Global Stock Market BLOG - Mike Burnick

Is Santa Clause Coming to Town?

U.S. stocks turned in their best two-day performance in over five-years on Tuesday and Wednesday, with yesterday’s 2.6% advance by the Dow Industrials the best percentage gain this year. Is this the start of the Santa Clause rally?

This year, the jolly old elf may come to town the week after next, dressed like Ben Bernanke, and bearing the gift of another Fed rate cut.

According to the talking heads on CNBC, the prospect of more easy money to come when the Fed next meets in less than two-weeks is the main catalyst driving the rally in stocks. Fed fund futures are showing a 100% chance that the Fed will lower its benchmark rate by at least another quarter-point on December 11.

Federal Reserve Vice Chairman Donald Kohn spread some holiday cheer on Wall Street yesterday, saying in a speech that the “uncertainties” about the economy are “unusually high” and that the Fed would be “flexible and pragmatic” in response.

Investors interpreted Kohn’s remarks favorably, indicating the Fed will indeed continue to cut rates in response to the credit crunch market shock that’s still gripping Wall Street.

Credit Markets Still Crunched

According to Bloomberg, “The London interbank offered rate that banks charge each other for euro loans due after the end of the year jumped 64 basis points to 4.81 percent, the highest since May 2001.”

Meanwhile the Libor rate for borrowing in U.S. dollars also jumped 40 basis points to 5.23% – the biggest move in more than a decade.”

This key lending rate that banks charge each other for routine short-term funding is once again going through the roof, as happened in August and September, before the Fed began easing interest rates.

The reason Libor rates are shooting higher this time around is being attributed to high levels of cash demand going into year-end, when financial market activity will slow down considerably.  But there’s something more sinister at work here.

Averting a New Year’s Credit Crisis

A money manager interviewed by Bloomberg put it best: “The increases we've seen in borrowing costs cannot be simply explained away by year-end pressures; this is a full-on credit crisis.” Indeed, with the New Year less than five weeks away, banks are hunkering down with as much cold-hard cash as they can get their hands on in this uncertain environment.

Add in the fact that investors are terrified to have too many long positions going into the holidays, and you've got the recipe for an intensified credit crunch.

This is why Fed officials seem to be going out of their way to sound sympathetic, or “dovish” in recent remarks. It’s also the reason that central banks around the world, led by the fed, are busy injecting plenty of extra-credit into the global financial system right now.

All of this cheap money seems to be having the desired effect so far, as witnessed by big gains in U.S. stocks recently.

But it’s not just the U.S. that’s partying like its 1999 all over again. Markets in Asia, particularly beaten down Japanese shares are surging higher too.

Will Global Stocks Continue Enjoying a Year-end Bounce?

In fact, The MSCI Asia Pacific Index climbed 2.5% today, Japan's Nikkei 225 Stock Average jumped 2.4%, and Hong Kong's Hang Seng China Enterprises Index surged over 4% higher, on top of a 5%-plus move yesterday, bringing its two-day gains to nearly 10%.

Even mainland China is rallying yet again, with the Shanghai-Shenzhen CSI 300 index adding 5% overnight.

China’s A-shares have had a rough ride in recent weeks. In fact, the CSI 300 declined 21% from its October 16th peak, before the recent bounce. Not to worry you China bulls – it’s still the world’s best performing stock index this year – up about 130% year to date.

Meanwhile, the China Enterprises Index of H-share listings has continued its out performance over mainland listed A-shares, as it has since mid-year. The H-share index has gained nearly 50% in value, just since mid-August, even after the recent global market correction.

Considering the region's robust economic growth, soaring business profitability, and relatively attractive share prices, the Asia-Pacific region has far more reason to rally than U.S. stocks do this holiday season.

So keep a sharp eye on Asia during this Santa Clause rally.

Korean Firm Forges Ahead in Asia

I have often commented on how the entire Asia Pacific region that surrounds China and India are booming, thanks to robust growth in these two emerging Asian giants. That’s why a recent story in the Financial Times caught my attention, since it shows this global dynamic at work, from one steel company’s point of view.

South Korea’s largest steelmaker Posco (PKX) made headlines earlier this year when it was revealed that Warren Buffett owned a 4% stake in the company. Posco has been growing by leaps and bounds in recent years, thanks to booming economic growth at home, and across the entire Asian region.

Ambitious Global Expansion Plans to Include China

In fact, Posco today is the world’s 4th largest steel producer, and is rapidly closing in on Japanese rival Nippon Steel for the #3 spot. According to the article “the steelmaker has enjoyed annual sales growth of 12 per cent over the past decade,” tripling its total sales of steel since 1997. Posco is in the midst of an aggressive expansion plan as “it aims to triple sales” over the next 10-years!

Posco is opening state-of-the-art steel plants all around the region including Vietnam and India. Now, Posco is looking to invest directly in the booming Chinese market – the world’s largest consumer of steel. The company is in talks with Beijing to partner up with China by taking a minority stake in local Chinese steel companies.

The attraction for China is obvious: an increased supply of a key basic resource it needs to sustain the country’s expansion. Posco also has superior technology to offer, and that’s the real icing on top.

Posco’s Cutting Edge Steelmaking Technology is a Competitive Edge

Posco has developed a cutting-edge steel making technology called Finex that allows “the production of molten iron directly from iron ore and non-coking coal, the process cuts out the processing needed for blast furnaces. Finex facilities are also about 20 per cent cheaper to build than traditional blast furnaces and they produce steel for about 15 per cent less.”

A cheaper, more cost effective steel making technology is exactly what the Chinese need, as officials in Beijing grow wary of rising inflation at home.

For Posco this deal makes a lot of since too, because China is the company’s fastest growing export market. In fact, China accounted for 25.3% of Posco’s export sales last year, while Japan gobbled up nearly 20%, and the rest of Asia 19%. North America accounts for just 9.6% of sales.

