Jeff Saut Presents: Subprime Sublime?
While participants should typically be cautious of drawing conclusions from such a low-volume, holiday-interrupted environment, last week's action was impressive.
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.
"We have just about given up on a financial crisis this time because there is so much liquidity around. However, last week has us thinking. Bringing in Jeff Lane underscores the scope of the problems at Bear (Stearns). In addition, both homebuilding stocks and the ABX subprime bond index were hard hit again last week. More homebuilders reported disastrous results. An almost $1 bln hedge fund in London (Caliber Global) closed due to losses on U.S. subprime. There was talk of subprime problems leeching across the entire CDO market. ISI's house price survey is declining at a faster rate and ISI's homebuilding survey declined to a depressing 30:1 last week. And to top it all off, regulators on Friday issued tighter lending standards. And to really top it all off, oil closed above $70." (ISI's Ed Hyman- July 2, 2007)
"Liquidity is a coward, when you need her most she runs away and hides." That old market axiom has clearly stood the test of time. Most recently, the "liquidity cowardess" ran and hid from the subprime complex, causing the ABX-HE.BBB-Subprime Index to lose nearly 50% of its value. Concurrent with that price decline has been a sentiment slide, as reflected in The New York Times, whose reference to the subprime woes has seen a downward verbiage skein that has the glide path of a stone. To wit, "Largely contained," "mostly contained," "reasonably well-contained," "severe but contained." "Contained?" ... Well, maybe on a macro basis, but try telling that to investors in certain subprime-focused investment funds that have seen their principal erode and in some cases evaporate. Indeed, just a few weeks ago the Bear Stearns (BSC) "bombshell" brought the issue home to roost with the implosion of a couple of highly-leveraged subprime hedge funds.
As I understand it, the Bear Stearns High Grade Structured Credit Strategies Enhanced Fund raised some $600 mln nearly a year ago and immediately purchased more than $11 bln of securities (mainly subprime related) while selling short another $4.5 bln, causing one Wall Street wag to lament, "High grade, now there's an oxymoron!"
Plainly, the lackadaisical lending standards by the mortgage crowd just a few years ago are now showing upon Wall Street's proverbial doorstep and have been magnified by the "financial engineering" afforded in the derivative markets. Yet while the housing debacle has stepped to center stage, there is more at work than just housing. Verily, since the beginning of this year I have opined that the fooler in 2007 might just be that the Fed, instead of lowering interest rates, either keeps them the same or actually raises them.
I reiterated that higher rate view in May, when the yield on the 10-year Treasury note broke out above its technical downtrend line that was 10 months in the making and traveled above its April 16 reaction high of 4.78%. Again, at the beginning of June, I noted that January's yield high of 4.9% had been bettered and just a few weeks ago I commented when the June 2006 "yield yelp" high of 5.25% was surpassed. While some may argue that the timeframe I am using is too short, a longer "look" back to 1981's rate-ratchet peak of roughly 16% (see chart) suggests the same thing; higher interest rates are in the offing, barring a severe economic slowdown.
I think that view was reinforced by the recent upward shift in the yield curve that I wrote about in my June 18, 2007 report titled "Curves":
"Whatever the reason, in a little over one month the much discussed inverted yield curve has completely reversed in a classic 'steepening move' that has confirmed a mega-trend reversal in long-term interest rates (read: higher rates)."
Interestingly, the now positively-sloped yield curve has come from a rise in longer-dated bonds rather than a decline in yields on the short-end of the yield spectrum. This is not an unimportant point, for as Ned Davis of Ned Davis Research writes, "... a year after steepening caused by rising long-term rates (rather than falling short-term rates- emphasis mine), the S&P 500 has performed worse than the all-period performance."
Ned's study encompasses roughly 20 years and, from the perspective of common sense, makes sense, for over most of that timeframe "financials" have been the largest sector weighting in the S&P 500. And financials, ladies and gentlemen, tend to underperform in a rising interest rate environment.
Consistent with these thoughts, I continue to underweight the financials, particularly the banking complex (save special situations in the community banks). If forced to make a "financials commitment," I would favor the insurance complex, financials "in drag" like General Electric (GE), which is rated "outperform" by my research correspondent, and select brokerage stocks. The brokerage complex remains interesting because it plays to one of my long-held themes. The said theme is that the 1970s was the decade of the product when the "boomers" got out of college and bought their first house, first car, etc. The 1980s was the decade of the image where we bought the bigger house on the golf course, the Mercedes Benz, etc. The 1990s were experiential as we went to Europe and brought back experiences, not "things." Now, the new millennium is the decade of the relationship, whereby we are looking for relationships with people we can trust, be it a boat mechanic, a lawyer, and especially a financial advisor, as we regrettably inherit the wealth our parents have accumulated.
As for the equity markets, last week's holiday-shortened environment still saw stocks traveling higher. While participants should typically be cautious of drawing conclusions from such a low-volume, holiday-interrupted environment, last week's action was impressive. "Impressive" because stocks rallied despite a rise in the 10-year Treasury yield from 5.03% to 5.19% as the Bank of England raised interest rates for the fifth time this year to a now 5.75% rate. "Impressive" because the D-J Transports gained 2.6% for the three-and-a-half-session trading week despite crude oil's 3% weekly gain to a 10-month high of $72.81. "Impressive" because crude oil continues to trade higher while natural gas continues to trade lower. "Impressive" because private equity firms continued to pay some pretty fancy multiples for public companies. "Impressive" because... well, just plain impressive!
The result left most of the indices I follow higher for the week and I with a short-term "buy signal" on the S&P 500.
Evidently the good folks at the astute Lowry's organization agree, given the fact that their Buying Power Index rose to a new rally high last week while their Selling Pressure Index fell to a 20-month low. Lowry's also points out that its Operating Company Only Advance-Decline Line remains in a long-term uptrend, as well as that a short-term buy signal was triggered on July 2 when the 14-day stochastic indicator rose above its 3-day moving average. Interestingly, the only really cautionary comments Lowry's had were regarding the interest-sensitive stocks (a topic dear to my heart), and the D-J Utility Average (DJUA), about which it notes: "a breakdown in the DJUA below its June low of 485 would tend to confirm a new downtrend for Utilities and could, if it occurs, qualify as one of the initial cracks in the dam for the broad market."
I have been unwaveringly bullish on the utilities since their October 2002 low up until recently. Over that timeframe the lowly utilities have gained some 230% versus the D-J Industrial's 89% gain. Given my underweight-the-financials strategy, I have paired back on the utilities sector rather dramatically over the past seven months. I have used those freed-up monies to invest in another theme, namely companies that "sell" to the utility companies since they are going to have to spend notionally $1 trln over the next 20 years to bring the U.S. electricity complex into the digital age.
The call for this week: Like International Strategy & Investment (ISI)'s Ed Hyman, I too have been expecting some sort of financial crisis. Unlike Ed, I have not just about given up on one. Whether the subprime situation proves to be such a crisis remains to be seen.
What's worth noting, however, is that a financial crisis is overdue, as can been seen in the charts from ISI on the next page. I like the folks at ISI, having read Ed's work for the past 30-plus years; I have found it invaluable in helping me avoid the many pitfalls of investing. I have also owned, and recommend, ISI's mutual funds since they have provided outsized returns on a risk-adjusted basis. A case in point would be the ISI North American Government Bond Fund (NOAMX), which despite a very difficult interest rate environment has returned 6.95% on a trailing 12-month basis. I also like the ISI Strategy Fund (STRTX), which is up 17.27% over that same timeframe. I continue to invest accordingly.
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