Upbeat words, mellow mood
On Wall Street, an optimistic Federal Reserve chief trumps just about everything else -- including mortgage-market debacles and jitters over possible hedge fund meltdowns.
That was evident last week as investors weighed Fed Chairman Ben S. Bernanke’s upbeat words on the economy in his semiannual testimony to Congress.
Although he gave the obligatory nod to inflation concerns, much of Bernanke’s commentary was right in line with the economic “soft landing” scenario that underlies the bullish case for stocks.
“The U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable, average pace of growth,” the Fed chief told the Senate on Wednesday.
Investors got the message: If the economy slows and inflation stays tame, the Fed is done raising interest rates. And if rates aren’t going up anymore, there’s always the chance they could start coming down.
The stock market responded with the rare occurrence of simultaneous record highs for the Dow Jones industrial, transportation and utility share indexes.
Before Wednesday, the last time those three market indexes closed at new highs on the same day was March 17, 1998. Since 1928, that hat trick has occurred just 20 times. And for the most part, the event has been a harbinger of more gains for stocks rather than a warning of an impending peak.
Another sign of the broad-based demand for stocks: The Value Line Arithmetic index, which gives equal weight to each of its 1,600 U.S. stocks regardless of company size, hit a fresh record high Friday and is up 5.3% this year. If it keeps up this pace, the index will jump about 40% for the year.
Not that anyone believes that’s going to happen. Indeed, the better stocks perform, many investors’ natural tendency is to wonder what might go wrong.
There’s never a shortage of things to worry about, but two threats to the market’s blissful mood seem to stand out now.
One is the direct fallout from the economic slowdown that Bernanke expects to persist. The housing market is ground zero for these concerns, as home prices continue to decline in many parts of the country (although not in Southern California, where the median sale price was 5% higher in January than a year earlier, DataQuick Information Systems reported last week).
Some homeowners who got mortgages even though they were high credit risks now are finding that they really couldn’t afford to buy after all. That is translating into rising defaults on so-called sub-prime mortgages designed for these borrowers, and hefty losses for some lenders that once thrived by serving that market niche.
Shares of Irvine-based New Century Financial Corp., a major name in sub-prime loans, have plunged to four-year lows since the company this month warned it would have to restate 2006 earnings because of mounting loan defaults. (The stock closed Friday at $19.40, up 62 cents; it’s down 39% this year.)
But is this a bigger story, beyond the troubles of some overzealous lenders?
Wall Street obviously doesn’t think so. And Jan Hatzius, chief U.S. economist at Goldman, Sachs & Co., believes the market has it right.
“It’s hard to make the case that it should be a big macro story,” he says.
Even if $300 billion of sub-prime and other high-risk mortgages go bad in the next few years -- a significant sum -- “this would be equivalent to just one bad day in the U.S. equity market in terms of the wealth destruction,” Hatzius says.
To put it another way, it would be the same as broad market indexes falling about 1.6%. That’s not exactly a crash.
Still, the mortgage mess feeds into worries about a second threat: the indirect fallout from a slower economy.
The sub-prime loan woes are rippling into the bond market, because many of those loans were packaged and sold to yield-hungry investors via mortgage-backed bonds.
That raises the possibility of a disastrous chain reaction in markets if hedge funds and other big-money players, feeling the need to lower their risk levels, rush to unwind the aggressive bets they’ve made on bonds, stocks, currencies and other assets in recent years.
One brokerage report making the rounds in London in recent weeks painted a picture of global markets as Krakatoa, a reference to the devastating Indonesian volcano explosion of 1883 that was felt worldwide.
Hedge funds, private-equity investors and other high rollers have made liberal use of borrowed money to make their bets. Leverage magnifies gains when markets are going your way. But when a bet goes sour, leverage magnifies your losses.
The risk of a cascade of selling by leveraged investors desperate to close out their positions is ever present in markets, of course. The question is whether it’s a far greater risk today than Wall Street overall wants to believe -- in other words, a volcano ready to blow.
A big test may loom: Japan, with its rock-bottom interest rates, has been a popular place for global speculators to borrow and use the loan proceeds to buy investments elsewhere. This is called the carry trade.
If Japanese interest rates were to rise, those speculators might be driven to quickly close out their loans and sell whatever it was they bought -- sub-prime mortgage bonds, nickel futures or something else that had been hot.
Fear of a Japan-induced selling wave ticked up last week after the Japanese government said the nation’s economy grew at a 4.8% annualized rate in the fourth quarter, far faster than expected. That fueled talk that the Bank of Japan could raise its benchmark short-term interest rate from 0.25% to 0.5% when policymakers meet this week.
Even at 0.5%, Japan’s rate would be a pittance. But in markets, it’s often the trend that matters. The Bank of Japan raised the rate from zero in July. Another increase could cement the idea of an upward trend.
And that, in turn, could compel some leveraged speculators to terminate their bets.
A surge in the value of the yen last week, from 122 yen per dollar at the start of the week to 119.26 on Friday, reflected the sudden turn in sentiment on Japanese rates. And as the yen strengthens, it makes life worse for speculators by raising the cost of paying off their yen loans.
“There are some people who are feeling pain right now,” says Michael Woolfolk, currency strategist at Bank of New York.
But if these are the early rumblings of Krakatoa, it’s clear that booming global stock markets aren’t paying much attention.
Investors may just have been lulled into a false sense of security. It’s happened before.
Or it may be that, for many investors, the Krakatoa scenarios either are too far-fetched or are so dire that there wouldn’t be any point in trying to prepare for them.
To Wall Street, what isn’t far-fetched is that the Fed could be engineering the same economic transition it achieved in the mid-1980s and again in the mid-1990s: a soft landing that stretches out the expansion and, thus, stocks’ bull market.
Ben Bernanke sees history repeating, and right now that’s pushing aside a lot of things investors might otherwise be fearful about.