This means that Posco is very well dialed in to the epicenter of global growth... Asia, and is relatively insulated from the slowing U.S. economy. Warren Buffett strikes again!

So Now It’s Official: U.S. Stocks in “Correction”

Don’t blame international markets for yesterday’s sharp reversal of fortune in U.S. stocks. Equity markets in Asia moved sharply higher on Monday, but the U.S. failed to follow through on the upside.

Instead U.S. indexes fell to new correction lows – down over 10% from record highs achieved on October 9th – just seven short weeks ago. 

Domestic stocks opened higher in the morning, but quickly succumbed to another strong bout of selling; thanks to more worries about the ongoing credit-crunch market shock that’s impacting the financial sector. In the end, the Dow Jones Industrial Average suffered another triple-digit decline (-237 points, -1.8%) while the S&P 500 Index shed a still more bearish 2.3%.

Asian Markets Turn in Strong Rally

Markets in Asia, and to a lesser extent in Europe, tried to get Wall Street kick-started to the upside this week. The MSCI Asia Pacific Index jumped 2.7% overnight on Monday – the biggest advance since mid-September. Japan’s Topix index jumped 2%, South Korea’s Kospi index surged 4.7%, and in Hong Kong the China Enterprises Index soared 5.4%.

But it didn’t help Wall Street much.  The culprit was an old familiar tune: the credit-crunch blues, which have been impacting the financial sector since the summer. Yesterday HSBC, a leading bank in the U.K. suffering from U.S. sub-prime problems, dropped another bomb on investors. Here’s how Bloomberg described it (emphasis mine):

“Banks and brokerages declined after HSBC, Europe's largest bank, said it will bail out two structured investment vehicles by taking on $45 billion of assets to avoid a fire sale of bond holdings. Banks are trying to prevent SIVs, companies that borrow short-term to invest in higher-yielding securities, from collapsing and forcing fund managers to sell their $320 billion of assets. Bank of America, Citigroup and JPMorgan are trying to persuade competitors to help finance an $80 billion ``SuperSIV'' fund to bail out the companies.”

Too Many “Unknowns” Still Have Investors Fearful

I wish Wall Street, and its front-man: U.S. Treasury Secretary Hank Paulson, all the best luck in getting the proposed super-SIV up and running in time to bail-out... er that is relieve the Wall Street credit crunch.

The reality is that there are still just too many “unknowns” out there. It’s not yet known what the financial sector’s true exposure is to toxic sub-prime paper that’s defaulting at an accelerating rate. And how could it be known? Sub-prime mortgage resets will continue to RISE into the spring of 2008.

This will trigger a still “unknown” number of additional loan delinquencies on Main Street. Nationwide, foreclosures have surged to the highest level in 50-years, and are still climbing. We are certain to see a growing number of asset-backed loan defaults on Wall Street as a result. But just how much: that’s the great “unknown.”

During the depths of the last “great” U.S. housing depression in the 1930’s, President Franklin D. Roosevelt said “we have nothing to fear but fear itself.” On Wall Street however, the reverse is true. Financial markets fear EVERYTHING – and especially the unknown.

Fear is Feeding on Itself in Financial Sector Now

As banks and brokers go careening headlong toward year-end – just six-weeks away – they are once again growing fearful to loan cash to each other, even on a short term basis.

Bloomberg reports that 3-month Libor rates -- a key inter-bank lending rate – “rose for a ninth day to 5.05 percent” in London yesterday. “That's 55 basis points more than the Fed's benchmark rate, the widest gap since the Fed cut its benchmark rate for the first time in 4 1/2 years on Sept. 18.”

Fear among investors tends to feed on itself until a full-blown panic is reached. Are we there yet? NO; but we may be getting close.

Watch to see if Asian markets can hang on to yesterday’s gains, or will follow Wall Street lower yet again. This morning these markets closed slightly lower in “sympathy” with Wall Streets drubbing on Monday. Stay tuned.

Black Friday Gives Consumer and Market Sentiment a Boost

The all important post-Thanksgiving holiday shopping season began with mixed results last week. There were more shoppers on the prowl at malls and stores across the nation in search of deals; but they spent less on average than a year ago.

According to the National Retail Federation (NRF), 147 million Americans performed their economic duty by visiting stores on “black Friday”, the day after Thanksgiving. That’s a 4.8% increase in “traffic” from a year ago.

This is often the busiest day of the year for retailers with some opening in the wee hours of the morning to accommodate the onslaught of shoppers. It is said that retailers, after loosing money on average over the first ten-months of the year, can make it all back and go into “the black” (turning profitable) in the frenzied days after Thanksgiving.

Thrifty Shoppers Holding Out for Bargains

The bad news on black Friday was that the average “ticket” was lower than expected. In fact, shoppers spent 3.5% less than last year on their purchases. The mixed results so far seem to confirm industry forecasts of a rather lackluster holiday shopping season. The NRF for its part predicts the “slowest increase in sales in five years.”

Consumers are clearly cutting back on spending. With home prices falling more than 5% from their peak, oil prices sky-rocketing to $100 per barrel, and the average American household already drowning in debt... who can blame consumers for being thrifty?

However shares of beleaguered U.S. retailers got a boost in Friday’s shortened trading session amid relief that the post-Thanksgiving sales results weren’t even worse than expected. Wal-Mart shares rose nearly 2% Friday, while Target jumped almost 6% and Macy’s surged over 5% higher.

Stocks are Beginning to Offer Bargains Amid Global Correction

Retailers weren’t the only stocks to bounce on Friday. In fact, global stock markets have been undergoing a steady correction since October, as I pointed out in my previous blog (Are Global Stocks Heading for a Bear Market?).

