Predicting a market correction is sometimes easier than actually witnessing it.  In our June article, we offered our thoughts and forecast about the market acting like Tsunamis that come in multiple waves!  We just witnessed almost two months of 200 point swings on the Dow and multiple percentage declines in all three major US indices followed by huge rallies in a few days.  This activity feels like riding a roller coaster.  A daily microscopic view of all the gyrations makes it difficult to see and understand what really is going on with the economy and with the stock market. 

In general, the stock market reacts to three fundamentals:  first, what is happening in the general economy; second, how easy is it for business to access cash (liquidity); and third, are the current weaknesses in the economy expanding to derail the first two fundamentals.  Everything else is psychology.  In any six month period, emotions (the interior) may move the market more than the fundamentals; but on a long term basis (beyond six months) the fundamentals are what matter.  For instance, daily market trading between Memorial Day and Labor Day is less than average.  Under those conditions, a little bit of panic can move the market much greater than at other times of the year.  Below is a chart illustrating this effect from the last few years.  Notice over the last three years the summer has been one of the most volatile periods for the equity markets. 

When we examine the chart and review the same indices since 2005, we see that volatility was high in the summer of 2005 as well.  From May of 2006 until mid September, we experienced great volatility in the US equity markets and in both years we ended with positive returns for the year and excellent economic growth.  (In 2006 the Dow was up 16.3%, S&P 500 was up 13.6% and the NASDAQ was up 9.5%; in 2005 the Dow was down less than a point, -0.61, S&P 500 was up 3.0% and the NASDAQ was up 1.4%.)  In 2005, the Dow closed at 10,717, 12,463 on the 29^th of December 2006 and on August 30, 2007 it closed at 13,288.  So the Dow is up 24% from 2005's close and 6.6% from the beginning of 2007.  The statistics show that despite volatility the general direction of the stock market is positive, which is what we currently expect for 2007. 

During these earlier periods, interest rates were rising (the beginning of the end of the housing bubble) and the catalyst for the subprime meltdown (we are experiencing today).  The clean up of the subprime mess and the credit crunch will not disappear overnight, and we suspect may take years because the long term effect will decrease the demand for housing.  In our recent history, housing busts occurred most notably starting in the late 1980s and ending in the early 1990s.  

Housing slowdowns always cause a slowdown in the overall economy.  However, relevant facts that do not make the news may give you a broader picture of the current situation.  There are approximately 300 million Americans.  These 300 million Americans are divided into 114 million households.  This means there are approximately 2.57 people per household.  According to the March 2006 US Census Bureau report, the same report lists 78.3 million homeowners and 36.1 million renters (of which 1.4 million do not pay rent).  The 78.3 million Americans who own homes can be broken out further:  33 million Americans own their home without a mortgage and of the remaining 45 million, a full 37.5 million are considered prime mortgage holders. 

As we noted in an earlier report on the subprime mortgage market, almost 40% of homeowners own their houses free and clear.  This group is highly represented by the approximate 35 million American retirees who receive Social Security.  Of the remaining 60% of homeowners with mortgages, better than 80% are classified as prime mortgages.  The percentage of prime mortgage holders who make their monthly payments on time approximates 97%.  A small 3% are delinquent, slightly higher than average, but hardly enough to destroy the prime mortgage market.  Only 14% of the 60% of mortgages in the United States are subprime and Alt-A mortgages (usually these are of the no-income verification type loans).  With interest rates high and home values decreasing, we must make an educated guess that many of these loans will foreclose.  Assuming that the entire mortgage market is $10 trillion dollars, the subprime and Alt-A market is $140 billion.  If half of the loans are foreclosed (this would be a high estimate), the result is $70 billion in foreclosures.  Usually a bank can assume 67% of their money in these markets is recoverable.  For argument's sake, let's make it awful and say they lose 50%.  That means there is a $35 billion loss from foreclosures spread out over the entire US with higher concentrations in Nevada, Florida and Arizona (the location of most subprime loans). 

Although, a $35 billion dollar loss may seem huge, it is not as if one company or group will absorb the entire loss or that it is a significant part of an investment portfolio (outside of some banking groups, hedge funds and private equity groups).  To add perspective, the entire bond market is valued at about $27 trillion with the mortgage component comprising about one third of this, $6.5 trillion.  Approximately half of all fixed income securities are in money markets, US, federal agencies and Municipal Bonds.  Twenty percent of all bonds are corporate bonds. [1]On the grand scale, we are looking at a loss of slightly more than ½ of 1% of the entire mortgage market.  Most pension funds and fixed income portfolios try to match the overall percentages; therefore, in truth most portfolios have an exposure of slightly more than ½ of 1% of their entire holdings.  The fees for managing the portfolios are usually greater than the loss in a worst case scenario.  For these reasons, the subprime market collapse should not have had the recent effect on the equity markets.

