Saturday, July 28, 2007

What lies ahead for the markets?

After last week's action in the world financial markets, it's time to take a breather and consider what lies ahead.

First, a review of some of the questions that might come to mind in the wake of our recent market events. The following are some of the concerns that seem to be planted in a great many minds.

  • Are we in for a major U.S. stock market correction?

  • Will the stock markets of emerging economies continue their outperformance of the U.S. markets, or will they overheat and begin to reverse themselves?

  • Have the credit markets been infected by the subprime market's contagion of fear, or are we merely seeing a temporary repricing of risk?

  • Have credit conditions tightened, and if so, does this spell the end for the LBO/private-equity boom?

To answer these questions, let's look to the insight of two noted financial thinkers and investors: John Mauldin, of Millennium Wave Advisors, and Marc Faber, of Marc Faber Limited.

Mauldin has written a piece called, "The Subprime Virus", which looks at the fun and folly of market prediction, while pointing out the usefulness of making predictions and creating economic scenarios in order to assess possible investment risks.

Here's the lead in to his analysis of the recent events in the credit markets.

John Keynes, upon being confronted by someone that he had made a different prediction than what he held a his current view, is famously quoted as having said, "When the facts change, I change my mind. What do you do, sir?"

And I think that everyone in the group would agree. While we take the "game" of investments very seriously, if you do this long enough, you will get humbled quite often. That is why you constantly evaluate your analysis, and change them when the facts change.

And the credit markets are changing their opinion in a very rapid manner. Earlier this spring, the credit markets started to get concerned about subprime mortgages. But "everyone" said it would not spread to the rest of the credit markets, so there was no cause for concern. I was not so sanguine. I have consistently thought that the entire credit markets would be affected, through a tightening of credit standards. And now the markets are starting to agree.

If you read through the essay, you'll see that Mauldin is making one very important point. The "credit markets are acting in tandem", and many assets are currently heading down together due to a tightening of credit and an unwinding of yen carry trades. The leverage that fueled synchronous rallies in stocks, high-yield bonds, and commodities is now working against traders and investors on the downside.

We also have some similar points being made by Marc Faber in a recent Bloomberg Television interview.

Speaking on Friday, Faber gave his reasons as to why the recent market corrections were a bit overdue. In Marc's view, the market internals have lately been much weaker than the leading stock indices would otherwise suggest.

He also adds that credit growth, which has fueled many of the recent asset bubbles in commodities, stocks, and real estate worldwide, is slowing, and that this will cause problems for the economy. As for LBO and dealmaking activity, Marc feels the peak has been reached.

So, if you are one of the investors or market watchers pondering such questions, you may find it worthwhile to review the arguments and opinions offered above. Good reading and listening, and we'll see you on Monday.