The U.S. S&P 500 Index had declined nearly 9% prior to Friday’s bounce, while the MSCI Emerging Market Index had pulled back about 12% from its October peak.

Global markets look overdue for a relief rally of some kind. The character and strength of such a rally should reveal valuable clues about the market’s primary trend over the next several months.

More good news about the U.S. consumer should help sustain such a bounce, at least in the short run. More negative news on the health of the consumer; especially another housing-related market shock, and all bets are off.

Are Global Stocks Heading for a Bear Market?

Well it’s official. One of the world’s largest stock markets has now “officially” entered bear-market territory.

Last week, Japan became the first of the world’s 10 biggest stock markets to enter a bear market,” according to Bloomberg news. Japan’s benchmark Topix index, which is a broad gauge of stock prices in the land of the rising sun, has now fallen 21% from it’s highs reached early this year. That was before the U.S. credit-crunch began to shock financial markets around the world.

The commonly used rule-of-thumb for gauging bear markets is a decline of 20% or more from a previous peak. While a stock market “correction” is in place once an index has declined over 10%. Japan’s other major benchmark, the Nikkei 225 Index, is closing in on “bear market” territory with a decline of 18.3% from its 2007 peak.

Japan has Lagged for Years as Attractive Values Get Cheaper Still

Of course Japan has been a troubled market for years; decades in fact. The nation has been plagued by uneven economic growth as it struggles with the aftershocks of a deflationary spiral that lasted throughout the 1990’s, The Topix Index enjoyed a nice bull-run from 2003 to early 2006, more than doubling in value over that stretch.

However the bull market rally seemed to loose its steam that year, finishing little changed in 2006. The Topix then toped-out just above the 1,800 level in February of this year. A fund manager quoted by Bloomberg put it this way; “Japan hasn't been an area of stellar growth for 10 years.”

However Japan is an area of compelling value at this point. The world’s worst performing major index is now trading at just 17.5 times earnings, which is just HALF of its average value over the past four years. The index is even cheaper than the S&P 500, which is valued at about 17.7 times earnings.

Japan’s Topix Index is home to many of the world’s most undervalued banks too, including Mitsubishi UFJ and Mizuho, both of which have warned of profit declines this year due to shrinking loan demand and fallout from the U.S. sub-prime market shock. There are certainly some bargains on sale in the land of the rising sun – unfortunately for early investors (including yours truly) stocks that already appeared undervalued earlier this year have gotten even cheaper since then.

Global Markets in “Correction Mode”

But it’s not just Japan’s equity markets that have been suffering declines lately. In fact, the month of November, which has historically been kind to stock market investors, has instead been a particularly cruel month this year.  Most global markets have fallen this month.

In the U.S. the S&P 500 Index is down 8.6% from its recent high, and is rapidly closing in on “correction” territory. The blue-chip U.S. index has given up all its early year gains and is now about flat on a year-to-date basis, after suffering its worst monthly decline in November, since September 2002.

The selling hasn’t been confined to the U.S. and Japan however. The MSCI World Index of developed global stock markets has fallen about 8% from its record high reached on Halloween. Meanwhile, the MSCI Emerging Market index has declined 12% from its October peak. Global stock markets are in the midst of an across the board “correction.” Only time will tell if other major markets go the way of the Topix, entering bear-market territory next year.

Right now, I’m betting on just a “correction” which should result in some very attractive buying opportunities for global investors – especially in Japan.

Sub-prime Crisis Keeps Pulling Me Back In

Writing as frequently as I have in recent months about the ongoing Wall Street credit crunch saga makes me feel a bit like the “Godfather”, Michael Corleone: Just when I thought that I was done they pull me back in!

But the fact that the sub-prime induced credit crunch is perhaps the biggest financial story in decades helps provide lots of material for me. Also, the standard Wall Street/Washington approach to this crisis has followed the usual pattern: First, ignore the problem; second, dismiss the problem as largely irrelevant; third, deny the problem will have any lasting impact on the economy.

Treasury’s Paulson Provides Dire Sub-prime Forecast for 2008

It’s deliciously entertaining in such circumstances to point out the truth; that the sub-prime crisis has become much worse than anyone thought just a few months ago, and it will continue to impact financial markets for quite some time to come.

Just in the past few days in fact, Wall Street firms have begun to turn on each other, as I mentioned in yesterday’s blog (The Sharks are Circling on Wall Street... Looking for a Year-End Meal). After first denying that the credit crunch would have any meaningful impact on banks’ bottom line profits, analysts are now stumbling over one another to issue the direst forecasts of expected sub-prime loan losses and assets write-offs.

In a recent interview with the Wall Street Journal, even Treasury Secretary (and former Goldman Sachs alum) Henry Paulson had a somber outlook on sub-prime, the emphasis is mine: “We'll watch carefully mortgages that will be reset. The quality [of the 2008 resets] will be lower, when you think about it. Of the 2005 ones, roughly 10% of those end in default; the others refinance. The nature of the problem will be significantly bigger next year because 2006 [mortgages] had lower underwriting standards, no amortization, and no down payments.” Yikes!

Industry Bellwether Freddie Mac Takes a $2 Billion Hit

I have been writing for some time about the peak in overall sub-prime mortgage resets won’t even be reached until the spring of 2008. And we will not see a significant decline in reset activity until late next year and moving into 2009. Meanwhile, the process for Wall Street to clear all of these bad loans off their books will last even longer; well into 2009 and perhaps not until 2010.

Yesterday, mortgage giant Freddie Mac reported a much larger than expected $2 billion loss related to credit crunch fallout. The government-charted Freddie, along with it’s twin Fannie Mae are expected to provide stability to the home mortgage market in times of crisis, buying and guaranteeing mortgages against default.

