Actually it was a dapper middle aged male with a neatly trimmed beard who spoke. When the Fed chief cut the discount rate Friday morning, the market breathed a sigh of relief.  The implication is that Fed will take additional action, if necessary.  The liquidity crisis will be contained. Earlier last week, the major averages retreated 10% from their July highs (and all-time highs for the DJIA and S&P 500), an “official” market correction.

 

The market may bump along for a while, September and October are typically the worst months of the year for the market (although this was not true in 2006). High volatility will be the norm and the market may well test the lows it reached last week, but there will not be another leg down. We should expect more bad news from hedge funds and other participants in the junk mortgage and securitization markets but the damage will be limited to those players and will not drag down the rest of the market.

 

Corporate earnings, except for financial companies that operate in the effected parts of the credit market, have continued to come through. Morgan Stanley’s current estimate for S&P earnings growth for 2007 and 2008 is 8.6% and 11.6%, respectively. (The consensus is for greater earnings growth in 2008.)

 

Won’t the slowdown in the housing and mortgage markets drag down earnings growth, you ask? Let’s look back at the late 1980s. The S&L industry was shut down due to insolvency brought about by bad real estate loans. Remember the RTC? The damage to the banking system was greater and more direct then, than now. (There is a difference between a hedge fund, and a Federally insured savings institution, becoming insolvent.) The economy grew in the ‘80s, despite the problems in the banking system, and it will continue to grow in 2007 and 2008 as long as the housing market does not materially weaken.

 

The stock market was not overvalued (at least not by much) at its July peak. To be conservative, let’s suppose that the market was fairly value at the beginning of the year (See Earnings Matter). Assuming a constant P/E ratio and Morgan Stanley’s earnings estimates, sometime next year the S&P 500 should reach 1,700 and the Dow should reach 15,000. My caveats to this prediction are to continue watching new jobs creation and retail sales. A downturn in either could be a precursor to a recession and the market will react accordingly.

 

It’s time to rebalance your mutual fund portfolio. Those of you who rebalanced into Treasuries in July are particularly fortunate. Now you should rebalance back into equities.

It’s hard to believe, but the Dow, S&P and NASDAQ all closed up for the week. Friday was a roller coaster day in the markets and, as they gyrated up and down, it was too close to call as to whether the indices would finish the week plus or minus. 

 

The Europeans are taking our credit problems more seriously than are we, witness the downward movements on their stock exchanges and the amount of liquidity the European Central Bank poured into the system. The fact that Europe is effected by our mortgage and securitization problems demonstrates the interconnectivity of world financial markets.

 

The Fed injected funds into the US financial system. (The Fed is acting responsibly, notwithstanding what Jim Cramer says. As much as I respect Jim, the Fed has no obligation to bail out hedge funds or attempt to eliminate – which it couldn’t do anyway – market corrections.) The Fed is essentially providing liquidity to the overnight financing market. These internments, Repos, will rollover again at the beginning of this week. If the market calms and the Fed can withdraw its excess liquidity, then the current stock market correction should be over. If the credit markets remain so illiquid that the Fed has to be the lender of last resort, then the stock market has another 2%-3% decline in store, along with continued high volatility. 

 

Speaking of stores, last week’s retail sales numbers were disappointing, particularly for chains catering to teenagers.  When have you known teenagers to curb their spending? One month’s data doesn’t make a trend, but we should add retail sales to new jobs creation for clues as to whether the economy will keep growing or slip into a recession (and the stock market declines another 10%). 

 

Right now, let’s wait to see what the Fed has to do this week before we declare the correction to have run its course.

Last week was another down week for the stock market, attributed to problems in the subprime sector rippling through the debt market. The jobs report also was a disappointment. The Dow, S&P 500, and NASDAQ are down 5.8%, 7.7% and 7.7%, respectively, from their July peak (all-time highs for the Dow and S&P). These declines exceed the February – March correction and they should because they’re reflecting more serious problems (the Feb. – Mar. adjustment was a reaction to a pullback in the Chinese market).

 

What to expect this week?   More of the same. Subprime is finally getting the attention it deserves (even though the problem has been around for months). The market for securitizations is shaky (and all loans, not just subprime mortgages, are packaged and resold in securitized form). The big question is what will the Fed do when it meets on Tuesday? Answer: leave rates unchanged. This will be a disappointment for some and force others to accept reality – the debt market troubles and jobs report are within the bounds of normal economic variations and the Fed won’t (nor should it try to) react to small bumps in the road. 

