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Why Sub-Prime and Private Equity Are Sabotaging This Bull Market

Today's comment is by Eric Roseman,

Dear G&G Newsletter Reader,

Although global stocks are recovering from last week's plunge, I still see more distress for the troubled U.S. sub-prime mortgage market and more funding problems that are now engulfing private equity companies.

After the deepest weekly plunge in stock values since late 2002, it's highly unlikely that the bull market can quickly recover and resume its primary trend. That's because credit spreads, or the yield differential between risk-free Treasury bonds and lower credit bonds, is rapidly widening from all-time lows (see the chart below).

A liquidity crisis has emerged globally and markets are screaming for more credit as the distressed debt market continues to hemorrhage.

The problem is most central banks are still raising interest rates while the Federal Reserve remains vigilant and continues to target rising inflation.

If central banks won't cut lending rates, then global market participants will have to soak-up the excesses in credit derivatives, leveraged loans and mortgage-backed securities. That task is far more difficult when the Fed isn't creating liquidity to offset credit distress.



A 10-Second History Lesson

With high-yield bonds plunging in value since last week, more than 40 deals have been shelved as institutional buyers have backed away from leveraged loans. If you look at history,, buyers are reacting just as they did the last time we had a major credit crisis. In fact, previous credit crises have accurately foreshadowed additional stress for stocks.

According to Morgan Stanley, turmoil in credit markets this year is likely to continue to spillover into stocks. Over the last 20 years, corporate bond spreads widened on average six months before European stocks reached highs in 1987, 1991, 1998 and 2000. Subsequent declines of at least 10% followed for European shares.

The same phenomenon occurred in the United States during those four years when stocks declined right after the liquidity crisis in the credit markets.

The distressed debt sector, marked by junk bonds and syndicated loans, is suffering from the inability to secure crucial financing amid soaring yields. Treasury bonds drew the bulk of safe-haven flows last week from nervous investors. As equities tanked, weaker credits saw their yields hit fresh 52-week highs, including emerging market bonds.

Also, several more mortgage-backed hedge funds in Australia, the United Kingdom and the United States have collapsed or closed as a result of huge losses.

The Overseas Markets Are Catching a Cold from the Sub-Prime Plague

The sub-prime crisis in the United States has now spread overseas, although on a much smaller scale.

In Germany, two banks, including the country's second largest, Commerzbank AG, reported losses exceeding US$100 million this year. Britain's HSBC Holdings, the biggest bank in the world, aggressively purchased U.S. sub-prime subsidiaries earlier this decade and has been saddled with huge losses far in excess of Commerzbank's.

Fallout from the sub-prime mess is also affecting REITs.



Watch as REITs Crash 15% in 2007!

After a stunning six-year rally, U.S. real estate investment trusts or REITs, have crashed 15% this year taking the majority of REITs elsewhere in the world, including Europe, to the basement.

Eventually, the best bargains in the market will surface in U.S. and European financial services stocks, including REITs. Many of these issues have either corrected sharply or crashed.

But until the Fed relents and starts cutting interest rates or the last shoe finally drops, stay away from the financial services sector. Lower lows are coming our way.

Thanks

Gary Gray
Tax & Financial Consultant, RFC
G&G Associates
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