The sub prime debacle continued last week as BNP Paribas, a large French bank, reported losses in some of their hedge funds. The news caused a further tightening of credit and the European Central Bank, the US Federal Reserve and the Bank of Japan all added liquidity to the market to calm things. While this is not unprecedented, it is a little more drastic action than we have seen up to this point during the recent turmoil. On the other hand, it is exactly what central banks are supposed to do in these situations. Central banks are lenders of last resort; when the market isn’t working they provide the liquidity the market needs until things return to normal.
As I warned in my last market update, the stock market did retest the lows of 8/1, but the averages were able to close above the worst levels of that day. While I still stand by my prediction that the lows for this correction have already been seen, I must admit that last week really tested my conviction. And some of the indicators I watch are still flashing warning signs. The American Association of Individual Investors sentiment poll is still showing too many bulls for my comfort and the option market is giving some mixed signals. This morning as the market rebounded, there was a lot of call buying activity in the indices which indicates that a lot of investors are betting on this rebound. I would have preferred to see a little more skepticism. On the other hand, individual stock put buying is still at very elevated levels, which from a contrarian standpoint is bullish. As I said, mixed signals.
The damage to the economy from the sub prime problems has so far been minimal. There have been reports that jumbo mortgages have been a little harder to get or have come with somewhat higher interest rates and sub prime borrowers are pretty much locked out, but mortgages that conform to Fannie Mae and Freddie Mac guidelines still seem to be getting done. Of course, this won’t help the already hurting housing market, but that is old news and the dire predictions about consumer spending have yet to materialize. That doesn’t mean that they won’t, but this morning’s retail sales report showed an increase in July of 0.4% ex-autos and 0.3% overall. That was slightly better than expected and much better than June’s revised 0.7% drop. The retail sales number would have been higher if sales at gas stations hadn’t fallen due to a drop in gas prices during the month. Inventories also rose some last month but the rise was expected.
There was a lot of talk last week about the possibility of a Fed rate cut; if you didn’t see it, Jim Cramer on CNBC had a meltdown in which he basically screamed for Bernanke to cut rates. Cramer is a first class nutjob and publicity hound who only a month ago said the sub prime market would be no problem for the economy and now he’s screaming for a rate cut like the next depression is upon us. Why does this man get so much attention? If anything, Cramer’s outburst made it less likely that Bernanke will cut rates. He doesn’t want to be seen as responding to pressure from Wall Street. I don’t think the Fed should cut rates now. Inflation is still too high and the economy is not in danger of recession – there is no reason to cut rates. Furthermore, the system worked just as it is supposed to last week. The Fed provided liquidity without cutting rates and they can do that again if need be. What they don’t need to do is make everyone nervous by cutting rates in a panic.
I have not changed my outlook due to the recent problems. Stocks are relatively cheap at about 15 times earnings. Interest rates are relatively low and core inflation seems to be moderating. The housing market is weak (and maybe getting weaker), but I still contend that it won’t be enough to cause a recession. We are still overweight stocks, underweight REITs, equal weight on commodities and slightly overweight cash and fixed income. That allocation has served us well during the correction and I see no reason to change it for now.