 

The market will work its way lower this week approaching a10% decline from its July peak.  This works out to: Dow 12,600, S&P 1,400, NASDAQ 2,450. (10% is the average correction in a bull market, then it starts heading higher.) The question is: will this be a gradual process (i.e., 100 and 200 point down days) or will we have capitulation and a 500 point down day on the Dow and similar declines on the other indices (and a possible overcorrection and buying opportunity)?

 

There are two risks to the bull market correction scenario:  1. Problems in the debt market become worse – more Bear Stearns-type funds go under or the securitization market shuts down.  2. The new job creation index continues to weaken, because of more layoffs in the home building industry. If either of these events occur, we’ll be facing a possible recession and a 20% market decline.

 

The new jobs created/employment question will take weeks to unfold, and the problems in the debt market appear to be contained, so I’m betting on a 10% correction right now.

It was a stormy week in the market.  The correction I’ve long anticipated, and the biggest one week loss since March 2003, materialized but the sky didn’t fall. The chart below puts the week in perspective.

12 month                                19.5%              15.5%              24.7%

Year-to-Date                             6.4%                2.9%                6.1%

Feb. – Mar. correction               -5.6%              -5.6%               -6.9%

From 2007 high                        -5.3%              -6.1%               -5.8%

Last week                                 -4.2%              -4.9%               -4.7%

 

Any investor should be happy with the twelve month returns of the major indices. If we assume the market was undervalued in 2006 and reached fair value at the beginning of 2007, the year-to-date returns on the Dow and the NASDAQ are respectable. Corporate earnings are expected to grow by approximately 5% in 2007 (see Earnings Matter), so the Dow’s and the NASDAQ’s appreciation is marching in step. The S&P is lagging due to its exposure to homebuilders and financial intuitions. (Those of you who own sector funds, note the risk.)

 

Last week’s correction came about because of widening credit spreads and illiquidity in certain parts of the debt market. The Chrysler LBO debt couldn’t be sold, so the banks were forced to hold it, and securitizations, an offshoot of the subprime mortgage problem, were effected. 

 

Significantly, the market’s psychology shifted. All the issues leading up to the correction have been known for months but the market chose to look at the glass as half full (see The Glass is Half Full and Half Empty) until last week.  Strong Q2 GDP growth of 3.4% and low inflation numbers were ignored. So was the strong 6.4% growth in exports - which shows the competitiveness of US companies and the positive impact of a weak dollar. The market took a bearish position, focusing on the residential housing market – weak new home sales and a rising inventory of existing homes on the market – and consumer spending increasing by just 1.3%.

 

Risk abound. There could be a full-blown credit meltdown. (See The Perfect Storm.) The construction industry accounts for 1 out of 10 jobs. Further weakness in the residential market could lead to more layoffs.   The price of oil could hit a record high this week, leading to further weakness in consumer spending. A declining residential market and increasing oil prices could bring on a recession.

 

I don’t think so. At least not right now.   The circuit breakers worked well last week. Treasury rates fell as investors sought safety. The world is awash in dollars which it has to recycle through the US at some point and the global economy is strong, witness the aforementioned overseas sales growth by US companies. (Many of the largest US companies generate 50% or more of their sales overseas, which is one of the reasons why Big Cap stock funds have performed well).  As a last resort, the Fed could step in and cut rates just as it did during the last credit crisis (Russia and Long Term Capital Management), ten years ago.

 

What do I expect for the upcoming week? A violate market which works its way lower. You’ll note form the chart above that the correction thus far has been less than the Chinese-market induced February – March correction. As painful as they are, the good news about corrections over the past twenty years is that they’ve been swift. The tests will be if the Dow can hold above 13,000 and the S&P above 1,450. These are psychological levels, nothing more, but psychology is a powerful short term driver of the market. I see the markets falling by less than 10% from their high of 2007 (a recessionary market correction would be 20%), so we’re more than halfway through the pain.

 

Whether this is a correction in a bull market or the harbinger of a recession depends upon upcoming economic news. Watch employment data, specifically, new job creation (not unemployment). Job creation is the canary in the coal mine. Negative job creation means a recession is on the way. A second indicator will be a downturn in the commercial real estate market. Either one could turn this correction into a 20% decline. So, ignore the chicken but watch the canary.