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The first quarter of 2008 was characterized by extreme turbulence in the financial markets as the economy weakened toward recession. A bear market in real estate has now led to the biggest crisis for the financial sector in thirty years as the world’s largest banks have written down as much as $230 billion worth of subprime loans and collateralized debt obligations since the beginning of 2007. Deterioration in the credit markets has led to a “credit crunch” of unknown proportions, whose duration is still in question. The most surprising element in the first quarter is the lack of this financial turbulence spilling over into manufacturing, household spending, or other areas of the economy. Some economists in recent days have been drawn into believing that the worst may be over for the stock market, as the Bear Stearns bailout or the additional $19 billion write down by UBS (for a total of $37 billion) is interpreted as a sign that we have hit bottom. However, any investor optimism may be premature for several reasons:

The market which is leading to the subprime mortgage meltdown is the real estate market, which has shown no signs of stabilizing. Many mortgages over the past five years had low introductory rates, and will be re-setting upward this and next year. This may accelerate foreclosures, which are already at a record rate.
There are plenty of future loan write-downs coming among financial institutions. The German Banking Supervisory Authority (BaFin) has estimated that the worldwide potential total could be $460-$600 billion, although no one really knows.
Leverage in the U.S. household sector, expressed as debt-to-income, is still at historic highs. While weakness in the mortgage loan market is by now well known, some economists predict new problems in the credit card and auto loan market.
U.S. households will be forced to spend less, which will have a negative impact on economic growth. For the period 2000-2006, GDP grew at 2.4% per year, 85% of which was due to consumer spending. While household debt grew in the 1990’s by only 1.5% per year, it grew by 5.5% per year in the 2001-2006 period. As households pay down debt, GDP growth will soften.

Will the bad news get considerably worse in the quarters ahead? If credit worries ease up, things should go better for the economy and the stock market. The Federal Reserve cut their key Federal Funds rate by 1.5% in the first quarter, down to a level of 2.25%. If the senate housing relief package is passed next week, this may help to underpin the credit markets. Furthermore, the collective effect of tax rebates which will be offered to the American public this year may provide needed fiscal stimulus. Excepting a breakout of the crucial 1400 level on the S&P 500 index, however, we would continue to remain cautious on the stock market.

For the first quarter of 2008, the Dow fell 7.6 percent, the S&P 500 was down 9.9 percent and the Nasdaq lost 14.1 percent.
Grant Rogers Elizabeth Allen

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