Instead, Freddie revealed yesterday that it has recently “been forced to sell mortgages to ease its financial woes,” according to the Wall Street Journal. The company actually sold off about $20 billion of mortgage loans in September, followed by another $25 billion in October. Freddie says it was forced to take such actions due to its dwindling capital margins, but the effect is to destabilize the mortgage market, rather than providing a backstop.

Freddie’s Outlook: Expect Loan Losses to Triple in 2008 and Brace for a Dividend Cut

In fact, losses at Freddie Mac and expectations for more red-ink this quarter “put the company in jeopardy of falling below minimum capital levels” as required by regulators.  As a result, Freddie is seriously considering the unthinkable possibility (for a blue-chip financial firm) of slashing its dividend by 50% in the fourth-quarter to preserve about $646 million in cash.

Even worse was Freddie’s outlook. Since the firm is such an industry bellwether, it’s forward-looking guidance can be a key barometer for where the entire financial sector is headed. And the forecast from Freddie was NOT reassuring.

“Freddie estimated that its losses related to defaults on single-family homes will grow to $1.5 billion in 2008 and $2.1 billion in 2009 from an estimated $493 million for all of 2007. That forecast assumed that home prices at the depth of the downturn would be down 5% from their peak.”

So by Freddie Mac’s own estimates, loan losses will triple next year from 2007 levels – and quadruple in 2009! But Freddie may still be far underestimating the depth of its troubles assuming only a 5% slide in home prices. On a nationwide basis, home prices are already down about 5% over the past 12 months, with many economists predicting declines of 15% to 20% before it’s over.

The Sharks are Circling on Wall Street... Looking for a Year-End Meal

Yesterday was another sub-prime related wipe-out on Wall Street as big banks and brokers tumbled again, due to ratings downgrades from their own kind. This is a sure sign that the credit-crunch market shock is entering a new and more dangerous phase.

Citigroup, the largest bank in the U.S. as measured by assets, dropped to fresh four-year lows after its Wall Street “colleague” Goldman Sachs downgraded the stock. Goldman said that credit-market losses may cause Citi to report $15 billion in additional losses and asset write-offs over the next two quarters.

But Goldman was on the warpath for scalps from more than just Citigroup. Merrill Lynch and Morgan Stanley also slumped toward new lows after a Goldman analyst cut the share-price estimate on both stocks, sighting more sub-prime fallout ahead for these two brokers as well.

Blood in the Water on Wall Street Won’t Affect Year-End Bonuses

When Wall Street’s elite firms begin attacking their own like a pack of hungry sharks smelling blood in the water; you just know that the credit crunch is taking a turn for the worse. I expect more market shocks dead ahead.

Now contrast that story with this reported by Bloomberg news yesterday; the headline says it all: “Wall Street Plans $38 Billion of Bonuses as Shareholders Lose.”

Investors in the financial sector are taking it on the chin this year, with big banks and brokers slumping the most since 2002. In fact, firms in the securities industry have lost $74 billion of their combined stock market value this year, according to Bloomberg. But that “won't prevent Wall Street from paying record bonuses, totaling almost $38 billion” this year.

Yes, you read that right. Wall Street fat-cats will still enjoy huge bonuses this year; despite growing sub-prime related losses!

Bonuses Equal Four-Times the Average American’s Income

In fact, the “average” bonus paid on Wall Street this Holiday season is likely to be about $201,500 per person – “more than four times the $48,201 median household income in the U.S. last year, according to U.S. Census Bureau statistics.” 

Wall Street is swimming in red-ink thanks to nearly $50 billion (and counting) in losses and asset write-offs so far due to the credit crunch. Ah, but booming M&A activity earlier this year should provide plenty of year-end bonus money for the Wall Street fat-cats.

But don’t be fooled. Once the books are finally closed on 2007, and those hefty year end bonuses are paid and cashed in – that’s when you’ll begin seeing the real financial damage caused by the credit crunch. Just as soon as this year’s bonuses are safely paid, that’ll be the signal to clear-the-decks with even more asset charge-offs and losses in early ’08.

Whatever you do; please don’t pity the Wall Street investment bankers this time next year when you read about skimpy 2008 bonus awards. Just remember the fat paychecks they cashed in December 2007 – on the backs of billions in investor losses – and still growing!

The Buck Stops Here...

Ministers from the Organization of Petroleum Exporting Countries (OPEC) gathered last week and over the weekend in Riyadh, Saudi Arabia with much to celebrate as oil prices move ever closer to $100 per barrel.

OPEC is set to reach $685 billion in total crude oil export revenue this year, a jump of nearly 10% from 2006 levels. And next year, OPEC’s oil riches should surge past $760 billion up another 16%, according to estimates from the U.S. Energy Information Administration. Oil revenues are up 19% this year for Saudi Arabia, OPEC’s biggest exporter. Kuwait’s oil export sales are up nearly 27%, and in the UAE crude oil revenue is soaring 32.6% over a year ago.

One of the byproducts of OPEC’s oil riches is a newfound desire among members to decouple themselves from the sinking fortunes of the U.S. dollar. Many oil-rich OPEC states in the Middle East have had their own currencies pegged to the U.S. dollar for some time. And nearly all OPEC members price their oil exports in dollars in the global marketplace. But that may not be the case for long.

The Sinking Dollar is a Drag on Gulf States

The U.S. Dollar Index traded recently at a record low against a basket of other major currencies, “the weakest level since the index started in 1973,” according to Bloomberg. The historic slide in the greenback has triggered talk that the Persian Gulf states may consider dropping their peg to the dollar.

Bloomberg news reported yesterday that “the six member countries of the Gulf Cooperation Council (GCC) that includes Saudi Arabia and Kuwait will discuss a proposal next month to revalue their currencies.

In fact, a proposal “to change the value of the currencies of the Arab nations” is on the docket for a meeting of the Gulf Cooperation Council scheduled for early December.

