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U.S. House Prices Analysis and Trend Forecast 2019 to 2021

Nolte Notes - Sublime to Sub-prime

Interest-Rates / Subprime Mortgage Risks Jul 24, 2007 - 05:04 PM GMT

By: Paul_J_Nolte

Interest-Rates The market focus has begun to move from the sublime to sub-prime. Housing was to be well contained, earnings growth (although slowing) was to march inexorably higher and investors mergers and acquisitions were going to (eventually!) remove every stock from the markets. Then Friday happened. Earnings warnings from Caterpillar and a miss by internet giant Google cast doubt about the overall strength of earnings for the quarter.

A combination of sub-prime worries (it is not contained, may permanently impair Bear Sterns etc) and yet another hiking of interest rates by China served notice to the markets that all is not well at the corner of Wall & Broad. While earnings from the financial sector were decent, the worries over the effect of sub-prime lending and the disappearance of two of Bear Sterns hedge funds have many firms increasing loan loss reserves and talking down next quarter's earnings. The first pass at economic growth for the second quarter will be released this week and is not likely to be market moving unless it wildly misses the current estimates of roughly 3%. A focus in the report will be the inflation component, however given the relatively benign reports on both consumer and producer prices last week; we would expect confirmation of modest inflation.

The big question after Friday's decline – did the market breakout of the two-month trading range or merely fake out investors into believing a new leg up is ahead? Comparing the “breakout” day with Friday might give a bit of insight. The number of declining stocks on Friday was higher than the advancing stocks on 7/12, total volume was higher on Friday and too the total declining volume was a higher multiple of advancing volume than was advancing over declining on 7/12.

So, it looks on paper as though Friday's decline trumps the breakout day by most technical measures, meaning that we would define the breakout as nothing more than a fake out and the next likely test will be the bottom of the range 2-3% below Friday's close. If indeed that test is a failure, then the characteristic of the market will have changed and we will, at that time, begin moving more to the sidelines. What we are seeing over the past couple of months is a shift in the market participants, from small cap and even value stocks toward large cap and growth. Depending upon how the markets unfold over the next couple of weeks, we too will shift more to a large cap growth strategy for the first time in seven years. 

The sub-prime “issue” has been a benefit to the treasury market, as investors begin to shun higher risk investments and move to the safety of the treasury markets. As a result, the 10-year bond broke the 5% level after touching 5.25% just a few short weeks ago. The curve that was once steepening, indicating a recovering economy, has once again begun to flatten, as short-term bonds are less than 10 basis points (100ths of a percentage point) away from those of the 30 year bond.

However, all the excitement in the bond market has done little for our model, as it remains at a “2” reading (still negative) indicating that rates are still likely to rise in the future. The testimony from Chairman Bernanke also indicated that the Fed is not likely to be active in the yield market and will leave interest rates right where they are for the foreseeable future.

By Paul J. Nolte CFA

Copyright © 2007 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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