U.S. Subprime Meltdown Costs the World $8.6 Trillion

There's something happening here. What it is ain't exactly clear.

There's a man at the Fed who's confused. And now investors, they feel quite abused.

You get the idea. The Dow fell 173 points in New York when Ben Bernanke and Hank Paulson went to Capitol Hill to repeat how bad things are in the housing and credit markets. Australian stocks have opened down to begin the day. So let's unpack what the dynamic duo said, and take a look at a few other non-trivial matters.

Bernanke told the Congress critters that, "The outlook for the economy has worsened in recent months and the downside risks to growth have increased." Yes. They have. "To date," he added, "the largest economic effects of the financial turmoil appear to have been on the housing market, which, as you know, has deteriorated significantly over the past two years or so."

We're not going to spend any time reciting all the evidence that points to more woes in the housing market. It's been well established. What's at stake now is how much longer this slow-motion crisis goes on and-the special burden of today's letter-what happens to stocks in a lower interest rate environment.

Bank of America chief market strategist Joseph Quinlan told investors that the current financial crisis is, "one of the most vicious in financial history." A research paper from his bank says the related fall-out from the crisis has caused $8.6 trillion in stock market losses worldwide, trimming a full 14.6% from the total world market capitalisation.

"It could take months or even years before Wall Street and others get a handle on the true cost of the US subprime meltdown and the attendant global credit crunch," Quinlan added. "While subprime loans were once thought to be relatively small in scale and contained to just one segment of the US financial sector, the opposite has become painfully evident over the past few months."

In New York, Governor Elliott Spitzer-under what authority it is not entirely clear to your editor-has given the monoline bond insurers three to five business days to find new capital or face a break-up. Spitzer wants the mononlines to break up their business into two parts: healthy toxic (Warren Buffet wants to buy the healthy parts, municipal bonds).

And if he has to count to three one more time, they all go straight to bed without dinner.

Why the sudden deadline? After all, we've been slouching toward insolvency for weeks now with the bond insurers. The trouble is, the ambiguity surrounding their future is now bleeding into other borrowing markets, raising borrowing costs for municipalities and leading to outright lending freezes in other markets (like the auction-rate securities we mentioned yesterday.

The gangrene is spread up the leg of the body financial. It is time to amputate. Spitzer reckons that resolution of the monoline's ultimate fate will free up lending in other markets and normal activity can resume. For a moment, let's assume he's right. What happens next?

Well here's the thing. Banks are wary of lending. They know the Fed will keep lowering rates this year as the housing crisis unfolds. But that doesn't mean the banks will loan. What about investors?

"Worldwide risk aversion and cash levels touched new highs in February, according to Merrill Lynch's survey of fund managers, with about 30 pct of respondents saying that they are hedged against further falls in equities over the next three months," according to an article at Forbes.

Investors are sitting on the beach with a pile of cash, waiting for the "all clear" signal to get back in the water. But no one wants to dip a toe in without some convincing bottom in the equity market. Won't someone please ring a bell?

All other things being equal, the chart below suggests to us that investors are going to wait until the Dow retests it 2007 low near 11,500 before bulling their way back into stocks. In reality, a decline below 12,000 would probably clear out a lot of sellers. But markets tend to overshoot on the downside, especially volatile markets. And this one is volatile.

And the All Ords?

The 52-week low for it is at 5,222, or 7.5% below where it trades at right now (5,645). A real cathartic correction would probably take us down to around 5,000 and just under…and at that point, anyone in cash would probably go all in.

Of course the build up of huge cash surpluses doesn't automatically mean investors will buy stocks once they regain their nerve. But it's hard to see investors going aggressively into property, or bonds, or anything else really. Absent even more risk aversion, the cash is going to come into play at some point.

We're still of the opinion that 2008 is going to be the year of the trading range. But today we admit the possibility that while the credit market continues to deflate and struggle and banks continue to mark down and shed assets, lower interest rates and huge cash balances may translate into higher stock prices.

The worst is probably NOT behind us. But as Businessweek reports, "For all the doomsaying, corporate cash abounds. According to Moody's Investors Service a record $1.6 trillion in cash sits on the books of non-financial U.S. companies, $600 billion more than was there five years ago."

Moody's hasn't been earning any gold stars for its foresight lately. But $1.6 trillion is a lot of cash. "The stars have aligned for corporations to start shelling out. Assets are in play or just plain cheaper than they were months ago; buyout shops are overextended and actually backing out of deals; debt is vexingly hard to score. Snooze, and some Beijing banker or Gulf sheikh will beat you to the punch."

There is a perception among some investors that the U.S. dollar is actually undervalued, making U.S. assets (and possible U.S. equities) undervalued too. We do not share this perception. But the idea is gathering steam. So watch for the cash. It could be on the move soon.

Yesterday we mentioned that aluminium might be the first metal to become a casualty of higher coal prices. Coal shortages (and high prices) in South Africa and China have a direct impact on companies that run aluminium smelters. Reuters reports that Eskom, South Africa's main supplier, is considering buying back power it previously committed to supplying the aluminium industry. It would affect BHP's smelters at Bayside and Hillside and the Mozal smelter in Mozambique.

Meanwhile, aluminium rallied yesterday by 4% in trading on the London Metals Exchange. It's a seven month high for "solid electricity" and the biggest one-day gain since late 2006. Chinalco said its smelting capacity would be reduced by storms. Couple that with Eskom's plan to buy back power promised to BHP smelters and you see a hiccup in aluminium production that no one planned for, hence the higher prices.

Dan Denning
The Daily Reckoning Australia

P.S. to get The Daily Reckoning direct to your inbox sign up to our free e-mail newsletter or if you prefer to use RSS, subscribe to the Daily Reckoning RSS feed.

Related Articles:

• None Found