Saudi Arabia, OPECs biggest producer with historic political ties to the U.S. has long resisted such a move, but it may be just a matter of time. As the dollar falls further, even the Saudi royal family is feeling the heat.

Imported Inflation Thanks to the Dollar Peg

The falling value of the dollar is sparking inflation concerns in countries that maintain a peg to the buck. “Saudi Arabia's consumer prices rose at a record 4.9 percent pace in August, after averaging less than 1 percent over the last decade” according to Bloomberg. In fact, this process of diversifying away from the dollar is already underway.

“United Arab Emirates central bank Governor Sultan Bin Nasser al-Suwaidi said his bank has a target of moving 10 percent of its currency reserves into euros and has ``already diversified to some extent.'' The $50 billion Qatar Investment Authority said Sept. 4 it was looking to buy assets in Asia to counter a weak dollar.” Even global guru Jim Rogers, who has recently advocated moving assets out of the buck, has said “the dollar peg is doomed.”

In fact, GCC members have already broken ranks from the dollar club with Kuwait now linking its currency to a basket of foreign currencies including the dollar.  With a high probability of more Fed rate cuts to come, pressure will only increase inside OPEC for a landmark break from the buck.

When and if this happens, it will be an historic event in the history of global finance, and may mean the beginning of the end for the U.S. dollar as the world’s reserve currency.

And it may also give quite a boost to the GCC economy, which have been enjoying robust growth, but are struggling with inflation as a consequence of the falling dollar. Cutting the dollar peg should help cut back on imported inflation in the Middle East.

Money Market Funds Suffering a Sub-Prime Squeeze

Money market mutual funds used to be considered among the safest investments by holding short-term U.S. Treasury and agency debt in order to minimize risk.

Only rarely in the history of modern finance have money market funds “broken the buck” – trading below the $1 per share net asset value that all such funds seek to maintain. But that was before this year’s credit crunch…

The ongoing trauma of the U.S. sub-prime crisis is revealing plenty of risky assets in some of the biggest money market funds in the nation. In fact, both Legg Mason and SunTrust Banks recently propped-up shaky “money-market funds to cushion them from possible losses on debt issued by structured investment vehicles” or SIVs, according to Bloomberg news.

Will Bad Debts from Leaky SIVs Drown Money Market Funds?

To recap, SIVs are off balance sheet entities set up by banks and brokers to buy other securities, typically risky sub-prime mortgage debt, way too much of it as it turns out. Most of the cash needed to purchase theses securities is raised by issuing commercial paper, which usually matures in 270 days or less.

As I have commented before (The Credit Crunch Rolls On in CP Market), when the crisis intensified this summer, the market for asset-backed commercial paper crashed 30% in value – falling from $1.2 trillion in early August to less than $850 billion now. This means that SIVs are stuck in a real cash-crunch, unable to roll-over and repay billions in outstanding commercial paper.

OK, so how does this relate to money market mutual funds, you ask?

Well, it seems that quite a few funds, hungry to boost yields in a low-return environment, gobbled up a bit too much of the most toxic asset backed commercial paper. Now, after the market crashed 30% in value, money funds are bracing for big potential losses on the commercial paper investments they hold.

“U.S. money funds have $50 billion in SIV debt”

According to Bloomberg, “Legg Mason invested $100 million in one of its money funds and arranged $238 million in credit for two others. Funds run by Legg Mason held about $10 billion of SIV debt, accounting for 6 percent of the company's money-market assets at the end of October, according to its filing with the SEC.”

Meanwhile, SunTrust has petitioned the SEC to bail-out two of its money market funds that purchased $115 million in notes issued by a SIV called Cheyne Plc, that’s now in big trouble and facing liquidation.

Last month, Wachovia reported a $40 million loss on asset-backed commercial paper it bought from its Evergreen Investment Management division. One of Evergreen’s money market funds had nearly $3 billion in asset-backed paper at the end of March, but has since cut back it’s holdings to $1.76 billion at the end of September.

And there’s a lot more of this toxic sub-prime paper floating around in the financial system. In fact, the 10 largest managers of U.S. money funds have $50 billion in SIV debt,” according to Bloomberg.

Don’t be surprised to find even more sub-prime mortgage losses surfacing in the most unlikely places.

What’s in your money-market fund's wallet?

Can You Top This Write-Off...

In a game of "can you top this" banking analysts in the U.S. and around the world are desperately trying to get a handle on the full extent of losses from the sub-prime credit crunch. Each day the estimates get more sobering.

According to an article today in Bloomberg, a Deutsche Bank analyst is predicting that "losses from the falling value of subprime mortgage assets may reach $300 billion to $400 billion worldwide.

Wall Street's largest banks and brokers will be forced to write down as much as $130 billion," as a result of the sup-prime credit crunch. That figure tops a similarly dire forecast floated last week by the Royal Bank of Scotland, which I reported on Friday (U.S. Banks, Brokers May Face $100 Billion in Additional Write-offs ).

Deutsche Bank's analysis reckons that 30% to 40% of the approximately $1.2 trillion in sub-prime mortgage loans outstanding will eventually default, while so far default rates are running in the mid-teens. "Banks and brokers may have to write off $60 billion to $70 billion this year," according to the report.

Over the past several months, big Wall Street firms have so far acknowledged about $40 billion in sub-prime related losses or asset write-offs. Presumably then we can expect a very sharp increase between now and year end.

The next big issue for investors to grapple with is pending re-valuation of billions in Level 3 assets sitting on the books of big Wall Street firms.

Jim Grant, of Grant's Interest Rate Observer worries about the lurking dangers posed by difficult to price Level 3 assets, "the valuation of which is very subjective." According to Grant, "if one were to mark these Level 3 assets to zero, then many of our leading financial institutions would be broke."

