FYI | Jul 25 2007
By Greg Peel
The Dow posted its biggest fall since March – the beginning of the subprime crisis – last night closing down 227 points or 1.6%. This was just slightly off the lows of down 242. Both the S&P 500 and the Nasdaq suffered falls of close to 2%.
It was never likely to start well for the Dow last night, with American Express having been sold off in late trading the day before, but while a flat result from Dupont was not well received, it was the second quarter result from America’s largest mortgage lender that really sent the porridge stone cold.
Countrywide is not a Dow component, but the resulting spill over into financial stocks was manifest. Dow component JP Morgan Chase posted a very solid quarterly result, and was sold off heavily. Financials account for some 20% of the S&P 500.
Countrywide’s net income was down 33% for the quarter. Clearly, a loss was always expected, and it was expected that a lot of that would be due to the subprime situation. What wasn’t expected was that the bulk of the loss would be contributed to equity loans – prime home equity loans. Australians will be familiar with the popularity of homeowners borrowing against the newfound additional equity in their properties as the housing market boomed. This was a newish product banks were pushing hard a few years ago. They became popular in the US as well, and now those borrowing against their equity have found that equity evaporate. Countrywide shares were down 12%.
This has signalled a step up in the subprime crisis into the greater credit market. This is what the world has been fearing.
Nor did it help the Dow last night that energy stocks decided to correct sharply after a third successive fall in the oil price. Crude fell US$1.33 to US$73.56/bbl as rumour had it that US supplies were growing (our favourite inventory story) and that OPEC had come out and said it could cover any global supply shortfall (not that it ever does). Exxon – one of the recent star performers of the Dow – was sold off heavily.
In the broad market, the Golden Arches sagged as McDonalds – which had recently posted well-received sales figures – posted a very rare fall in quarterly earnings. Elsewhere Apple – another recent star performer – was sold off 6% after the world had learnt that (a) the company would need to quickly issue a patch for its iPhone to prevent hacking and (b), the number of iPhone connections turned out to be not nearly as many as expected when AT&T announced its result. AT&T, a Dow component, was also sold off. Indeed 29 of 30 Dow stocks finished down on the day. Only telco Verizon held up, but it is in play.
So what did the bulls think of all this?
The Dow is now down 2.2% from its high of 14,000 and up 10% year to date. This is just a healthy, if not welcomed, correction, says Goldilocks. There is nothing wrong with a bit of a credit market shake-out to put things back into perspective. Corporate quarterly profits – a third of which have now been reported – are running at about 7-10% growth. 45% of those profits have come from offshore operations. The global economy is very strong.
Yes, there is a problem in junk debt. But if you look at the bigger picture, the junk bond/Treasury yield spread has only blown out about 75 basis points to around 330bps. In 2002, that spread was 1000bps.
However, the less bullish warn that a major concern is the amount of LBO bonds still overhanging the market unsold, and the reduced capacity for private equity to raise debt at required levels from here on in. Take LBOs out of the equity market, and you’ve taken away its prop. A possible benchmark for the extent of the problem will be established as a result of private equity giant Cerebus Capital Management’s intended buyout of Chrysler. There are supposedly US$250bn in unplaced buyout bonds already overhanging the market, and if Cerebus fails to raise the debt required, at the spread required, a withdrawal of the bid could send a dangerous shudder through the equity market.
The bulls are nevertheless heartened that last night’s supposed catastrophe did not spark another flight to quality to US Treasuries. The ten-year bond yield only slipped a couple of points to 4.94%. But what will be more comforting in the bars around Wall Street this evening will be that once again all-important after-market.
After the bell, Amazon.com came out with a strong quarterly profit result and the shares rallied by as much as 13%. Why is this important? Because Amazon is a retailer. The greatest danger for the US economy is if the housing slump precipitates a dramatic drop in consumer spending. Already there is talk that the market will bounce back tomorrow.
The US dollar turned weak again against the euro and pound last night (but still not against the yen). This was enough to allow a slight rally in the gold price – to US$681.80/oz – despite the sharp sell-off in oil. The base metals were mixed, with nickel posting another fall (2.6%) in New York while zinc managed a 3% jump.
Ahead of today’s second quarter CPI release in Australia – 11.30am east coast time – the SPI Overnight closed down 70 points.
