Is Sub Prime Cancer Terminal?

Hi, Friends,

I’m back from Japan, recovering from jet lag and looking forward to 10 days in the office to reset my body clock. One gets an interesting view of world markets from Asia as the trading day begins there and the continuing supremacy of the Chinese market dominates the region’s news. Wall Street Sector Selector maintains a profitable position in Asian markets which is a good thing considering recent developments in U.S. markets.

Last week we discussed how volatility in the stock markets would continue as the markets adjust to the prospect of higher interest rates, and this week certainly demonstrated that to be true.

Higher rates and inflation seem to be on the horizon, and it’s becoming increasingly clear that the sub-prime mortgage fallout is serious and spreading, in my view, a cancer that could be terminal for this bull market. And just as we had reached record highs in the S@P 500.

Here’s why this situation is so dismal:

Forecasts estimate that there will be more than 1 million mortgage foreclosures this year and that fully 60% of them will come from the sub-prime sector. In Minneapolis alone, foreclosures doubled in 2006 and will double again in 2007, fueled by record levels of sub-prime defaults.

To fully understand the extent of this exposure, one needs to understand that sub-prime mortgages went from $370 Million in 2000 to $1.17 Billion (with a Capital B!) in 2006. And now, almost 14% of these loans are in default.

So, who cares? These are mostly borrowers in inner cities who don’t have any financial or political clout anyway. Right? Wrong.

Not only is enormous human and economic cost coming to these local areas, but it turns out that big players like Bear Sterns, Merrill Lynch and major hedge funds have all bought into and repackaged these securities in search of market busting returns.

And now, these risky bets are coming home to roost. Bear Sterns has two hedge funds heavily involved in this market, and the largest of these is down 23% this year. The company has $20 Billion exposure in these 2 funds, a part of $1.8 Trillion in securities backed by sub-prime debt, and both are in danger of closing up shop.

These are big numbers now going south, and this week Merrill Lynch bailed out of their commitment to Bear Sterns, selling $850 Million in collateral. To make matters worse, these are illiquid securities and many, if not all of them, might be mis-priced and worth far less than current estimates show.

It doesn’t take a rocket scientist to figure out that if institutions like Bear Sterns and Merrill Lynch are getting burned and heading for the exits that the rest of the U.S. equity market might not be far behind.

And, of course, on top of the sub-prime problem, the real estate “slowdown” is turning into a dead stop as rates rise and U.S. homebuilders this week reported their lowest level of confidence in 16 years. With oil close to 9 month highs, the consumer is being squeezed on all fronts, especially those living large on their home equity lines of credit and still driving gas guzzling SUVs.

All these factors add up to a treacherous summer market as we pass the Summer Solstice and the longest day of the year.

And, no surprise, this week the markets reacted to all of these issues with the Dow shedding 2%, the S@P 1.9 % and the NASDAQ 1.4.

Wall Street Sector Selector lost 0.54%, once again demonstrating the power of relative strength, sentiment and the Greed and Fear Index.

Our goal is to make more than the indexes when the markets rise and lose less when they fall. So far, greed is still in control but fear continues to creep ever more strongly into the picture. The uptrend of this current bull market remains in place, although much more tenuously than at the beginning of the month.

We’ll be watching for opportunities that could develop as the market weakens because Wall Street Sector Selector is designed to be able to make money in falling as well as rising markets, something that “buy and hold” investors can’t do.

This weekend finds our family on the road. My young son and I are in Portland for a 4 day swim meet while my wife and #1 son are driving down I-5 to Santa Barbara. Mom’s helping him move into his first apartment which will be his base of operations for summer school and training for the U.S. National Swimming Championships in August.

I hope the first weekend of summer finds you well and having fun with friends and family.

Till next week,

Your partner in prosperity,

John Nyaradi
Publisher
Wall Street Sector Selector
http://wall-street-sector-selector.com