Wilting in a Market Meltdown
As credit dries up, fears of recession spook investors
The subprime mortgage mess that roiled the nation's credit market is now threatening one of the longest uninterrupted bull runs in stocks. Investors are waiting for the next domino to fall, as government officials warned last week that the housing-related financial crisis is likely to slow U.S. economic growth.
Near the end of one of the most nervous weeks on Wall Street in years--one in which housing starts plummeted to their lowest level in a decade--the stock market officially fell into a "correction," a decline of 10 percent or more. It was the first such drop since the last bear market ended in October 2002, which means that this financial crisis did something that neither the Iraq war nor record oil prices could.
The Dow Jones industrial average slipped well below the 13,000 level after trading above 14,000 as recently as July 19. Shares of mortgage-related businesses like Countrywide Financial and KKR Financial took big hits amid growing concerns about a credit crunch in the economy. Countrywide, one of the largest players in mortgage originations, was forced to tap an $11.5 billion reserve line of credit because, like so many other financial firms, it was struggling to raise funds through its mortgage-backed securities.
What's so frightening about this sell-off is that "it's impossible to tell where you are," says Howard Silverblatt, senior analyst with Standard & Poor's. "We could be right at the bottom just before things head up, or we could be in a free fall."
Last week, it felt more like a free fall.
Fixed-income investors have already felt the effects of the credit crunch, as holders of certain types of mortgage-backed securities have seen their investments plunge in value amid rising problems in the subprime market, which caters to borrowers with poor credit histories.
Home sales continue to decline, as potential buyers have begun to feel the effects of this crunch. Credit checks are getting more stringent, and interest rates on big home loans are rising. A report last week showed home-builder confidence at its lowest level in 16 years.
As aggressive lenders turned downright timid, the equity markets started to wilt.
"There are two things going on in the equity markets," says Mark Zandi, chief economist for Moody's Economy.com. "One is the realization that private equity, which relied on cheap credit to fuel its activities, is not going to provide the juice to equity prices that it has in the recent past." The other, Zandi adds, is that Wall Street is now considering how the weakening housing market will affect the broader economy. Treasury Secretary Henry Paulson told the Wall Street Journal that the sector's troubles will "extract a penalty" on growth but not cause a recession. But many investors think a downturn is more likely now than just a couple of weeks ago.
Indeed, the mortgage crisis especially threatens the profits of financial-services companies, already under pressure. Today, financial stocks represent more than 20 percent of the Standard & Poor's 500 index. That makes financial services the most influential sector in the market.
Still, investors need to take a deep breath. While some are bracing for an even bigger fall, as retailers like Wal-Mart and Home Depot offer dim earnings forecasts, few are predicting a bear market, usually defined as a 20 percent drop in value.
There have been six significant market drops since 2003--and none of them proved fatal to the bull market, notes James Paulsen, chief investment strategist for Wells Capital Management. And despite the concerns over exposure to subprime-related debt, "the U.S. corporate sector remains in very good shape," says Markus Schomer, global economic strategist for AIG Investments. Corporate balance sheets are sound, profit margins are near 40-year highs, and cash flows remain strong, he says.
Here are several things investors should watch for:
The globalization of the subprime sell-off. The one thing that the United States is still good at exporting is its financial products. And the U.S. credit mess now seems to be spilling over into the global financial markets. Recently, three hedge funds run by BNP Paribas, based in France, announced that they could not allow investors to cash out because of difficulties in valuing securities backed by subprime mortgages. And European central banks have done more than the U.S. Federal Reserve to inject cash into the market to shore up financial institutions. That suggests the subprime mess could be as big a problem abroad as in the United States. But the booming global economy might better withstand the credit shock.
Rising volatility as investors reassess their appetite for risk. Since the bear market ended in 2002, investors have been spoiled by an unusually long period of calm in the markets. But it now appears that volatility will persist. The Chicago Board Options Exchange volatility index shot up to more than 30 last week, more than twice as high as at the start of July.
Weakness in financial stocks. Financial institutions are announcing their exposure to subprime-related debt almost daily, and firms that work directly in the mortgage market are getting hit the hardest. Shares of Thornburg Mortgage were nearly cut in half last week after analysts downgraded its stock.
A traditional flight to quality. In times of financial turmoil, investors often sell the riskiest assets in their portfolios and head for the safest. The safe haven of choice for global investors is still U.S. treasury bonds. Not surprisingly, the flood of investments into U.S. treasuries has pushed the yield on 10-year notes down from 5.25 percent in mid-June to 4.65 percent last week.
For stock investors, this means two things: growing demand for shares of high-quality companies that lead their industries and those of dividend-paying firms. Between July 19, when the sell-off began, and August 14, stocks with an "A" grade from S&P (based on earnings quality and other fundamentals) fell 8.9 percent on average, while "B" stocks lost 10 percent and "C" stocks 12.9 percent.
So while dominoes are falling, prudent domino players may be repositioning their portfolios.
This story appears in the August 27, 2007 print edition of U.S. News & World Report.