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Old 11-12-2007, 02:33 PM
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Default The Credit Crunch and Other Market Myths

The Credit Crunch and Other Market Myths
Last Update: 05-Nov-07 07:48 ET


Financial stocks have been hammered the past few trading sessions. This is justified. The idea that there is a "credit crunch", however, is flat-out wrong. It is a total myth that is belied by the facts. Two other myths that need debunking are that a weak dollar is bad for U.S. stocks, and that the U.S. budget deficit is large and increasing.

The Myth of the Credit Crunch

Briefing.com has had the financial sector at an underperform rating since April. This has proved justified. We expect a continued difficult environment for financial stocks in the months ahead.

The reason is well known - many financial companies hold assets backed wholly or partly by subprime mortgages that are becoming less valuable as delinquencies rise. Companies holding these assets must take charges to earnings to reflect the decrease in value. This is what is happening at Citigroup, which is going to take a huge hit to earnings as they write-down the value of their collateralized debt obligations (CDOs).

But, the revaluing of these assets downwards is NOT A CREDIT CRUNCH. A credit crunch occurs when banks are restricting lending to borrowers that would normally receive credit.

To date, there has been no restriction in the availability of credit outside the subprime mortgage area (where it should have been restricted a long time ago).

In fact, there has been a surge in credit in recent months. The chart below shows that total bank credit has exploded at a 12% annual rate the past seven months.



The explosive growth is partly due to a shift in corporate financing from the commercial paper market to bank loans, but the core lending numbers are also rising.

Below is a chart of commercial and industrial loans, and real estate loans, over the same period since March. C&I loans are rising at a 24% annual rate, and real estate loans are even rising at a 10% rate.



Credit is clearly available to qualified customers. THERE IS NO CREDIT CRUNCH.

This is more than semantics. A credit crunch implies that credit growth will be restricted as banks tighten lending standards across all sectors, with a subsequent restraining impact on overall economic growth. There is absolutely no evidence that this is the case.

This means that the write-down of CDO assets is a problem almost entirely isolated to the financial sector and companies holding those assets. This will not drag the economy into recession.

Of course, the financial sector is very important to the overall stock market. We remain very concerned about the profit outlook at these firms for the fourth quarter. Lackluster or poor performance in this sector, which makes up 20% of the S&P 500, will be a major drag on the overall index.

However, the problems in the financial sector are not a reason for panic to spread to other sectors. There are, of course, profit issues for retail, energy, and other sectors as well, but the type of widespread panic selling seen Thursday and Friday because of "credit crunch" fears was without justification.

The Myth of the Weak Dollar

Another myth that needs debunking is that a weak dollar is bad for U.S. stocks.

This myth may be partly rooted in semantics. What is meant by a "weak" dollar these days is that it is trading at a lower exchange rate against the euro. When stated this way, it is clear that a "weak" dollar is actually a positive for U.S. stocks.

The facts are that a lower exchange rate for the dollar: 1) increases U.S. exports, and 2) increases the dollar value of overseas profits of U.S. multinational firms. These facts are indisputable. Both are unquestionably bullish for U.S. companies that export or have overseas operations.

The argument that a lower exchange rate is bad for U.S. stocks seems to be based on the general arguments that it will lead to higher U.S. inflation, might lead to lower demand for U.S. stocks from overseas investors, or that it somehow mystically reflects unknown weakness in the U.S. economy.

There is no data to support any of these arguments. In fact, the hard data of the past five years refutes these arguments.

Over the past five years, the exchange rate of the dollar has fallen 30 percent against the euro. During the same time, the S&P is up 87%, the U.S. economy has grown at a 2.8% compound annual rate, inflation rates have fallen, and overseas demand for U.S. stocks has not wavered.

Ask any CEO or CFO of a major U.S. company with international operations - is a lower exchange rate for the dollar better or worse for your company? Everyone will say a lower exchange rate is better for profits.

The use of the word "weak" perhaps implies a weak U.S. economy (not true) or reduced purchasing power within the U.S. (also not true). The facts are that a lower exchange rate for the U.S. dollar against the euro is a net positive for the U.S. stock market. (For more on this, please see the October 15 Big Picture column.)

The Myth of the Large U.S. Budget Deficit

Here are the facts: 1) The U.S. budget deficit is low, and shrinking. 2) The total debt burden of the U.S. is declining.

The U.S. budget deficit for the fiscal year ended September was 1.2% of GDP. That is about half the average of the past forty years.

It has been shrinking steadily since fiscal 2004 when it hit 3.5% of GDP. It was 2.6% in fiscal 2005, 1.9% in fiscal 2006, and is now down to 1.2%. That undeniable downtrend is good news that has garnered virtually no press attention.

A surge in tax revenues the past few years accounts for the decline in the deficit. Revenues were up 6.7% in fiscal 2007. Expenditures rose at the slowest pace in 10 years and were up just 2.8%. (Yes, this includes all defense expenditures including those related to Iraq).

Furthermore, the total outstanding debt of the U.S. relative to GDP is shrinking. It was 36.5% of GDP for fiscal 2007. That is down from 36.9% a year ago. This figure has been dropping the past couple of years because the level of the outstanding debt has risen at a slower percentage rate than nominal GDP. The U.S. debt burden level is well below that of most developed countries.

The budget deficit situation is not bearish for stocks. It does not reflect a large buildup of debt that will cripple the U.S. economy or (at current trends) place an undue burden on future generations. The myth of the huge budget deficit is proving hard to dispel despite the facts.

What it All Means

There are plenty of rational reasons to have a cautious view towards the stock market outlook.

The fears, however, should be kept in check. Doing so, and having a sound understanding of the facts, will help investors get through difficult periods and even highlight buying opportunities when others are panicking.

Our market view is cautious. We are only moderately bullish and recognize that the near term action could be very choppy. However, we expect the market to be higher a year from now and continue to believe a year-end rally is more likely than not.

Our view is not affected by the myths that apparently are too seductive for journalists and analysts to address rationally.

We aren't going to get caught up in the seemingly endless hype that the write-offs by Citigroup and others will create a credit crunch that will take the economy into recession. Every time we hear a talking head mention the horrors of a weak dollar on TV, we simply turn off the volume. Most infuriating is the continued talk of the "huge deficit problem" even though this is refuted by a simple review of the facts.

There are enough legitimate issues to worry about given the troubles in the housing and financial sectors, as well as the overall profit outlook, without having to listen to these ridiculous myths just because someone wants to throw additional weight behind a bearish argument. Recognize these arguments for what they are - pure myths.

- - Dick Green, Briefing.com.
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