The 2008 Second Quarter
By Akber Zaidi
Los Angeles, CA
The second quarter of 2008 was another difficult one for the world’s markets. The S&P was down 2.9% for the quarter and 12.1% for the first half of 2008. The negative trend echoed throughout the world, with the European markets down better than 15%YTD and the Asian markets down nearly 20%. The hope that the worst of the credit crunch was over and that earnings growth would rebound as the year progressed failed to materialize. Those hopes were shattered as the effects of the credit crisis continued. The same problems that existed earlier this year - the banking crisis, collapsing home prices and rising inflation - have yet to be resolved.
In the past few years banks and brokers benefited from six developments: the expansion of the mortgage markets, the expansion of credit derivatives, the expansion of the private equity sector, the growth of hedge funds (prime brokerage), the expansion of international markets and the leveraging of their balance sheets. None of these factors are present at the moment and don’t seem likely to emerge in the next few years. Although $108 billion in losses and provisions has been booked so far by banks and brokers, Morgan Stanley estimates that an additional $175 billion in losses and provisions should occur over the next year. This possibility has caused the price of one of the major Wall Street firms Lehman Brothers to collapse 70% so far this year. Sophisticated investors are betting against Lehman because they are skeptical about its accounting. We suggest avoiding banks and brokers until we get a bottom in housing prices.
Housing prices continued to decline last quarter. Home prices in 20 major US cities have dropped a record 18% from their peak and are now back to where they were in 2004. Harvard University's annual report on housing said the housing slump, already shaping up to be the worst in a generation, still hasn't run its full course. The study said the fall in home prices and the rise in mortgage defaults are the worst since the 1960s and 1970s. A separate report found fewer Americans plan to buy a home anytime soon, suggesting more price declines in the months to come. Many analysts expect prices to decline an additional 10% before hitting bottom as the housing market is battered by tighter lending standards and a wave of foreclosures that is boosting supply. Our research indicates that real estate will not bottom until 2009 or 2010.
The Federal Reserve has kept short-term rates at 2% while inflation is running at 4% in the US and created a situation of negative real interest rates. Negative real interest rates encourage speculation because cash held in money markets cannot keep up with inflation. We are currently experiencing speculative prices in food and energy costs. Grain and crude oil prices are higher than they have ever been. Soaring food prices have caused riots from Haiti to Egypt to Bangladesh.
Rising oil prices have caused 24 airlines to go bankrupt in the past six months, including Aloha Airlines, which began service in 1946. While global inflation is at 5.5%, inflation in Third World countries is more than double that. Saudi Arabia’s inflation is at 10.5%, the highest in 30 years, Philippines’ is at 11.4%, the highest in 9 years and Pakistan’s is at 17.5%, the highest ever. The only way to combat inflation is to raise rates. More than three quarters of the world's central banks have already raised rates but the US and Europe have not.
Sinking home values, inflation and soaring gas prices have pushed the index of consumers’ expectations for the future to the lowest level ever. Because of such extreme negativity the stock market may have a reactionary bounce up during the third quarter. We continue to believe investors should underweight equities as an asset class.
What can we do? We are in an age of falling corporate profits, a collapsing housing market, rising inflation and diminishing oil production. We suggest avoiding the markets that are still in crisis. These include the stock market, especially the financials (banks, brokers etc), the real estate market, especially housing (housing prices have not yet bottomed) and the bond market, especially long dated bonds (accelerating inflation will drive rates higher).
The sector that is in a long-term bull market is commodities. This group includes oil, metals and grains and their related stocks. Due to the potential for a continuing down market, we recommend investors reposition their portfolios to lighten up in the under-performing sectors when they run up and concentrate in the sectors that are working on pullbacks in price.
(Akber Zaidi is President of Alpha Asset Management. He can be reached at firstname.lastname@example.org)