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Stock Prices Plunge In "The Perfect Storm"

FORECASTS & TRENDS E-LETTER
Gary D. Halbert
August 14, 2007

IN THIS ISSUE:

1.   Stocks Make New Record Highs, Then Plummet

2.   Forget The Cheese, Just Let Me Out Of The Trap!

3.   Unwinding The “Yen Carry Trade”

4.   Fed & Central Banks To The Rescue

5.   So What Next? – BCA’s Latest Analysis

6.   Conclusions – Keep Seatbelts Fastened

Introduction

The last several weeks have been a tumultuous time in the equity markets, both in the US and abroad.  Despite some surprisingly good economic and inflation news, the equity markets have been spooked by the sub-prime mortgage debacle, which has now led to a mini-credit crunch and more hedge fund blow-ups.  As a result, we are now in a liquidity squeeze.

After topping a record 14,000 in mid-July, the Dow Jones plunged to near 13,000 last week.  Likewise, the S&P 500, which hit a new all-time high above 1,550 in July, plummeted to below 1,450 last week.  Hedge funds, institutional players and individual investors have been selling stocks with abandon, especially over the last two weeks.

While the problems with sub-prime mortgages and related loan defaults are large, they are reasonably identifiable in terms of potential size.  The greater problem on Wall Street seems to be that investors don’t know where the next blow-up will be and/or whether the sub-prime debacle will seriously threaten the prime mortgage lenders and the big money center banks.  As a result, investors have been flocking to the sidelines.

Making matters worse, the Japanese yen has continued to be relatively strong so far this month, and that is causing some hedge funds and large investors around the world to unwind their various so-called “yen carry trades.”  It is unknown just how much money is still in these carry trades, but it is believed to be huge and this, too, is adding pressure in both the currency markets and the credit markets.

The combination of the sub-prime and related mortgage dilemma, the credit crunch, plunging equity markets and unwinding of the yen carry trade was referred to by some analysts and traders as “the perfect storm,” in that losses in the last several weeks have been huge for many market participants. 

The liquidity squeeze reached a point last week at which the Fed and central banks around the world stepped in and injected massive amounts of liquidity into the system to stave off what looked to be a potential financial market meltdown.  It remains to be seen if this large liquidity infusion will be enough for the credit markets to relax and stabilize, or if the central banks will have to inject even more credit into the system, or lower interest rates.

The big question, of course, is whether the latest plunge in the equity markets is just the much- anticipated “correction” we have been looking for, or whether the credit crunch continues and sends equities into a bear market.  BCA continues to believe it’s the former and not the latter.  I will share BCA’s latest thinking with you below.

Stocks Make New Record Highs, Then Plummet

Over the last six weeks, we’ve seen yet another gut-wrenching roller coaster in the equity markets.  Following a brief setback in late June, the DJIA soared to a new milestone at 14,000 in mid-July.  More importantly, the much broader S&P 500 Index finally managed to reach a new all-time high above 1,550.  Investors, traders and market analysts were jubilant.  

S&P 500 Chart (Daily)

But in the last full week of July, stocks got hammered with the Dow and the S&P 500 losing over 4% in just one week.  This weakness came despite some of the best economic news we’ve seen all year.  2Q Gross Domestic Product surged by 3.4% (annual rate), well above most pre-report estimates.  And the inflation figures in that same GDP report indicated that core inflation was finally down to near the Fed’s supposed comfort zone.  Analysts agreed this meant no more interest rate hikes.

Good news of this magnitude should have sent stocks soaring – it didn’t.  In fact, just the opposite occurred.  Stocks have continued to fall.  As we all know now, the latest plunge in stock prices is primarily due to the continuing sub-prime and related mortgage debacle which has resulted in a credit crunch.  Institutional players, hedge funds of many sizes and shapes, and even individual investors were selling with abandon last week, and it remains to be seen how long this lasts.

The S&P 500 and the Dow have now fallen into an area where there should be good intermediate support based on technical analysis.  My best guess is that the major equity markets will stabilize over the next week or so – assuming this is just a correction as I have suggested over the last several weeks.  But of course there is always the chance the markets could blow out intermediate support levels and test the long-term support levels.  I tend to doubt this for reasons I will outline below, but here is the long-term chart of the S&P 500, which puts the latest sell-off in perspective (ie – it hasn’t been all that bad).

S&P 500 Chart (Monthly)

Forget The Cheese, Just Let Me Out Of The Trap!

The near-panic selling of equities we’ve seen over the last few weeks is interesting on at least a couple of levels.  First, we all have learned about the sub-prime mortgage problem over the last 3-6 months.  It has not been a secret, it’s been out in the open, thanks to the talking head financial shows that have gone on and on with the sub-prime woes, and even the mainstream media.  No one should have been surprised.

