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What Went Wrong? October 23, 2007 By Mat Johnson "This is like déjà vu all over again." — Yogi Berra The major equity market indices suffered steep declines this past week, virtually reversing the post Fed rate cut run-up. The brunt of the week’s losses were realized this past Friday, on the 20th anniversary of Black Monday, when the Dow Jones Industrial Average (DJIA) lost -508 points or -23%. For the week the DJIA slipped -4.1%, the S&P 500 fell -3.9%, while the NASDAQ Composite ended the week -2.9% lower. Small cap stocks, as measured by the Russell 2000 index, continued their 2007 weak trend, leading all market indices lower by -5% last week. While the major indices continue to be solidly in the black for 2007, with the exception of small cap stocks (up just 1.4% year-to-date), this past week’s renewed concerns over the housing market and credit market conditions have sparked renewed unease over the future economic growth and as a consequence business conditions going forward. Several events came together this past week that ultimately fanned the flames of investor concern. First off were a number of earnings reports from financial center banks that missed analyst expectations, with each citing credit market losses and the continuing housing slump as the source of weakness. The Federal Reserve echoed this poor sentiment on the housing sector, indicating that weakness was likely to continue well into 2008. As if this weren't enough bad news, the Commerce Department reported that new housing starts fell more than -10% in September, to the lowest level since 1993. This last report suggests that a recovery in the housing sector in 2008 may be an optimistic forecast. One of the few bright spots this past week, came from the business investment side of the economy, where technology companies reported improved business conditions and relatively strong demand, with a particular benefit seen from overseas markets. Notably, this past week's poor news flow came in the face of very high investor sentiment levels, with the ratio of bullish-to-bearish investment advisors rising to a very high 3.2x, up from just 1.1x in late August. The bulls-to-bears ratio among individual investors rose to a more moderate 1.7x, up from less than 1.0x in early September. Given the widely recognized contrarian nature of these surveys, last week’s poor market action is somewhat consistent with the existing high level of bullish sentiment. Looking ahead to this week, the key items of note remain the same. Earnings reports will continue though move beyond financial sector reports. The key will be how well company earnings can counter this week’s economic calendar, where Wednesday we will see the release of Existing Home Sales for September then September New Home Sales on Thursday. Neither report is expected to suggest any sudden improvement. Also out will be September Durable Goods Orders, a key report on the future strength of the future pace of business investment, and at this point the key to offsetting housing and financial sector weakness. The final economic report of the week will be October Consumer Sentiment. While the survey is a very small sample of consumer sentiment, there will likely be a lot of interest nonetheless as it will serve as the proverbial canary in assessing how consumers are tolerating the poor news surrounding home values, the volatility in the stock market, job market confidence and of course their indication of future spending — the latter being of key importance in advance of the holiday shopping season. What Could Go Right? There has been a disproportionate focus recently on what is going wrong, leading to heightened volatility surrounding housing and credit market developments. Despite the poor news backdrop however, economic and stock market fundamentals continue to be broadly positive. The economy continues to grow, albeit modestly, while employment conditions continue to show modest growth. By comparison with the early 1990s, where there also existed a financial sector "crisis" (savings and loans), a housing market "correction," and a sharp upturn in energy prices, the broader economy and employment conditions in particular, has remained quite resilient. Thus far, this aspect has already gone right. Much of the U.S. economy’s resilience is likely owed to globalization, most notably the outsourcing of much of our volatile manufacturing employment. In prior financial "crises," the economy has been subject to far more employment volatility as a result of manufacturing sector employment. Additionally, while much attention has been placed on current domestic concerns, international economic growth has continued nearly unabated. This taken together with the weak dollar that has vexed foreign demand for U.S. assets, strength in foreign economies may ultimately prove a catalyst for U.S. multinationals. As the dollar has declined, it is creating a more attractive pricing environment for U.S. goods and services in the global marketplace. Should this lead to stronger demand and a strengthening in U.S. company fundamentals, the end result could be greater foreign demand for U.S. financial assets and U.S. equities in particular.

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