Market is Reading Too Much Into IBM’s Positive Result

The financial economy may be careening around like a drunk businessmen at a trade show, but it doesn't seem to be slowing down iron ore. "Expectations of higher benchmark iron ore prices are rising with the rumour that Brazilian mining giant Vale has pitched a massive 70% price increase at Chinese negotiators."

This would be welcome news for Aussie ore juniors. The juniors, like everything else in the market, have been smacked down hard in the last month. But a rise in the ore price of that magnitude would seem to confirm that the building and infrastructure boom in China will continue for at least 2008-even if the stock market struggles.

"Such a rise would replicate the 71.5 per cent rise in 2005-06 when the market was caught short by iron ore suppliers badly underestimating the extent of China's soaring steel production and consequent iron ore demand." Today's iron ore price is both demand driven and supply driven. But it's mostly history driven. China's industrializing. The process takes years…and lots of ore.

While we're on the subject of underestimating, are American investors reading too much into IBM's positive result? The Dow was up triple digits in Monday trading. You hate to argue with the stock market. But we have a distinct impression that IBM's positive earnings result is a big fat red herring.

Big blue, as the tech bellwether is called, said its fourth quarter revenues will be up 10%, mostly on higher sales in Asia and emerging markets. Now there's a theme the market can hang its hat on. It goes something like this: multinationals with diversification in their customer base will survive any housing and credit related turmoil and crank out the cash. Right.

It could be. But the premise behind the theme is that the bear market in credit won't have an effect in the real economy, at least not beyond the financial sector and the 24,000 people Citigroup may lay off (according to wire service reports). There is some precedent for the collapse of an asset bubble without any noticeable effect in the real world.

The Mexican Peso Crisis in 1994…LTCM and the Asian Contagion in 1998…and even the bursting of the tech bubble in 2000…all these bubbles came and went and the world kept spinning. The gears of industry turned and the wheels of commerce hummed along. Why would it be different this time? We turn the floor over to Wolfgang Munchau, writing in yesterday's Financial Times.

"If this had been a mere subprime crisis, it would now be over. But it is not, and nor will it be over soon. The reason is that several other pockets of the credit market are also vulnerable. Credit cards are one such segment, similar in size to the subprime market."

What? You mean there is a whole other class of liabilities lurking on corporate balance sheets that have been masquerading as assets? Yet more assets whose value depends on the ability of American consumers to pay their credit card on time? How much?

The data is based on surveys of credit card master trusts. These are pools of credit card receivables put together by credit card companies and sold to investors. A survey done in December by the Associated Press reported that the value of accounts at least 30 days late on payment jumped 26% to $17 billion late last year.

"Heck, US$17 billion is nothing," you may be thinking. "Citigroup writes off that much in bad mortgage debt in one week. Shut up about the next phase of the credit crisis Denning." Hold on.

Another survey by credit consultancy RiskMetrics says delinquencies are rising at a faster clip for the 15 credit master trusts it serviced. More borrowers are failing to make payments on time. And some are not making them at all, defaulting altogether.

Our point? This current bear market in credit is unlike others because it's striking at heart of the global economy, consumer spending. Consumers are debt rich and asset poor already. Now they are finding out, en masse, that you can't you get rich spending more than you earn, and charging the difference on your plastic.

The market is all excited about IBM's earnings. But let's keep things in perspective. More importantly, while the market discounts last year's news, there are things ahead in 2008 which will have a negative impact on corporate earnings, the American consumer, and the global economy. For example, credit default swaps (CDS).

Munchau writes that, "The CDS market is worth about $US45,000bn (€30,500bn, £23,000bn). This is not an easy figure to imagine. It is more than three times the annual gross domestic product of the US. Economically, credit default swaps are insurance. But legally, they are not, which is why this market is largely unregulated."

"It is not difficult at all to see how the CDS market has the potential to cause serious financial contagion. The subprime crisis came fairly close to destabilising the global financial system. A CDS crisis, under a pessimistic scenario, could produce a global financial meltdown. This is not a prediction of what will happen, merely a contingent scenario. But it is contingent on an event - a nasty and long recession - that is not entirely improbable."

Worst case scenarios don't usually materialize. But it's not a bad idea to be aware of them.

Dan Denning
The Daily Reckoning Australia

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