Second, there is a broad and fairly well agreed upon range of estimates regarding the potential size of the sub-prime and related mortgage losses, at least as I read the tea leaves.  Most credible estimates put the potential sub-prime and related mortgage losses in the $50-$100 billion range.  Granted, this is a big number, but considering how vast the number of players is, this is not a number – by itself – that is going to tank the US economy or sink the large money center banks (sorry gloom-and-doom crowd).

So, if we have some fairly reasonable estimates regarding how bad the losses may be, then why is there such panic selling?  It may be fair to assume that market players, both large and small and in between, don’t trust the estimates.  But even if the estimates were twice as big, we are not likely looking at a financial crisis that would send the economy into a deep recession or worse.

The problem as I see it is that investors across the spectrum are tired of surprises.  They don’t know who might be next on the list to fail or have serious problems.  A couple of Bear Stearns hedge funds blew up as I reported in my July 31 E-Letter.  Of late we hear that some Goldman Sachs hedge funds may be in trouble.  On Monday morning, Goldman announced it was injecting some $2 billion of its own capital into the struggling “quantitative” hedge funds it operates, along with another billion or so from several wealthy private investors.  Yesterday morning (Monday), a spokesman for Goldman had the following to say about recent market conditions:

“Many funds employing quantitative strategies are currently under pressure as recent conditions have resulted in significant market dislocation. Across most sectors, there has been an increase in overlapping trades, a surge in volatility and an increase in correlations. These factors have combined to challenge many of the trading algorithms used in quantitative strategies. We believe the current values that the market is assigning to the assets underlying various funds represent a discount that is not supported by the fundamentals.”

The last few weeks have been a rough time for many hedge funds and futures funds as several markets that have been historically uncorrelated moved up and down in tandem.  Even many well diversified portfolios took a big hit.

Last week, we learned that one of France’s largest money center banks, BNP Paribus, froze withdrawals from three of its large hedge funds with (apparently) significant exposure to the US sub-prime mortgage markets.  So the sub-prime contagion has spread beyond our borders, but it is hardly a worldwide catastrophe that is going to shut down the global economic boom, or doom the equity markets to a prolonged bear market, in my opinion.

Nevertheless, many investors are just saying, Forget the cheese, just let me out of the trap.  I’m scared, so I will just take my remaining marbles and go home (sidelines).

Unwinding The “Yen Carry Trade”

At the risk of oversimplifying, the so-called yen carry trade is a transaction where investors borrow Japanese yen at a very depressed interest rate (as low as 0% in some cases), and then use those yen to purchase their investment of choice. Again oversimplifying, as an example, one can borrow yen at around 0.5%, convert the yen to dollars and purchase US Treasuries which currently pay around 5% for a nice return.  Sophisticated investors and hedge funds have been doing this for a number of years to finance any number of types of investments.

But the yen carry trade has always had an obvious component of risk (as is true in all currency plays).  The risk has been that the yen might go up, in which case one could be faced with converting back to the yen at an adverse price to unwind the trade.  While the yen has been relatively low for a very long time, the price recently turned unexpectedly higher.

Japanese Yen Chart (Daily)

In the bigger picture, the latest rise in the yen is not particularly significant.  As you can see from the longer-term yen chart below, the latest rally is hardly anything to get worked up about.  The yen is still cheap relative to most major currencies.

Japanese Yen Chart (Daily)

But when you consider everything else that is happening today – the sub-prime meltdown, the credit squeeze, the plunge in equities, etc. – a small jump in the yen has led to a flight to unwind the yen carry trade.  In this case, an oversimplification might be: Forget the cheese, this might be another trap.  Better get to the sidelines.

Why is this important?  Who cares really if a lot of fat cats and hedge funds are scared out of their yen carry trades?  The reason it is important is simply that it takes more liquidity out of the system at a time when the sub-prime debacle is causing widespread heartburn in the financial and equity markets.

Fed & Central Banks To The Rescue

The Fed Open Market Committee met on August 7 when the sub-prime woes were widespread, and many market analysts and investors alike were hoping the Fed might elect to drop short-term interest rates.  They didn’t.  The Fed Funds rate was left unchanged at 5.25% where it has been for over a year.

In the policy statement that accompanied the August FOMC announcement of no change, the Fed vaguely referred to the increased concerns in the credit markets, but continued the company line that inflation is still their main concern.  That was on Tuesday of last week, and the credit markets were roundly disappointed that the Fed did not directly address the sub-prime debacle in its policy statement.  Stocks sold off even more.

But by Thursday of last week, the Fed and other central banks around the world reacted vigorously to the increasing problems in the US credit markets and abroad.  The US Fed injected $62 billion in new reserves into the US credit system on Thursday and Friday of last week. The European Central Bank injected a whopping $213+ billion into its credit markets on Thursday and Friday of last week.  Other central banks around the world chipped in as well to relieve credit market liquidity concerns.

