.
I think that Monday is going to show July consumer sales to be much worse than people expect. Just think what will happen when we get a little job destruction, as I am sure this "crisis" is not going to help consumer confidence. When real consumer spending declines YoY, we typically see the recession right on the heels of it.
FOR IMMEDIATE RELEASE: CONTACT: HALLYE JORDAN
AUGUST 10, 2007 916-445-2636
Controller Releases July Cash Flow Figures
SACRAMENTO – State Controller John Chiang today released his monthly report detailing California’s cash balance, receipts and disbursements for July, the start of the 2007-08 fiscal year. The Statement of General Fund Cash Receipts and Disbursements showed total tax receipts were $787 million below (-16%) the Governor’s revised budget estimate issued in May, but were $132 million (3.3%) higher than tax revenues received in July 2006.
“Much of the July tax revenue shortfall appears to be due to disappointing sales tax revenues,” Chiang said. “However, next month’s cash flow figures should provide a clearer picture since quarterly sales taxes due July 31 often aren’t recorded in the General Fund until August.”
In July, sales tax revenues fell $465 million below (-34.2%) the Governor’s May Revise, and were $34 million below (-3.5%) sales tax revenues for July 2006. Personal income taxes were $165 million below (-5.5%) the May Revise estimate, but were $230 million above (8.8%) those received in July 2006. Corporate taxes were $4 million below (-1.2%) the May Revise estimate for the month, and $9 million below (-3.1) July 2006.
We are in a recession, no doubt about it. We've lost too much forward impetus to recover.
The political implications are worrisome, but strictly from a market standpoint this should provide some support for equities as the SW funds become large enough to matter. (On the other hand, SW investments will reduce cash available for purchases of US Treasury debt, which should raise rates and eventually probably have a *negative* effect on equity prices)
I'm guessing that China, in particular, will be interested in companies which are either (a)natural resource players, or (b)offer distribution channels for the sale of Chinese products in other countris
Effective interest rates are going to rise, because we are seeing a return of risk-based pricing.
Still, people have to put their money somewhere. The stock market isn't going to have the forward momentum it did, but I cannot see it collapsing broadly. I do expect some losses on indexes.
I had expected the awareness of the coming return of risk to lower stock prices earlier this year. The stock of some companies is going to continue to be badly hit, because of rational considerations. But still, much less money is going into RE. That money HAS to go somewhere.
If I were a foreign investor with a currency relatively strong in comparison to the US, I would be looking at some of these stocks as a potential opportunity. Looking at treasury yields, it's clear to me that many are pricing in a Fed drop in interest rates.
Of course, the wild card is the hedge funds and other over-leveraged funds which have paid no attention to risk. Then there is that absolutely huge "notational value" line item on bank balance sheets. No one knows what those values are now. That brings us back to Howard's point, which is that a stock heavily owned by institutions may well have its price depressed by a wave of sales to raise cash to cover other losses.
The economy is weak, but the problem in the financial system has to do with over-leveraged and risky investments that can produce a wave of selling which swamps pricing. I hate to put it this way, but if the junk debt instruments are unsaleable, the only thing to do is to sell the producing, stable assets of a fund to raise cash to cover margin calls.
My point is that if a company is strong and has a viable, cash-flowing business, that excess cash can be used to buy in if the prices drop significantly. This has the potential to turn into a decent buying opportunity with excellent long-term returns for an individual stock investor.
I'm not nearly at the point of buying in yet, because I will wait for a few months to see how low this will go. But I see no reason to sell stock in good companies even if I expect it to go down.
I believe that we are in a consumer-led recession now which is only masked by understated inflation. If we're not, I would expect lower spending by companies (domestic investment, etc) to put us there. I still see strong pipeline inflation, so the Fed would be foolish to drop rates.
Global stock markets have recovered some ground from last week's sharp falls after central banks moved to ease fears of a worldwide credit crisis.
European markets rose in morning trade, although the European Central Bank still pumped an extra 48bn euros ($65bn; £32bn) into the banking system.
By early afternoon, London's FTSE 100 was up 145 points to 6,183, while the Germany Dax was up 83 points to 7,426.
Credit concerns have been sparked by weakness in the US mortgage market.
Earlier on Monday, Asian markets saw modest rises, with Japan's main Nikkei index closing up 36 points at 16,800 and the Australian All Ordinaries index ending up 62.3 points at 6,027.5.
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