The stock market has still not come to grips with the chances that the credit turmoil is likely to continue for some time and that the probabilities for a recession are high. Already, the percentage of subprime mortgages that are in default is 16% for those originated in 2005, 12% for 2006 and 8% for the first half of 2007—and these percentages are rising rapidly. Moreover, most of these mortgages have not even been around long enough to reset upward from their original teaser rates.
The big problems are still ahead. Over the next six quarters about $1 trillion of mortgages will be reset to rates that will increase average monthly payments by about $300 a month. About 450,000 households will be facing resets in each of the six quarters. This means an even greater number of defaults that will throw more houses on the market and will result higher inventories and lower prices. It will also significantly increase the amount of toxic mortgages held by various financial institutions resulting in an ever-rising amount of future write-offs. In addition the households still able to make the increased monthly mortgage payments will find themselves with significantly less income to spend on other items, thereby rendering a blow to consumer spending on a macro basis.
We are now far from alone in this negative view of the credit situation. Blackrock CEO Laurence Fink said that announced credit losses at banks and securities firms are $45 billion and will get worse. He stated "Many institutions don’t know what the credit crunch is going to do earnings and their balance sheets." Economist Nouriel Roubini estimated that recognized losses could eventually amount to anywhere from $300-to-$500 billion, meaning that only 10% of the probable losses have so far been recognized. Goldman CEO Lloyd Blankenfein said his firm is still betting that mortgage-backed securities and CDOs will continue to fall, stating that "We continue to be net short on these markets."
Although the economy has not yet fallen off a cliff it is clearly softening. Consumers are facing the aforementioned resets in adjustable mortgage rates, falling housing wealth, tighter credit conditions, stagnant real income, higher oil prices and increasing food prices. Retail sales growth is declining while total 2007 auto sales are likely to be the weakest in ten years. The University of Michigan Consumer Confidence index has dropped from 96 in January to 75 currently. Industrial production growth has declined while business confidence surveys are at a low level, indicating a sluggish outlook for capital expenditures. Employment growth has slowed down significantly even according to the official numbers that have been puffed up by the questionable birth/death adjustment. In our view the chances for recession are high.
Although there is a lot of talk about fear in the market and buying the dip, the market is still a long way from discounting the high probability of recession. The S&P 500 is still slightly up for the year-to-date and down only 8% from the peak. Before or during the last eight recessions the market was down an average of 30% with a range of 16-to-50%. We note too that earnings estimates for 2008 have hardly come down at all. Given the outlook for the economy we think that severe downward earnings revisions are likely in the period ahead. Furthermore the technical condition of the market has also deteriorated in recent months with narrow breadth, less new highs, more new lows, late-day swoons and tepid volume on up days. As for the alleged fear, this week’s Investors’ Intelligence Survey still shows a heavy preponderance of bullishness among market observers. This lack of concern is typical of a troubled market that still has a long way to go on the downside.
