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Jeff Saut: Contained?


..."contained" the subprime situation is not; it is perilously close to spilling over into the "real" economy.


Editor's Note: The following article was written by Raymond James Chief Investment Strategist Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

"During the month of June, our portfolio experienced losses, mostly as a result of sharply wider corporate-credit spreads, unaccompanied by any concomitant move in equities, and exacerbated by a marked decline in liquidity. This occurred over a broad range of credit related instruments. In the first two weeks of July, spreads continued to widen and we experienced a loss similar to June. The weakness in corporate credit, particularly focused on loans and loan credit default swaps, accelerated sharply during the week of July 23." -Sowood Capital

I read Sowood Capital Management's letter to its investors last week after losing some 50% of its capital. Rather than attempt to parcel out what was left, the hedge fund decided to sell to Citadel Investment Group, a Chicago-based hedge fund. This is not the first hedge fund to wash up on the shores of the burgeoning subprime iceberg, but it was the most recent. Still, the investment community's intelligentsia chants "the subprime issues are contained."

"Contained?" Try telling that to Sowood's investors. Or how about Bear Stearns (BSC), or the German bank that imploded last week, exposing some $17 bln in subprime debt that it owned, or the Australian bank that announced that two of its hedge funds were down 25% due to subprime investments, or American Home Mortgage (AHM), whose shares traded at $36 in February but now change hands at $0.69 and was virtually forced to close its doors last week, or... well, you get the idea. In all fairness to the economists, they are referring to "contained" with regards to the banking system and I agree, the banking complex is in pretty good shape. But "contained" the subprime situation is not; it is perilously close to spilling over into the "real" economy.

At the most basic spillage level is housing and as scribed by Bloomberg's Kathleen Howley:

"U.S. foreclosures rose 58% in the first half of 2007 from a year earlier, led by California and Florida, as more homeowners fell behind on their monthly mortgage payments. Lenders sent notices of default, scheduled auctions, or repossessions to 573,397 properties in the January to June period... California foreclosures surged 170% to 104,572, the highest in the nation, and Florida gained 77% to 64,250."

Unsurprisingly, such statistics caused Moody's (MCO) to term the so called higher-quality Alt-A mortgages to be no better than subprime loans while stating that it will change how it rates related securities. Clearly, those changes will raise the cost of mortgage money, and raise the credit quality requirements for folks seeking mortgages, at a time when those teaser-rate loans of the last few years are repricing their interest rates at substantially higher levels.

Manifestly, over the past five years the preponderance of mortgage loans were of the "fancy" kind (no-doc, no money down, teaser rates, etc.) that left their owners boasting about creative financing. Said financing allowed participants to take the equity out of their homes, leverage it, and buy second homes, condos, boats, cars, stocks, etc. Unlike when I was a kid, and my generation's parents had "mortgage burning" parties when they paid off their mortgages, the creative-financing coalition leveraged themselves to the hilt. And, as long as housing prices went up it seemed like a perpetual money machine. Now, however, housing prices are falling and it appears the era of financial-engineering is unwinding. How this will play out is anyone's guess, but it seems disingenuous to think there will not be some collateral damage to the economy.

Clearly, the bond market thinks there is a problem given the decline in the 10-year T-note's yield from June's 5.35% into last week's 4.69% and as often stated, "I have always thought the bond crowd is smarter than the stock crowd." And maybe these factors are what's been troubling stocks over the last three weeks.

Indeed, just three weeks ago the S&P 500 (SPX) was testing its March 2000 all-time high at 1553.

Now we are 7.7% below that double-top high and the Street is insisting that the correction is over. While I certainly hope so, I am not so sure.

Speaking to these points, last week in my firm's verbal strategy, I said (as paraphrased):

My day began around 6:00 a.m. yesterday with some conference calls to European accounts. The pace quickened after the markets opened and traded back and forth between plus and minus so many times you had to erect a tollbooth at "go" to make any money. Nevertheless, I told portfolio managers that what I have experienced was a quick collapse from the recent highs that trapped most participants. Last Monday (7/30/07), participants arrived in "all is forgiven mode," staging a rally that lifted the Dow some 93 points. In numerous media appearances, however, I was less sanguine, suggesting that while hopefully the worst had passed, only time would tell if the rally would be anything more than a 1½- to 3-session bounce. Sure enough, after an open upside salvo Tuesday morning, the doleful Dow sank 146 points and in the process took out the previous Friday's lows as panic proliferated.

Said panic pervaded Wednesday morning's pre-open futures as the Dow was indicated another 150 points lower. A strange thing happened, however; after a mixed opening, the Dow gathered itself together and rallied 90 points before peaking and sagging back into the negative netherworld. This time, however, I was not as cautious as during Monday's malaise as I told accounts that various 200-DMAs were being tested and it looked like they were going to hold, at least in the short run. Moreover, the early week action had the earmarks of a selling climax followed by a rally attempt that failed, leading to a downside retest of those climax lows. Importantly, it looked to me as if one of the stock market's most worrisome groups had made a major bottom. This is not an unimportant point, for if one of
the major boogieman groups has bottomed, it takes away at least some of the stock market's downside impetus. The group in question is none other than the homebuilders, as measured by the Housing Index (HGX).

Make no mistake; this is not my real estate team's "call," but mine alone. My bottoming sense comes after years of being bearish on the HGX during its crash, combined with last week's rumors of Beazer Homes' (BZH) bankruptcy, and the attendant downside climactic movement in the HGX. The action left a pretty rare/powerful downside reversal pattern in the candlestick charts around its 170 low, which I would circle as THE low. This does not mean, however, that I am buying the homebuilding stocks, for I still consider them to be "value traps." The point I was making is that if the HGX quits going down, it could be a positive for the overall stock market.

Given the aforementioned facts, I spent most of Wednesday telling accounts that I thought that the SPX was trying to bottom in the 1440-1460 area and was going to attempt to form a tradable low and maybe more. My addendum was, "it had better bottom, for if not my fear is that we could be in one of these 17- to 25-session selling stampedes that are only interrupted by 1½- to 3-session counter-trend pauses/rallies before the selling panic is complete." Does this mean I committed all of my sideline cash on Wednesday? Not really, but I did sell the last of my long Volatility Index (VIX) trading positions and am now waiting to see if the recent lows hold. If those lows are violated, then the odds increase that we are indeed into one of these 17- to 25-session downside skeins and today is only day 10!

Well, it is now Day 12 in the potential 17- to 25-session selling stampede and so far last Wednesday's DJIA low of 13,132 has held despite Friday's Flop. Unfortunately, the SPX broke its respective low on Friday, while the D-J Transports broke their June reaction low of 4994, thus confirming the DJIA's breakdown and therefore rendering a Dow Theory "sell signal." Additionally, we have had three 90% downside days since July 23, which is pretty rare and pretty negative. Plainly, it is "Kiss and Tell" time for the equity markets.

The call for this week: "Contained?" Tell that to the folks that have "pulled" 46 leveraged-finance deals worth $60 bln since the end of June! As for me, I have been defensively postured with a 30% cash position in the investment account (due to rebalancing) and now a 100% cash position in the trading account.

Since the investment account comprises 80% of the overall portfolio, and the trading account 20%, this leaves me with a 44% cash position in the total account. That stance is consistent with my mantra of "volatility presents opportunities for the well-prepared investor." Still, I have been "nicked" by this wicked decline, begging the question, "John Wayne, where are you?!"

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