He's quick to point out that not all Level 3 assets may need to be written-down to such an extend, but the problem is that Wall Street hasn't been very forthcoming as yet in disclosing the full extent of losses, leaving investors to speculate, and fear for the worse.

The lack of disclosure about the true extent of sub-prime problems is perhaps because even Wall Street's masters-of-the-universe simply do not know just how bad things may get out there. And that's the really scary part!

U.S. Banks, Brokers May Face $100 Billion in Additional Write-offs

The nightmare on Wall Street continues: This just in… Bloomberg reported yesterday that big U.S. banks and brokerage firms may be forced to write-off as much as $100 billion in additional sub-prime related losses, due to pending accounting rule changes that take effect November 15.

This is in addition to the roughly $40 billion in losses and asset write-offs that Wall Street has already been taken over the past few months, due to the sub-prime credit slump.

This morning, Wachovia joined a growing chorus of Wall Street banks that are announcing even more sub-prime related losses on their balance sheet. Wachovia said the value of sub-prime related debt fell about $1.1 billion in October alone. The Wall Street water-torture continues with new revelations nearly every day.

Recent rule changes by the Financial Accounting Standards Board make it more difficult for companies to avoid putting real-world market prices on their hardest-to-value securities, known as Level 3 assets.

As Easy as Level 1, 2, 3…

Level 1 assets are easy to price using mark-to-market accounting, you have all probably heard that term. This is where an asset's worth is based on a real price. For instance IBM… check the quote on the NYSE – that’s the “mark to market” price.

Level 2 assets use something called “mark-to- model”, but I call it Mark-to-Maybe. This is an estimate based on “observable inputs” which is used when no actually price quotes are available. An example might be a private transaction between two banks. They’re saying “Maybe” this is what its worth.

Then there’s Level 3 asset values, which are based on “unobservable” prices. This is basically the banks’ own “assumption” as to what the assets are worth. This is what’s been called “Mark-to-Make-Believe” accounting. Because it’s all just Fantasyland pricing… pure guesswork on the part of these Wall Street firms who of course are looking to cover their butts with the most generous valuation they can dream up.

Is the Financial Day of Reckoning Close at Hand?

However the day of reckoning may arrive in six more days, when the new and more stringent FASB accounting rules take affect. The $40 billion in charges taken so far are just the tip of the iceberg compared to what we may soon see.

According to analysis by the Royal Bank of Scotland, this “credit crunch may result in $250 billion to $500 billion of losses,” once all is said and done, as more banks and brokers are forced to revalue a decent portion of these “mark-to-make believe” assets.

Real world indexes that investors use to track deteriorating sub-prime bonds are showing “observable levels” (Level 2 pricing) that would wipe out ALL of the capital of several major Wall Street firms if the index prices were used to value their Level 3 assets.

Wall Street's Equity Wipe-Out

According to RBS, Morgan Stanley still carries Level 3 assets on its books equal to 251% of its total equity, “making it the most vulnerable to writedowns.” This means that if the house of Morgan writes-off just half its Level 3 assets – its entire equity capital would be wiped out!

Following close behind in terms of risk is Goldman Sachs at 185%, while Lehman Brothers has the equivalent of 159% of equity in Level 3 assets, and Bear Stearns with 154%. Citigroup, even after its announced $11 billion write-down, still has Level 3 assets worth about 105% of equity.

Stay tuned, next week could get really interesting.

A Green Christmas for Online Retailers in Europe

Investors, including yours truly, are growing understandably nervous about the health of the U.S. consumer amid the worsening credit crunch. Credit card issuer Capital One said yesterday that it may take up to a $5.5 billion charge this quarter for sub-prime related write-downs…and unexpected credit card losses!

This is the doomsday scenario for the American economy. Debt-laden consumers account for 70% of U.S. economic growth thanks to their conspicuous consumption habits. But if buyers go on strike this holiday season, refusing to whip out the plastic and charge-it; then it could be another big nail in the coffin.

However there is one bright spot, in this otherwise grim scenario: online shopping is booming, especially in Europe.

According to a recent article in the Financial Times, European internet users are prepared to “spend $72.9 billion in the run-up to Christmas.” Consumers in the UK are the biggest online shopping fans in Europe and are expected to shell-out EUR19.6 billion this holiday season.

Norway, although it accounts for just under 2% of the European online market, comes in 2nd highest in terms of money spent online per shopper, while France is third. In Britain, Germany and Sweden online spending runs above average, with about 70% of internet users in these countries willing to buy online.

Increased broadband penetration in Europe, shoppers in a hurry, and “growing confidence in the speed and reliability of online retail sales,” should result in a 58% increase in European online sales this year, according to the article.

In the U.S., home to long-time online shopping leaders like Amazon.com, “the online spending growth rate is flattening off, although it is still in double digits.”

Online sales in the all-important Thanksgiving to Christmas stretch is expected to total $33 billion this year. That keeps the U.S. consumer on top online at least for now, but internet-savvy shoppers in the U.K. are right behind.

Outlook for Big Banks and Brokers Remains Grim at Best

In spite of the Fed’s valiant attempt to provide liquidity Wall Street banks and brokers still have far too much exposure to mounting credit crunch losses. The Fed reportedly pumped another $40 billion or so into the financial system last week, in addition to it’s cut in the Fed funds rate.  But it’s still not enough.

According to an article in the Financial Times, there was a “sharp fall” recently in a key derivative index that tracks the market for risky sub-prime debt. In fact, this index “has fallen about 30 per cent since the end of September.”

Is this an indication of another leg down for the financial sector amid a worsening credit crunch?

"Bonds rated BBB- are now trading at a record low of just 20 cents on the dollar", according to the article. This latest plunge in sub-prime bonds comes after many big banks had already closed their books last quarter, indicating more losses ahead for mortgage-backed debt holders in the fourth quarter. Mortgage data also shows a “marked acceleration in late payments and defaults on mortgages” in recent weeks.

