What is up with the economy???

August 16th 2007

Eating my sandwich before heading out to get my MIT student ID, I was shocked to learn that the Dow Composite had dropped another 300 points to 4095. I quite literally had to knock myself unconscious and drag my body out of the door so that I would avoid pressing the Panic Sell button on my 100% equity portfolio. And even though I was later found dancing outside the student center like an idiot with my new ID card, I was worried and confused. "What is going on with the market," I thought to myself, "how can Dow dropped 600 points or 11.1% in just 7 trading sessions? Are we heading towards re... re ... re... recession?" (Oh my... that was difficult to type)

Now... 11 trading sessions later, Dow Jones has bounced back nearly 8% on very low volume. The economy is at a crucial juncture to say the least. September is poised to be a volatile month, as Wall Street participants came back from vacation to analyze Fed's action on Sep 18th and the earning release by Bear Stern and the likes.

Divergence between the Economy and the Credit Market

Here is what I think... The Economy was doing very well for the 1st half of the year. GDP was on pace to a 4% annual growth... Inflation was controlled at 2% a year... Real income was rising and unemployment rate was low. Most important of all, 1st and 2nd quarter earnings for corporate America was growing at 8% and 12% rate, respectively.

Credit market was doing okay as well. Fed has stopped raising Fed Fund Rate for more than a year, reliving price pressure on Bond price. Subprime was not a big problem. Everyone in the market already knew about subprime mortgage mess (or else the yield won't be so high) It's just that most people in June didn't think that this was a real issue because subprime mortgage loans comprised only 2% of the credit market, and the 10% default rate was hardly out of ordinary. So it's not like "subprime woes" was a new news.

Suddenly, fear had started building in July, and Bear Stern hedge fund mess added fuel to this fear. Everyone understandably tried to reduce their exposure to subprime, causing the exit door to be extremely crowded. Investment banks who had quant funds that were heavily leveraged in subprime loans (i.e. Goldman Sachs) were hurt significantly by this market action. With loan's face value in a free fall, suddenly no credit was good credit. Even the prices of the most highly rated bonds were pressured, and as a result, mortgage companies like Countrywide, who would had otherwise been fine financially, were in deep trouble, forcing the Fed to step in and cut discounted rate. Fed's action allowed big player like Bank of America to swoop in and stabilize the mortgage market... for now.

Even though subprime problem hasn't fundamentally worsen to this degree, the fear has caused a real consequence. Usually, the health of credit and stock market are highly correlated with each other, but they are now in divergence. Depends on your personality, you can look at this situation as glass half empty or glass half full. If you are more pessimistic, you would think that the economy would eventually be dragged down by the credit woes because company will have no liquidity to run its operation. But if you are more optimistic, you'll believe that the strength of the economy can ease the problem in the credit market.

My Prediction

Rate cut or not, I think we are fine. I believe that the economy and the stock market will be trending up and we will survive September's volatility. Here are my reasons...

1. Central Bank and Washington DC are well aware of the consequence. They have acted and have promise to do more to avoid a recession, especially during the election year.
2. Corporate America do not need to borrow to run their operation. Cash level at most of the DJ30 companies are at all-time high. Earning growth needs to seriously deteriorate before Corporate America are forced to scale back and borrow.
3. People have jobs and they are becoming richer. Spending is not going away that quickly.
4. Mild hurricane season has kept the commodity price, hence inflation, relatively in check.
5. Global economic growth can save America from recession.
6. I am a MBA student and I am 100% invested in equity. I need the economy to be in a good shape so I can find a great internship and pay off my tuition.

Until next time...