This was very welcome news in the US and in markets around the world.  It remains to be seen if more liquidity injections are required – they may well be, depending on the latest developments in the sub-prime and related mortgage sectors.  There are widespread calls for the Fed to take the next step and cut interest rates, which the Fed is reluctant to do just because of the sub-prime dilemma.  The next few weeks will be interesting to watch.

So What Next? – BCA’s Latest Analysis

At this point, we clearly have more questions than answers regarding what lies next.  Does the sub-prime mortgage debacle worsen and send the US into a full-fledged credit crisis?  Are the equity markets headed into a bear market, or is this just the correction we’ve been predicting?  Could all of this cause US consumers to rein-in spending dramatically and send us into the next recession?

I could go on with such questions, but as usual, perhaps we would be best served to consider the latest analysis from BCA.  For many years, I have summarized BCA’s analysis and recommendations from time to time in my monthly newsletters and more recently in these weekly E-Letters.  Here is a summary of their latest analysis over the last two weeks.

BCA continues to feel that the most likely scenario – even in light of the latest sub-prime meltdown – is that:

1) The US economy will continue to grow, albeit at a disappointing pace, over the next couple of quarters, with a modest rebound in 2008;

2) The US equity markets will continue to move at least modestly higher over the next year, and that the current setback is merely the correction that has been long overdue; and

3) The sub-prime and related mortgage debacle will not manifest into a serious, widespread credit crunch that threatens the major banks or sparks a recession.

This advice is consistent with BCA’s views in recent years, despite the latest developments in the housing downturn and the resultant problems in the sub-prime mortgage space and the problems in the credit markets.  This might sound naïve to some readers, but here are some selected quotes from BCA’s analyses over the last couple of weeks.

“Inflation concerns within the Fed will take a back seat if the financial system looks to be at risk.  If recent liquidity injections do not restore orderly markets, then, the next step is to rate cuts.  We think that, as in the 1998 [Russia/Long-Term Capital] episode, rate cuts would work quickly to restore order to financial markets because global growth is solid and balance sheets are in good shape on the whole.”

“Having anticipated a correction for some time, it is important not to join the now rapidly increasing bearish herd. Rather, one should be looking in the other direction. In the silver lining camp, some of the prior excesses have been eliminated/reduced. The market is becoming oversold and many technical indicators are signaling that the bulk of the correction has already occurred.”

“The revelation of more bad news will continue to keep investors on edge. Risks will be thoroughly reassessed and repriced, and the process will be both emotional and debilitating.  Nevertheless, we do not believe the recent market actions signal the beginning of a bear market, as the world economy has too much forward momentum for a bear market in stocks to take hold.”

“In sum, business conditions are healthier than the recent downdraft in the financial markets would lead many to believe.  The broad market is likely to stay in a volatile bottoming process, and the next upleg in share prices should unfold by yearend, albeit with a narrower list of leaders.”

While the editors at BCA certainly understand the seriousness of the sub-prime and related credit problems, they feel that the Fed and foreign central banks will do whatever is required – including lowering rates if necessary – to keep liquidity in the credit markets.  And they believe US equities will be higher by the end of the year.

Conclusions – Keep Seat Belts Fastened

As investors, we should keep a close eye on the developments, not only in the equity markets, but also the credit markets.  While the most likely scenario is that we slug our way through the current credit crunch, just as we did in 1998 with the Russia/Long Term Capital blow-up, there is a chance that investors will panic and drive the equity markets considerably lower. 

Clearly, the Fed is on top of the situation, what with the huge injection of reserves last week, as are most of the major foreign central banks.  This is Fed chairman Bernanke’s first real challenge, and we can bet that he does not want to see a financial crisis this early in his tenure.  Look for the Fed to take the next step and drop interest rates if there is any hint that the credit markets are seizing up.

As I have been saying over the last several months, expect market volatility to remain very high in both directions, especially as the sub-prime and related mortgage problems play out.  Unfortunately, this is not an environment that is comfortable for most investors.

The latest market turmoil is yet another example of why I have the bulk of my own money with professional money managers that use “active management strategies” that can hedge positions and/or move to the safety of cash should market conditions so warrant.

For more information on the equity managers I recommend, call us at 800-348-3601 or visit my website at www.halbertwealth.com.

Wishing you profits,

Gary D. Halbert

SPECIAL ARTICLES

Why the sub-prime scare is overblown, by Ben Stein (must read)
http://www.nytimes.com/2007/08/12/business/yourmoney/12every.html?_r=2&ref=business&oref=slogin&oref=slogin

The Pain, And Gain, of the Subprime Meltdown
http://www.washingtonpost.com/wp-dyn/content/article/2007/08/12/AR2007081200815.html

Jim Cramer’s latest tirade (the paper version)
http://nymag.com/news/businessfinance/bottomline/35813/

Rally in Japanese Yen Spooks Global Markets
http://usmarket.seekingalpha.com/article/42613


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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