We believe that the overactive volatility is also a result of the psychological (interior) response of market movement.  From an integral perspective, the lower right quadrant (exterior) offers information that our economy has not suddenly fallen off a cliff.  It is operating as would be expected with a housing slowdown working its way through the economy.  The upper right quadrant shows individual companies in particular sectors have either taken profits or losses from the current situation.  Simply stated, there is nothing economically radically different from six weeks ago that accounts for the current volatility.  So, viewing from an integral perspective, the We (society surprise at the reaction by the stock market) causes some I's (individual investors) to panic and sell when it is best to notice the whole from a larger awareness.  Broader awareness using an integral map allows one to see the short term issue and opens space for opportunities and conscious choices.     

Current volatility can also be attributed to Paine Webber investing much more heavily into subprime mortgages than they had reported; subsequently, they lost more money than expected.  Other companies, such as Thornburg Mortgage Association (which does not originate or invest in subprime but instead invests in jumbo mortgages, the prime of the prime), suffered calls on their loans from their bankers.  They experienced and survived a cash squeeze but it still further frightened the market.  Both companies for different reasons lost capital and their shareholders lost a good part of their investment.

The important part for investors is that the losses were taken quickly and reported.  Panic set in quickly and our Federal Reserve, along with the Central Banks of other countries, quickly provided sufficient liquidity to stem the crisis.  Now we face the psychological pain (fear) that maybe there are worse situations around the corner.  Panic is all about fear rather than reality.  We anticipate a few more confessions of financial institutions which may produce some difficulties in the coming weeks and months.  Those companies will see their shares drop and the market may drop a bit too, but the severity should be moderate compared to the last six weeks.  We also suspect that the coming losses will not be as huge as the losses already reported, so we believe the worst of the volatility is most likely behind us.  One last note, the US Stock Market is valued at $18 trillion.  If one is a subprime mortgage company or heavily invested in subprime mortgages or a borrower who is less than prime, it is a major problem.  However, for the rest of us, the subprime mortgage albeit a problem; it is a relatively minute one for the majority of investors! 

To put the investment in perspective, it is estimated that when the internet bubble burst, $7 trillion in equity was wiped out in an 18 month period.  Should half the subprime loans go sour and the banks only receive 50 cents on the dollar on foreclosed homes, the entire loss is estimated at $35 billion.  Granted, $35 billion is a lot of money, but it is nothing compared to the $7 trillion lost from the internet bubble burst or the $2 trillion loss from the 9/11 attack.  And even with the 9/11 attack, we had one of the mildest recessions on record and bounced back quickly. 

Now looking out at the fundamentals, what is going to propel us into a recession or keep us from falling off the proverbial cliff?  First and foremost, according to the federal government Bureau of Labor Statistics, 146 million Americans are employed as of July 2007 with 7.1 million Americans unemployed.  Another 68 million Americans are under 18 and are not included in these figures as well as 35 million Americans who receive Social Security.  There are also 85 million Americans of working age but unemployed and not seeking work.  So 96% of us are working. 

For the past 48 years (since 1959), we have not had a reduction in consumer spending.  Even after the internet bubble burst, consumers continued to spend just as they did during the 1974, 1978, 1987, and 1994 recessions.  With housing prices dropping in a controlled manner and only the subprime bubble bursting, consumers will likely continue their pattern albeit a slower pace.  All in all, a positive result.  Wal-Mart sales are hurting; but Tiffany's, Hermes, Target and Kohl's all seem to be holding strong.  I doubt subprime mortgagees buy in Tiffany's so we are not surprised that the lowest end retailers are suffering.  That is to be expected. 

Back to our Tsunami metaphor, we are not surprised that the volatility continues in the market and we expect it to remain for several weeks.  Unless we observe more negative numbers spread to other sectors of the economy, i.e., beyond housing, finances and the construction industry, we believe the economy is slowing but will not go into a recession.  Most trade publications that poll consumer and business purchases are showing a mild reduction in spending but not enough to push us into a recession.  Therefore, we expect the global expansion, which continues to assist our economic growth, to avoid a recession. 

In conclusion, given these thoughts, information and perspective we do not recommend any changes in our investment decisions because most of what we are seeing we expected the direction although not the severity. 

[1] This information is gathered from the SIFMA (Securities Industry Financial Market Association).