The More Things Change the More They Stay the Same

By: Steve Rubis

Benjamin Graham liked to use this old French maxim in much of his writings on the market. We feel that given the 400 point drop in the Dow today truly illustrates both the letter and spirit of the saying. At this juncture, it seems prudent to take stock of where the market is at and where it has come from. There are a few key points which need analysis: (1) where the market has come from, (2) Chinese stocks, (3) rising interest rates, (4) the housing market, (5) broker call rates. These four variables, if you will, seem to each have a significant impact on where the market will go in 2007.

First, investors need to develop and understanding an appreciation of where the market has come from. Today’s levels are a far cry from the depths of despair back in the summer of 2002. Little did we know then that October 2002 would be the first bottom in a double bottom (the second came in March 2003) and that the market would then take off for the next four years. Much of the market action of last summer seemed to suggest that the market would hit a rough spot at some point in the future. There was a great deal of heady trading in stocks like Andersons, Hansen Natural, and Goldman Sachs just to name a few. As all good traders know, and as Jesse Livermore so eloquently pointed out, major market movements suffer from a roughly six month lag time (Reminiscences of a Stock Operator). The fact that many of the above mentioned stock and others suffered significant declines was a harbinger of the future.

The second issue that investors seem to face at this time is the unprecedented growth in Chinese Stocks. China has been the place for all “hip” investors since the market started inching upward back in 02 – 03. A seemingly endless list of companies have benefited from this extreme growth: Net Ease (NTES), Baidu.com (BIDU), China Netcom Group (CN), China Telecom Corp (CHA), Sina Corp (SINA) and final SOHU.com (SOHU). These stocks have been rewarding investors quite well and all seem to have dropped in today’s sell off. The bullishness of yesterday evenings Asia Squawk Box seems quite fortuitous now that Chinese stocks have dropped 9%. We think that this 9% drop needs to be noted because it seems eerily similar to the end of the tech bubble back in 2001. All stocks eventually adhere to the laws of gravity – what goes up must come down. It seems that Chinese stocks might be in for a cool down.

Next, rising interest rates mean a plethora of problems for economic growth and equity returns. As rates rise, the Fed risks sending the country into a recession, which will in turn affect China’s economy sending stocks lower. The US and Chinese economies are tied at the hip due to the trade deficit. President Bush has created a precarious position where the Chinese are locked into purchasing US Treasuries in order to keep the trade deficit from hurting the economy. Each rate hike applies a little more pressure to the brakes of economic growth. If the economy enters a recession, the extremely large position in US debt held by the Chinese will become quite dicey. The agreement to hold US debt between China and the US is already hurting the Chinese economy. Central bankers are forced to hold a depreciating asset, when there are more attractive alternative investments.

Furthermore, the rising interest rates will begin to hurt the US housing market. We have stated that the housing market was in a bubble last summer. This theory was proven true; however, there has not been much economic fallout. Last summer, interest rates were still below the historical average. As they approach the 5% level, interest rates begin to revert to the mean or historical average. If rates continue to rise there should be a heightened default rate on exotic loans, i.e. ARM’s and interest only. These defaults coupled with rising rates will make the credit market tighten more than anyone can remember. The days of the “housing ATM” will end, and real estate prices will begin to drop. Again, no asset can continue on a perpetual upward price assent; just ask homeowners in California and Texas in the 1990s. Tightened credit markets will keep much needed funds out of would be home buyers pockets. Without the credit, the home buying population will dry up, and in turn prices will fall.

Lastly, the broker call rate currently signals that investors should expect some sort of down turn in the near future. Broker call rates have hovered around the 7% mark for the last six months. In our view, when the broker rates rise above 6%, investors must be more aware of the investing climate. As rates rise above 6%, a signal is sent to investors that less money is available for investment. Rising rates keep speculators from coming to the table; these speculators are essential in keeping upward momentum in the market. After all, someone has to buy the securities when the smart money wants to cash out, and without speculators the possibilities of finding a buyer become scarce.

We do not wish to sound an all out alarm or call to battle stations. Our goal is to get investors thinking, while raising awareness of the fact that a significant down turn could be right around the corner. Many people seem to forget that a chart of the bottom of the tech bubble and a chart of the end of the depression were strikingly similar, so much so that the charts were almost indistinguishable. The market came out of depression in 1932 and rose until 1937; the question is will 2007 provide the significant downturn needed before the market continues to go higher?