Market Skittishness

Posted on May 21, 2007 by David Laidlaw 

On February 27th, the Shanghai stock market lost 9% of its value and our equity markets fell in sympathy. While there should be almost no causal relationship between China’s stock market and ours since the health of China’s economy is not dependent upon the health of its stock market, there were more fundamental reasons for the domestic market volatility during late February and March. Borrowers with low credit scores began defaulting on their mortgages at increasing rates and there are indications that economic growth is slowing.

Over the past six or seven years, low interest rates spurred increased borrowing to buy residential real estate. Real estate was viewed as a good investment since, as some say, they stopped making land and financial assets such as stocks were too risky. The relationship between real estate prices and lending was self-supporting. Households borrowed more money since interest rates were low and their home equity increased as the price of their property appreciated. Lenders felt comfortable lending ever greater amounts of money since real estate prices were increasing and they believed their loans could be recouped easily through foreclosure if borrowers defaulted.

This scenario began to unwind in the subprime mortgage market. Borrowers with weak credit histories are now defaulting on their loans at greater rates. The Mortgage Bankers Association reported that 4th Quarter 2006 loan delinquencies in the subprime mortgage space were 13.3%, up 0.8% from the prior quarter. These delinquencies rose again to 14.3% in January. On April 2nd, New Century, the second largest subprime lender, filed for Chapter 11 bankruptcy protection and fired half of its workforce. The fear is that this weakness will spread from the subprime market, which is about 10% of the mortgage market, to more creditworthy borrowers resulting in a slowing economy as consumers spend less.

The Federal Reserve Board also indicated that it was concerned about slowing economic growth. In the Chairman’s tes tim ony to Congress at the end of March, Ben Bernanke opined that the economy was expanding at a rate of about 2% which is a slower rate of growth than experienced over the previous few years. Aside from housing, capital spending by businesses was also less robust than expected.

Even though we are aware of the risks posed by weakness in the housing sector and slower growth, we do not view the recent volatility as a precursor to a dramatic sell-off. The employment market continues to expand which should cushion the blow from any real estate depreciation. The United States and South Korea also signed a significant bilateral trade agreement. Assuming this agreement is ratified, this deal is very positive for increasing global trade especially with a dynamic trading partner in a growing part of the world.

Finally, as we have discussed earlier, stocks prices are reasonable relative to corporate profitability. The continued strength in the private equity space is evidence of the attractive valuations for stocks. Buy-out deals by private equity firms become ever larger. During March alone, Clayton, Dublier & Rice announced a takeover bid of $4.8 billion for ServiceMaster, and real estate mogul, Sam Zell, bought The Tribune Company for $8.2 billion. Kolberg, Kravis, Roberts & Co. has put together a $32 billion package to acquire TXU Corp. and also bought First Data Corporation for $27 billion. The First Data transaction represented a premium to its market value of over 20% when the deal was announced.

The clear message here is that large and sophisticated pools of capital continue to see value in corporate America even given the above concerns about slower growth.