It ain't over 'til its over -- and it ain't over.
Last week, the market rallied out of the abyss as it has on so many occasions over the past 12 months, as neither rain, snow nor structured finance seems capable of keeping Mr. Market in the doghouse -- and me off of the cold linoleum floor, drinking cheap tequila.
Everybody, it seems, is getting fat in this market, except for Papa Kass.
Later in this article: three reasons we're in for tough sledding. But first, was the financials' rally all it was cracked up to be?
As recently as Thursday, I suggested that an oversold bounce could be in the offing in financials, and bounce they did after
stellar results that evening, speculation that
Stanley O'Neal was about to be fired (which proved correct), after
"upbeat" forecast (which I don't believe for a minute), and probably on the basis of a growing view that the worst of the mortgage writedowns is behind for the financials.
I suspect the short-term rally is not yet over in the money-center banks, as they are still quite oversold; that it is about over for brokerage stocks (
an excellent summary on the group over the weekend); and that some of the specialty finance companies, such as private mortgage insurers and mortgage originators, have already had most (if not all) of their "fun in the sun" during last week's dead-cat bounce.
Looking beyond the very short term of the days and weeks ahead, I could not be more bearish on the financial sector, for many of the reasons I have dwelled on in the past. The "revolution" in financial engineering over the last decade brought with it abnormally profitable credit creation and debt accumulation cycles and gave financial institutions unprecedented prosperity.
In turn, it is now producing abnormal writeoffs (and losses) and will, over the upcoming year, provide a normalization back toward the historical credit loss experiences of the past -- this occurring at a time during which the business cycle has matured and intermediaries' loss provisions are at historically low levels.
The prosperity -- for the financial institutions that packaged credit products, for the partners/shareholders of those firms and for the investors that benefited by the synchronized bull markets in almost every asset category -- was at first threatened and is now likely over. And, importantly, future profit streams will be squeezed.
Many will disagree with this notion and will cite the current strength in world markets. They will further argue, as they did during the advanced stages of the housing boom from 2004 to 2005, that demographic considerations herald a long boom or new paradigm for financial products and markets.
Unfortunately, favorable demographic trends could not offset the bursting of the housing bubble, nor will they offset the ramifications of the debt/credit excesses of the last decade. An abrupt swing from plentiful credit (and the creativity of securitizations) to reduced credit availability (and little interest in credit packaging) raises the likelihood of more frequent and larger financial accidents/crises. That swing also raises the chances for markedly reduced bank and brokerage profits, which lie ahead in a period of lumpy and uneven world economic growth.
I have always believed the credit markets regularly hold more economic truth than the equity markets; this might be particularly true these days when trigger-happy hedge fund managers with large carried interests in their funds worship at the altar of momentum in up-and-down markets.
This leads to daily, weekly and even monthly distortions in share prices -- a subject I
a week ago.
In support of this view, I offer the following three observations.
- 1. The generally lower-trending yields in the bond market -- the yield on the 10-year U.S. note is under 4.30% -- seem to be foretelling an economic slowdown and, possibly, a sharp deceleration or contraction in corporate profits in 2008. And the continued ramp in the price of crude oil continues apace (up another dollar this morning) and will likely serve to dampen personal consumption expenditures and pressure corporate profit margins (as input costs increase) on the outset of a "winter of our discontent."
2. As a byproduct of the mortgage mess, the
Financial Times and Challenger Gray & Christmas report that over 140,000 financial-services jobs have been lost in this down cycle. The protracted housing downturn will exacerbate the weakening job picture and points toward disappointing domestic economic growth in early 2008.
3. Even more important, my continued concerns regarding more subprime fallout are based on the substantive and
hellacious price action of the ABX BBB- subprime and the AAA-rated mortgage indices -- the sector that much of the Merrill Lynch writedown encompassed -- which continued their schmeissing through Friday's close.
For some perspective, the ABX BBB- Index now trades at around 20; it started the year above 95. More surprising, from both price depreciation and from the standpoint of being ignored by market participants, has been the decimation in the top-rated, credit-enhanced and well-protected ABX AAA Index, declining from around 95 to 85.
As a result, I am confident that not only does Merrill Lynch have more writedowns to come in the current quarter but that a number of other financial institutions, such as
American International Group (AIG) - Get Report and the money-center banks, have not faced up to the credit music. We shouldn't lose sight that September and October saw steady price degradation in mortgage product pricing, and I stand on my statement that AIG will report a writedown in excess of Merrill Lynch's $8 billion third-quarter 2007 loss, despite
CNBC refuting the story.
Finally, where I disagree most measurably with stock market bulls is that I still hold to the view, which the equity market roundly rejected last week, that the scope (and likely duration) of
housing's depression can not be "ring-fenced"
and that, in the fullness of time, a consumer-led slowdown is inevitable.
Chairman Ben Bernanke acts more and more like former Fed Chairman Arthur Burns (who was pushed around by President Nixon prior to the 1972 election) than former Fed Chairman Paul Volcker. I believe strongly that little positive can be accomplished to reverse either the housing slide or to remedy the status of the bad mortgage paper outstanding by the Federal Reserve when it again cuts interest rates on Wednesday.
There could, however, be adverse, unintended consequences in the form of higher commodity and energy prices and a lower U.S. dollar.
Although the interest rate reductions will actually hurt the average consumer, it will provide relief to overlevered speculators by reducing their cost of capital. And that will likely serve to alienate the U.S. electorate and could serve to move voters toward the Democratic party and its view of populism and, in the fullness of time, higher corporate and individual tax rates.
At time of publication, Kass and/or his funds were short CFC, although holdings can change at any time.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.