Tuesday, March 13, 2007

Second Leg of the Correction

On February 28th, after the 400 point loss on the Dow I wrote:

The market will probably try to make some kind of rebound over the next couple of weeks. I doubt it will make new highs though and a retest of the low yesterday would be routine. I will probably be looking to do some selling on the rebound and save my ammunition for the next downdraft. That's the plan anyway. Let's hope my timing is a little better this time.

Well today looks like the start of phase 2. The market did rebound and of course we did not make new highs. We'll see how things go, but my guess is that today is the start of the retest of the lows. The sub prime mortgage market gets the blame this morning as New Century Financial is defaulting all over the place. They're also now being investigated by the SEC and have receieved a subpeona from the US Attorney's Office for the Central District of California. It may be a New Century, but loaning money to folks who can't pay it back still has the same results as the in the old century. Accredited Home Lenders also seems to be under a little stress (the stock is down 52% right now) and is considering its "options". I suspect their options will be rather limited in the current environment.

The sub prime mess, which many dismissed at first, is starting to have some real effects. Many of the big Wall Street brokers bought these loans and packaged them into securities. They tried to protect themselves by including buy back provisions for loans that defaulted within a short time frame, but the loan originators don't have the cash to buy back all the mortgages that are now in default. As a result, expect some of the big boys to end up as creditors in bankruptcy court and to recover pennies on the dollar from these loans. The brokers will probably make an attempt at making their investors whole but the episode is likely to be costly.

The real question is whether the sub prime market is the canary in the coal mine. Will the defaults spread to the better loans? Will there be a credit squeeze? I am watching the economy closely and I think as long as job growth remains relatively strong, the damage should be contained to the sub prime sector. If that is the case, the long term damage to the economy will be minor. If the economy starts to roll over though, look out below because there will be a lot more defaults.

For now, we are sticking with our plan. I still expect the market to test the recent lows. While sentiment has turned sour very quickly with this correction, it still needs to get worse before I get very bullish again. I suspect another downdraft may do it, but I'll wait for confirmation before getting aggressive about buying.

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