Credit Squeeze Explained...

A few weeks ago at our meeting we watched this brief interactive overview of securitization, the subprime mortgage fallout and the subsequent credit squeeze. I think we all found it very helpful so I am posting it again so that others can watch it as well: FT.com: Credit Squeeze Explained

Investopedia

We had a very good meeting this week. We introduced a lot of jargon and technical terms in our case study. Here is a link to an Investopedia tutorial which should provide some background for the terms we used. Stocks Basics: Introduction

Freeport-McMoRan and the Mining Boom

Last week, PBCM bought Freeport-McMoRan (FCX) as a play on surging copper, silver and gold prices. While we won't divulge into our thesis here, Mark sent me an interesting article from the Financial Times on the mining and resource stock boom:

Mining

Published: October 21 2007 19:20

After being badly burnt by companies that made nothing, it is not surprising investors switched their allegiance to real assets when the dotcom bubble burst. What could be more real than stuff in the ground?

But seven years on, the incredible run in resource stocks has the look of a bubble itself. There is a near-universal bullishness, while some accuse sceptics of just not getting it. Mining sector bankers and commodity traders are in the ascendancy, much as their technology colleagues were in the 1990s. Retail investors are suddenly experts on nickel. In the same way that the internet was once an article of faith, investors now bow towards China.

The latest surge in resource stocks the sector has bounced more than 15 per cent since the 50 basis point rate cut in the US feels frothy. But the forward price/earnings ratio for the global metals and mining sector is still only 13 times. That is below the 10-year average of 15 times and well short of this decade's highs, when forward multiples hit 20 times. One reason why valuations pale beside the lunacy of the tech bubble is because company analysts are more conservative than commodity traders stock analysts' earnings estimates reflect commodity price forecasts as much as 40 per cent lower than prices in the commodity futures market.

Resource bulls argue that concerns about future supply are misplaced and that production problems will maintain upward pressure on everything from iron ore to copper. Indeed, one of the mysteries of the sector is why production growth has been so low, given that most metal prices are far above the levels required to justify investment. But even if that situation continues in the short term, it is a bad habit to extrapolate rising prices forever as new capacity is being built and one day China's growth will slow. Also common to all booms is the tendency to forget that even the most positive trends may already be discounted.

The SMLEC and Black Monday's 20th

Citigroup, JP Morgan and Bank of America recently unveiled their $100bn SMLEC (Single Master Liquidity Enhancement Conduit), which is designed to prevent a fire sale of illiquid Asset Backed Securities, which have been plagued by the recent subprime mortgage crisis. While the announcement briefly relieved fears of financial crisis, and while other banks have bought into the plan, the SMLEC has also raised a lot of questions. Many bankers are worried that the willingness of the SMLEC to buy assets at higher-than-market prices is a moral-hazard; they think that the financial institutions should take the hits for their risky bets. Moreover, many critics see the SMLEC as short term relief from symptoms of a much greater problem, and argue that the SMLEC will only push the problem deeper into the future. It remains unclear what role the Federal Reserve is playing in this mess. You can read more about it on FT.com:

On Wall Street: Out of frying pan but fire sale is on hold

Last Friday was the 20th Anniversary of Black Monday (October 19, 1987). Black Monday was one of the greatest financial crises of the 20th century, and basically occurred when a relatively small sell-off (due to fears of overvaluation) was massively amplified by systemic risks within the markets. As equities were sold off, many portfolio managers attempted to protect their portfolios through the same hedging strategy. But ironically, the more they hedged against their losses, the more losses they incurred. This led to more hedging and more losses, and the market quickly spiraled into free-fall. The market dropped 23% in one day, the largest single day drop on record.

Last week, many investors were spooked by the 20th anniversary of this crisis, especially since the subprime mortgage crisis has created so much uncertainty within the markets. While some investors were worried after the sell-off late Friday that a repeat scenario would occur at the beginning of this week (Mark and Tyler included), markets seem to have rebounded on strong earnings reports from companies like 3M, Apple, DuPont and AT&T, and also on news that other banks will be supporting the SMLEC.

Mini tech bubble?

This graph shows the three-month comparative returns on the NASDAQ (blue) and the S&P 500 (Orange). As we can see, the NASDAQ and the S&P took roughly the same hit from the subprime mortgage crisis at the end of the summer. The bottom graph shows volatility, which is helpful in noticing where things got really messy from the subprime issues. Since late August, both indices have rebounded dramatically, but they are beginning to diverge.

The NASDAQ is weighted heavily with technology stocks, whereas the S&P is a more diversified index covering technology, financials, industrials, etc. Since late September we have seen a roughly 4.5% divergence in these indices. Stocks such as Apple and Google have seen outstanding runs in their share prices, but some analysts are becoming skeptical of their market valuations.

We talked in previous meetings about the tech sector as a safe haven from the mortgage crisis, which could also be a contributing factor. As tech companies report their earnings this week, we will begin to see how they are really doing. Apple is off to a good start.