In the current credit environment, borrowers still face limited refinancing options even for prime-rated borrowers, and for sub-prime... forget it! That market has pretty much shut down, since lenders can no longer package and sell new sub-prime mortgage originations.

Many sub-prime firms have gone belly-up already, and many more are headed that way. This signals a big increase in delinquencies and loan losses yet to come.

The Hits that Keep on Coming

It’s pretty clear that the Fed’s 75 basis points of easing since mid-September was aimed squarely at bailing out Wall Street, rather than providing a lift to the overall economy that clearly doesn’t need the help.

Wall Street has now written-off more than $30 billion in sub-prime related loan losses in the past few months alone, and still counting. However “private sector economists think the total loss from mortgage problems could reach $200 billion or more, according to the Financial Times. "What everyone keeps asking is where are those losses sitting.”

Since Wall Street has so far only fessed up to $30 billion in “asset impairment charges” (aka “losses”), the $170 billion question is: where's the rest buried?

In other words, who’s holding the bag on the balance of $170 billion in potential losses? Again, from the Financial Times: “To judge from secondary market prices, losses on mortgage inventory are likely to be larger in the fourth quarter than the third quarter.”

Expect More Wall Street Losses After Thanksgiving

Many big Wall Street firms have a fiscal year that ends in November, so that they can close out their books well before year-end, giving them more time to calculate year-end bonuses.

But it may be a blue Christmas this year on Wall Street. That’s because closing out the books at the end of this month means marking to market even more of those mortgage-backed loans and derivatives of questionable value. I see more losses and charge offs in the not too distant future for Wall Street.

Here are a few things that are crystal clear in my mind:

1. Sub-prime adjustable-rate mortgage loans are already defaulting in record numbers: up about 100% year over year in the past five months.

2. The number of adjustable-rate mortgages resetting will increase in 2008 – almost surely resulting in higher default rates. The peak in resets is still months away.

3. Much of this toxic sub-prime paper was sliced, diced, and repackaged by Wall Street into collateralized debt securities in recent years.

4. These complex Wall Street issued mortgage-backed securities are now defaulting in record numbers (please see yesterday’s blog).

According to the FT article: “The multi-layered nature of these complex financial flows means it is hard to assess how defaults by homeowners will affect the value of related securities.”

Translation: nobody really knows how many more losses Wall Street will suffer going forward. But it’s a safe bet to assume it will be much more than we’ve heard about so far. Stay tuned!

Fed's Easy Money Won't Stop Wall Street's Red Ink

The Fed moved as expected last week and cut benchmark interest rates by a quarter-percent to 4.5%. That move was in line with consensus expectations, but the devil – as always – is in the details!

Explaining the 25 basis point reduction in Fed funds, the FOMC said “the pace of economic expansion will likely slow in the near term,” mainly due to the “housing correction.”

Some correction;  with housing starts at a 14-year low and national home prices sliding 5% lower on a year over year basis, this is already the worst housing bust since at least 1991 when the Savings & Loan industry blew up.

Even if housing manages to level-off and find a bottom, I expect the sub-prime crunch to get worse, adding more steep losses to the financial sector. The real nail in Wall Street’s coffin however may be the Fed’s growing reluctance to cut rates much further, as reflected in its official statement. Let’s get to those details…

If Economic Risks are Balanced, No More Easing is Needed

Another part of the Fed’s statement said: “After this action, the upside risks to inflation roughly balance the downside risks to growth.” To many observers this signals that the Fed may be through with cutting rates after last week's move.

According to one economist quoted by Bloomberg news, “The FOMC has just stated unequivocally that `we think we are done easing.' Whether they are or not remains to be seen, but the message is loud and clear.”

There was another strong indication that the Fed could be at or very near the end of the line in cutting rates. As reported in the New York Times, “the presidents of 6 of the Fed’s 12 regional banks did not ask for a reduction in the discount rate,” at the meeting. In other words, half of the regional Fed bank chiefs think the economy is doing just fine.

Economic Growth is Apparently Picking Up; Stoking Inflation Fears Again

Also making news last week was the surprisingly strong showing for the U.S. economy. The Commerce Department reported that GDP growth advanced 3.9% in the third-quarter, much faster than forecast and the best expansion in more than a year.

I'm more than a bit sceptical of these numbers, which are often subject to large revisions after the fact. I would not be surprised to see this data tempered in the months to come. But if the numbers hold up, it puts the Fed in a strange position of easing monetary policy while U.S. growth is accelerating –similar to the action taken by the Greenspan Fed in 1998.

Stronger growth stokes the fears of inflation, and the Fed’s statement warned that higher energy and commodity prices may spur faster inflation going forward. That's a shot across the bow of those who believe the Fed may continue aggressively cutting interest rates.

Sure enough, in the wake of the Fed’s action, December gold futures rocketed past $800 per ounce, while crude oil closed above $95 a barrel last week. Both of these facts are evidence that inflation is far from tame.

The biggest issue however, and the real reason the Fed seems so eager to please with lower rates, is the simple fact that Wall Street's big banks and brokers are still in deep trouble with mounting sub-prime loan losses.

Please tune in tomorrow, for more on this in my blog...

No Trouble in "Paradise" About a China Bubble

I’m writing to you from beautiful Paradise Island in The Bahamas, where I’m attending the Sovereign Society’s 2007 Offshore Advantage Academy. Here in “paradise” it’s easy to get distracted from the credit-crunch induced market shock that is gripping Wall Street right now.

I’ve been here since Friday, so I have had a chance to relax a bit and unwind, but events in global financial markets are always foremost in my mind. In fact, over the weekend I was updating the Global Market Investor portfolio, and was struck by the big gains from the two China ETFs I recommended less than six months ago.

