The Overnight Report: Resuming Normal Programming

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By Greg Peel

The Dow fell 283 points or 2.4% while the S&P fell 2.3% and the Nasdaq 2%.

To find a reason why the Dow was the worst performing index on the day, one can begin with JP Morgan down 7%, Bank of America down 9% and Citigroup down 10%. After a week of extraordinary rallies, sparked by (a) the US government’s promise to nationalise Fannie & Freddie if it had to, (b) the moratorium on naked short-selling which forced a scramble to short-cover, (c) the fall in the oil price evoking a reversal of the long energy/short financials play, and (d) the amount of cash sitting on the sidelines just looking for any sign a bottom has been reached, reality suddenly hit home with a thud.

Reasons to sell last night included the F/F rescue package being passed into law – which has a “buy the rumour, sell the fact” element to it, and the rally in the financial sector has been way too rapid – and a slight rise in the oil price, but most importantly it was the release of the June existing home sales numbers.

With all the concentration recently on who might go out the back door because of their mortgage securities, Wall Street’s attention had been somewhat drawn away from the root of the problem. Weak housing numbers have become de rigeur as each month has gone past, and so they were failing to be “news” anymore. Indeed, May existing home sales actually posted a slight increase, which led to suggestions that perhaps the worst was over. But last night consensus was that June would see a 1% drop in existing home sales, and the result was a 2.6% drop.

This doesn’t seem enormous, but it brought attention rapidly back to the heart of the problem.  June sales represented the slowest pace since 1998. The median sale price has dropped 6.1% year-on-year. There are now 4.5m existing homes for sale across the US representing 11.1 months of inventory under normal sales rates. This is the second highest level in 24 years. The increasing inventory is being driven by increasing foreclosures, and as house prices fall and equity turns negative, more and more sellers enter the market to try to beat foreclosure.

If you were wondering why quarter after quarter the US commercial, regional and investment banks seem to keep coming up with more and larger write-downs, it is not because they are still lying or kidding themselves or using dodgy valuation models. It’s because the more house prices fall and foreclosures increase, the further the value of mortgage securities fall. And because mortgage securities are held on extreme leverage, one little tick down in house prices translates into a very big tick down in mortgage security value. This reality hit home last night.

Merrill Lynch was down 14%, Lehman Bros 12%, Fannie Mae 20%, Washington Mutual 13% – the list goes on. Mind you, Fannie, for example, was previously up over 100% from its low. The bulls will argue this was simply a necessary correction to the rally which began last week. The bears will argue that even if the rally continues, it’s simply another typical relief-run in a bear market trend, and there is still no end in sight to US housing market woes.

To top things off, the weekly jobless claims rose by 34,000 to 402,000. These are volatile numbers, but anything over 400,000 causes jitters.

The auto industry is one area where job losses have been felt, but auto stocks have also posted some spectacular rallies this last week, driven by the US$20 fall in the price of oil. The oil price rose last night however, but only by US$1.05 to US$125.49/bbl on no news in particular. The US dollar was mixed. (Aussie down another half cent to US$0.9585.) But it was a very bad night for automakers nevertheless.

Ford reported its second quarter result last night – the worst quarterly result in its history. The maker of America’s most popular vehicle – the F150 gas-guzzling pick-up – lost close to US$9bn. Of that figure, US$8bn represented write-downs in the value of plants configured to produce pick-ups and SUVs. The Street expected an earnings per share loss of US27c but it got US62c. Ford announced it would now bring out a new range of small cars. Hallelujah. If you have no foresight, hindsight will have to do.

Ford shares fell 15%, taking Dow component General Motors down 11%.

And while we are firmly focused on oil at present, which has fallen about 13%, note that the price of natural gas is now down over 20% this month, including a 5% fall last night on higher than expected weekly inventories.

While gold managed to pull back US$8.30 to US$927.30/oz following sharp falls, it was not the same story on the LME. While the financial sector has tumbled, the switching trade for 2008 has been into energy and materials. Well now that it’s all over for energy for the time being, a sudden risk is posed. If there is nothing to buy – sell. Commodity funds decided it might be time to take risk off the table in metals last night, sending aluminium down 1%, copper, lead and zinc down 2%, and nickel down 5%. It has been a rare session recently when all metals have moved in the same direction. In late trading, copper closed under the psychological US$8,000/t mark and nickel under US$20,000/t.

Shares in BHP Billiton ((BHP)) fell 5% in New York.

The SPI Overnight fell 102 points.

The after-market news from last night was not particularly inspiring either. You know those brightly-coloured plastic clogs which became must-have footwear for everyone from kids to grannies last summer in Australia? Well the US company that makes those is called Crocs, and early this morning the company reduced its second quarter earnings guidance from an EPS range of US42-47c to a range of US3-7c, citing a “domestic marketplace more challenging than anticipated”. In late trading Crocs shares fell over 50%.

It may sound a strange thing to say, but this is all very healthy. Bear markets do not end on a single “V” bounce, they end on a wider-picture “U” correction which will contain many “V’s”. One of those “V’s” will mark the actual bottom – which will be on a day when sheer panic that the world is about to end will provoke enormous selling volume and extreme implied volatility (the VIX is currently at 23, by the way). But it won’t be the last “V”. We’ve had about 5 good “V’s” since Bear Stearns announced some problems with subprime hedge funds in June last year – each one lower than the previous. In the meantime we’ve had a commodities bubble.

The financial sector in the US is continuing to work out excess leverage, and the commodities sectors are pulling back to the reality of a global slowdown. Don’t forget that China’s economic growth is still running at 10%, and a potential pullback to 9% would have an impact, but still imply extraordinary growth. The more the stock market works through its excesses, the more stable a base will be formed from which the next true bull market can be launched.

Patience. Value is building.

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