Saturday, July 21, 2007

14,000 We Hardly Knew Ye - Again as Subprime Jumps The Fire Line

The stock market paid some attention to negative events on Friday.

All of the major stock groups in the S&P were down with Capital Goods, Conglomerates and Financials leading the way lower as subprime worries and a few bad earnings reports from Cat and Google got under the skin of investors.

Amazingly, an earnings miss the size of what Caterpillar posted was worthy of not rallying the stock, but pounding it down. Bad news was actually bad news there. Wow, fancy that. Just imagine what CAT's numbers would have looked like if the dollar had not been sliding as it was during the second quarter. But then again, the 'just imagine' line is as bad as saying, 'just imagine how how the stock market would be if financials did crater on subprime news'.

As for Google, investors and speculators got what they deserved, especially the short term specs (don't investors always get what they deserve - good, or bad?). The miss was three cents a share on the bottom line and margins were nominally eroded as the company has been spending more on R&D (hiring droves of developers and engineers). I actually commend the company for doing what it needs to do and that it's not held hostage by having to play the 'beat the guidance-numbers' game. Remember, GOOG is hiring folks who each have the brain power of several Wall Street talking heads combined, or several journalists for that matter. LOL. Big deal the stock fell $28 to $520.12, or just 5%. How many stocks fall 5% on Wall Street each and every day and how many have gone from sub $100 IPO to $500+ in a few years?

Caterpillar and Google were just noise. The real issue is the credit market. The subprime epidemic is spreading into the loans markets and going global. The call back in February that subprime would impact other levels of the debt markets was a no brainer - that's just the way debt markets work and have always worked. It was Bonds 101.. not rocket science... it's realizing there are rules and knowing them... it's knowing just a little history of past credit market blowups... understanding that there is something known as 'risk aversion'... it's known as being aware of the moving parts you're dealing with as an astute investor... it's called not being stupid enough to fall for the 'it's different this time' line, or not being dumb enough to dimiss the subprime meltdown as just another garden variety worry, or doom and gloom scenario that quickly becomes invalid... it known as realizing that the new forms of derivatives tied to debt make for an ever more explosive situation.

RMBS (residential mortgage backed securities), CDO (collateralized debt obligations) were first, now we're seeing trouble in CMBS (commercial mortgage backed securities), and CLOs (collateralized loan obligations), etc. Sorry to again break this to the folks with the pink colored glasses on, but subprime cannot be compartmentalized and IS impacting the overall economy at its core as it is no longer just a subprime issue. Perhaps many of us don't feel the impact of LBO debt re-pricings and widening swap spreads, but that doesn't mean that the world as we have known it, especially since the glory days of 1% Fed Funds from which we all benefitted, isn't changing rapidly.

On the subprime front, The new ABX BBB- 07-2 , which only started trading on Thursday, finished Friday down at 47-cents on the dollar. While the ABX numbers offer the latest fresh evidence of the subprime lending catastrophe (the biggest chunk of the 'fat city' mortgage activity over the last few years) it's becoming an old theme . We know that subprime is on the trash heap along with the national housing market. The KB Homes (KBH) chief said as much on Friday by stating he doesn't expect housing conditions to begin improving in earnest until 2009. Need more evidence that housing is down for the count and not even near a bottom? Just look at what's going on at Beazer Homes (BZH): Beazer Homes expected to take higher impairment charges, CDS spreads continues to widen. Need more evidence: Check out this Florida condo glut story.

The real downward driver for the stock market Friday was the realization that a flight to quality was going on into the safest asset of all - Treasurys, as the subprime contagion has jumped the fire line into the loans market. 10 year yield, lo and behold is now below 5%. Less than two weeks ago it was flirting with 5.25 on worries about growing international rate differentials.

It was one thing to merely have subprime as the sole problem child, but we're going into dimensions not seen in a few decades with the scare over corporate credit. Look no further than LCDX which gauges risk in high yield corporate loans. It slumped to 94.8 on Friday. The iTraxx LevX, the European version of LCDX, also slumped to the 96 level as loan worries have gone global. Credit default swaps anyone?? Fuggedaboudit.... spreads have widened rapidly. The JP Morgan EMBI+ index of emerging market debt index? Down, meaning spreads have widened there too.

It's all an ugly picture as the loan market tightens up. Flight to quality into U.S. treasuries is generally not positive for U.S. stocks so be careful. Let's face it, these credit worries are pretty heady stuff to sweep under the rug. It's not only sent money flow back towards Treasurys, but has also sent the dollar to flirt with the big 8-oh on the dollar index (though thank goodness the latest TIC report is showing money is still flowing back to this country - otherwise where would the dollar be?).

In the coming week, I'm looking to see what kind of merger Monday we're going to have involving LBOs. There were certainly many rumors last week including Macy's, Williams Sonoma, etc). If new deals do materialize that will be a big plus for the stock market.

I'm also looking for KKR to make some headway in solving its Boots problem: UPDATE 2-Boots extends loan deadline, to change terms. I'm also anxious to see what Cerberus has done to get the Chrysler deal closed. LaSorda says it's "very, very close": Chrysler says closing of Cerberus deal very close. Some progress on those two fronts could ease market fears.

It would also be nice to get more clarity on who's going to get stuck 'holding the bag':Citigroup CFO: Sees needing to reprice more LBO loans in 3Q.

As long as the there are no sudden jolts, like an announced LBO unraveling, or another hedge fund meltdown a la Bear Stearns, the Dow could again be revisiting 14k though I think there is going to be a funk early next week. The market been climbing a wall of worry since the Fed stopped lifting rates last year, and really since the 2003 lows. Investors have been conditioned to buy even as the wall of worry has turned into a cliff to be scaled. In an odd sort of way, money that has been exiting very risky areas such as structured credit has blown back to some extent to the stock market which in part is why we have visited 14k twice. Yes, lol, stocks to some look great compared to the structured credit world.
However, if a tiny degree of panic (150 point Dow decline is just 1%) enters the market as it did on Friday due to burgeoning indications of across the board credit squeeze that has broader implications for the economy, there sure is a need for more caution than ever. Investors need to be paying attention for signs of an approaching 'dislocation' event, or to at least be on guard for a potential stock market top IF the credit problems developing now turn into a real credit crunch.

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