Much has been said and written about China and how the market there has surely entered bubble territory. The Shanghai A-share index has nearly tripled in value since the beginning of last year.

My preferred point of entry for investing in China is Hong Kong, as I have pointed out here before. The reason is a simple one of valuation.

The A-share index trades at more than 60 times earnings now, while on the Stock Exchange of Hong Kong, the same companies trade at a steep discount of just over 20 times earnings.

As Beijing continues to relax investment restrictions, to more fully allow its citizens to invest overseas, this valuation gap is bound to close. And the likely beneficiary of this will be the Hong Kong listed H-shares that are included in the Hang Seng China Enterprises Index, which will surely attract some of the $2.3 trillion in Chinese savings.

Recently, Bloomberg noted that five of the top ten companies by market cap are now Chinese – compared with just three U.S. firms in the top ten. China Life, the nation’s biggest insurance firm recently cracked the top-10 along with: PetroChina, China Mobile, Sinopec, and ICBC. This milestone is surely a sign of the times.

One of the ETFs I recommended in May, the iShares China Fund (FXI) include many of these top firms, and has already gained an amazing 80% since then. While a bubble in the making it may be; it’s worth remembering (paraphrasing Keynes) that markets can stay irrational longer that you and I can remain solvent. The Chinese love to speculate in stocks and have plenty of gun-powder (pent up savings) as noted above, to blow this bubble much higher still.

As China-bull Jim Rogers has said: “China is one of the most exciting economies. The market is willing to pay a lot more for future growth.”

Hang on to the Hang Seng H-share Index for the ride of your life!

You Could See This One Coming From a Mile Away

Investors must have thought long and hard on Wednesday night about the real meaning of the Fed’s policy statement. And by the time markets opened again on Wall Street Thursday morning... they decided to re-think their knee-jerk decision to buy the day before.

Instead, RED was the color of the day in U.S. stock markets yesterday, as stocks gapped down at the opening bell and never looked back. When all was said and done, the S&P 500 Index dropped 2.6%. The Russell 2000 (small-caps) fell almost 4%. And the Banking Sector Index plunged more than 5.3%.

It was not a great day to be long and strong financial shares, or pretty much anything else for that matter.

High Anxiety on Wall Street - Over Sub-prime Crunch

The market’s break-down is not really surprising, given the credit-crunch headwinds that continue to buffet the markets. Reasons (or excuses) for the sell-off were widespread in the media.

Some attribute it to the Fed’s “balanced” view of the economy; meaning possibly no more rate cuts. Others say it has something to do with crude oil uncomfortably closing in on $100 per barrel. Still other pundits suggest growing angst over lackluster third-quarter earnings reports.

The truth is: it’s all of those things, and so much more. The sum of all investor fears these days includes a laundry list of issues. Stir them all together and it’s a recipe for heightened investor anxiety – and market volatility.

Banks Lead the Way... Down

Still the most telling stat from yesterday’s carnage is this: Banking Sector Index (BKX), down 5.4% yesterday, and 16.8% year to date; Financial Select Sector ETF (XLF), down 4.9% yesterday, and 12% so far this year.

These numbers seem like more than just a correction to me. Something is seriously wrong on Wall Street.

The S&P 500 Index is America’s blue-chip yardstick, the standard by which every other global investment and asset class is measured. In the 1990’s, the S&P was heavy in tech shares. That’s the reason the index soared to giddy heights in 2000, but so quickly crashed back to earth in 2002.

In recent years, financial shares have wrestled away the leadership mantle from the wrecked tech sector. Financial stocks make up 20% of the S&P 500 by market-cap weight – the biggest sector in the index.

No Quick Recovery for Financials

Financial shares have also accounted for the lion’s share of the S&P’s profits – nearly one-third of total S&P 500 earnings last year came from this sector. But the sector that once boosted overall earnings growth for the index is now a major drag on profitability. Third-quarter net income growth for the financial sector is plunging at a rate of -26%.

One of the S&P 500’s leading sectors since the current bull began is now a laggard. It reminds me of the old proverb: ‘the first shall be last.’

With the worst of the sub-prime credit crunch still to come in 2008 – don’t expect a quick recovery for the financial sector.

The Credit Crunch Rolls On in CP Market

The “big issue” that remains for gridlocked credit markets is how to jump-start the stalled market for asset-backed commercial paper (ABCP).

This market declined in size from $1.2 Billion in July – which represented half of the entire commercial paper market – to less than $900 Billion recently, according to Federal Reserve data. That’s a decline in value of more than 25%! That's on par with the stock market plunge that occured on Wall Street twenty years ago.

Nearly $900 billion in ABCP, much of it issued by Wall Street’s SIVs and tainted by the sub-prime crunch, will mature over the next six months and need to be “rolled-over” or refunded.

Since the CP market is essentially shut down, the only option for many of these funds now is to de-leverage – or begin liquidating assets at whatever prices can be obtained – to pay off creditors.

Unwinding Troubled SIVs: The Next Market Shock

Wall Street faces a painful process of unwinding these troubled SIVs. Quoting a recent Financial Times article, this process has already begun: “In total, the industry sold about $43bn of assets to meet repayments of maturing debt between early July and the end of September, according to data from Moody’s, the ratings agency.”

According to various estimates I have seen, there are about three dozen SIVs operating globally with a capital base of some $400 billion. But that’s NOT the total exposure to potential losses.

Remember, these SIVs are leveraged to the hilt the way many South American “banana-republics” used to be (or the way U.S. consumers are today), with total levered assets of perhaps $2 trillion or more.

So if wholesale liquidation of SIV’s begins to take place en mass, Mr. Paulson’s bailout fund (er, that is “Super Fund”) with just $80 billion of capital will be just a drop in the bucket compared to the torrent of unwinding sub-prime investments that will shock credit markets.