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Thursday, 15 March 2007 00:00 Written by James Van de Voorde

What a difference one week can make.  After 949 straight trading days without even a 2% single-day decline in the S&P 500, the longest such stretch of low volatility since 1950, stock market volatility came back with a vengeance during the last week of February and into the first week of March.  The 85% surge in the VIX index, the most common measure of stock market volatility, was the highest short-term spike in volatility since the September 11, 2001 terrorist attacks on the World Trade Center.    Through February month-end, the Dow Jones Industrial Average and S&P 500 Composite were down 1.56% and .81% respectively, while the NASDAQ Composite was barely positive at .04%.  These major market indices are now all down more than 5% from their recent highs.
    The question on investor’s minds is whether this is a market “correction”, historically defined as a decline of at least 10%, or the start of a new bear market in stocks.  Before analyzing the various causes associated with what we firmly believe to be a corrective phase, it is important to remember that the strong fundamentals underpinning the economy and the stock market remain intact.  Specifically, U.S. Gross Domestic Product (GDP) is still expected to advance by at least 2% for the year, inflation remains in check and within the Fed’s comfort zone, interest rates remain low and stable, earnings are likely to advance by mid to high single digits, corporate balance sheets are in great shape and valuations are very reasonable.  In fact, given the pullback in equity prices and subsequent rally in the bond market, stocks are as cheap relative to bonds as they have been in several years.
    In our January client newsletter, we offered our “base case” expectation for a 10% 2007 advance in the S&P 500, but cautioned that “we wouldn’t be surprised to see a 5% to 10% correction” due to the possibility for worsening conditions in the housing market and projected “an approximate range of 1350 to 1625 for the next 12 to 18 months”.  At 1374, the S&P 500 currently trades at 14.5 times S&P’s own 2007 forecast for operating earnings and stands approximately 2% from the bottom of our projected range. 
    What has changed to influence such a sharp pullback?  While the following list of worries is associated with causing the current correction, the answer may simply be that investors had become too complacent.  A correction should serve as a necessary (but painful) reminder of risk, shaking out weaker hands and speculators, and provide long-term investors an opportunity to buy on the dip.
    China: The Shanghai Composite Index fell 8.8% on Tuesday, February 27 for no apparent reason.   This was the biggest single day drop in that index since 1997.  The fact is that the Chinese index surged 130% in 2006, so a significant pullback should be expected and very healthy.  The Chinese economy continues to run on all cylinders, which is sparking inflation concerns and raises the possibility for higher interest rates or other growth curbing measures by the Chinese government.  The government denied rumors it was considering a capital gains tax to rein in speculation.  The decline in Chinese stocks and other emerging markets should serve as a vivid reminder of the close relationship between risk and reward.
    Japan: The Bank of Japan raised short-term interest rates from .25% to .5% on February 21.  For years now, hedge funds and other speculators have been borrowing at historically low interest rates in Japan and using the proceeds to buy higher risk investments around the world.  This has been referred to in hedge fund circles as the “carry trade”.  While the increase from .25% to .5% may not seem like a serious enough increase to warrant such a strong reaction, officials within the Bank of Japan have surprised markets by telegraphing the potential need for additional rate hikes.  To make matters worse, the Japanese Yen has rallied sharply against the dollar, making the repayment of yen loans more expensive with weaker dollars.  There are no precise statistics for the ultimate size of the so-called carry trade, though it has been estimated at $1 trillion.  The unwinding of this trade is no doubt wreaking havoc within the darkest corners of the unregulated hedge fund business.    
    Sub-prime mortgages:  The sub-prime market is defined by credit lending to the lowest quality borrowers (FICO scores less than 650).  Mortgages represent 30% or approximately $12.6 trillion of the total $42 trillion U.S. bond debt outstanding.  Of this $12.6 trillion, 15% or $2 trillion in adjustable rate mortgages will reset to higher interest rates over the next five years.  Of this $2 trillion, approximately $500 billion is considered sub-prime.  So, the sub-prime portion of the mortgage market represents 25% of the adjustable products due to reset over the next 5 years, but only a small fraction of the total mortgage market and an infinitesimal portion of the total market for U.S debt.  With delinquencies rapidly on the rise in this sector, shares of companies that specialize in sub-prime loans such as New Century Financial, NovaStar, Fremont General and even IndyMac have tumbled.  Likewise, most mortgage lenders and federal bank regulators are talking tough on raising lending standards.  In the short run, problems in the sub-prime market will all but eliminate what had become an important source of liquidity and perhaps accelerate the decline in the housing market.  In the long run, a more rational market for mortgage lending is sure to emerge.
    Recession: Since first warning of the risk for recession just prior to the beginning of this correction, former Fed Chairman Alan Greenspan has since softened his rhetoric and now recants that “it is possible we can get a U.S. recession toward the end of this year, but it is not probable”.  The catalyst for recession would almost certainly come from continued weakness in the housing market.  Yet, as we wrote in our January newsletter, we believe that the Federal Reserve would come to the market’s rescue with rate cuts and lessen the impact of a housing led contraction. 
    Indeed, in one short week, the futures market went from 14% odds that the Fed would cut rates this year to a remarkable 76% chance for a cut.  What a difference one week can make!  In the previous four rate hike campaigns engineered by the Federal Reserve (1984, 1988, 1994, 1999), there was an average of only four months after the last rate hike before the Fed changed its stance and actually cut rates.  Having paused at the August 2006 meeting of the FOMC, we currently stand at 7 months since the last rate hike.  With the yield on 10-year Treasury notes down to 4.46%, the bond market (and futures market) is at once signaling a flight to quality and increasing pressure on the Federal Reserve to cut rates.
    Finally, pessimism is rising sharply and, as a contrary indicator, signaling an imminent end to this correction.  In just one short week, the American Association of Individual Investors (AAII) survey on investor sentiment went from 53.9% bullish with 22.3% bearish to only 33.6% bullish with 39.6% bearish. 
    In short, as is typical during corrections of this sort, the market seems to only focus on the bad news and ignores any silver lining.  Fear is a powerful emotion, but not useful in governing our investment decisions.  We take great comfort in the fact that every single company in the core of Osher portfolios has a massive stock buyback plan in force, thereby allowing for the fulfillment of the buyback at more desirable prices.  Further, we are confident that this correction will further strengthen Osher holdings as investors seek shelter from the storm with the relative safety of high quality growth companies that are even more attractively priced.

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