It's on everybody's mind...what happened in the stock market last week, why did it happen, and what does the future hold?  I've got a few ideas...

However, some ugly economic data was released this past week that most certainly could have (and should have) impacted the US stock market:

• * Durable goods orders fell 7.8% in January

• * The National Association of Realtors reported that January existing home sales were down 
  
•   4.3% from last year and the median sales price was down 3.1%

• * Existing home sales fell 8.4% in 2006, the sharpest decline in home sales in 24 years

• * New home sales plunged 16.6%, the biggest percentage drop in 13 years

• * Residential fixed investment (home construction) fell 19.1%.

• * GDP for the last quarter of 2006 was revised down to 2.2% from an earlier estimate of 3.5%

• * Business spending fell 2.4% in the last quarter  

But these data points, which all indicate a rapidly slowing economy, were not nearly as troubling as the foundational cracks that appeared in the US mortgage markets last week.  For the past 2 years I have been consistently warning that the egregiously lax lending standards which fueled the housing bubble would someday trigger a significant financial crisis.  It would seem that the future has arrived.

Consider:

• * Since late 2006, 31 mortgage lenders have gone kaput

• * Foreclosures are soaring nationwide and hit an all time new record in MA.

• * Country Wide Financial, the biggest US mortgage lender, said that late payments on

• * Subprime debt instruments (bundles of subprime mortgages) sold off hard.

• * Concern developed that the mortgage bond pain could easily extend to so-called "A" rated

How bad and pervasive was this reckless mortgage lending?  Bad enough and pervasive enough that the nations largest auto manufacturer, GM, is experiencing severe difficulties as a result:

The world's largest auto maker disclosed Thursday that it will need more time to file its 2006 annual report with the Securities and Exchange Commission, marking the second year in a row the company has postponed the key filing. Many analysts attribute this year's delay to a substantial hit GM might take from the exposure its part-owned finance unit - GMAC Financial Services - has to the business of making mortgage loans to people with weak credit or heavy debt burdens.

If you are confused as to how a car company gets into trouble on subprime mortgage loans, imagine how the GM management feels!  They probably had no idea they were even involved in that business and now they are facing a "substantial hit" and can't file their financial statements because they don't know how much money they lost.

So here's how I saw last week playing out.

1. Far too many big investment banks and hedge funds had ignored risk for far too long and had bid up the prices of extremely risky assets to improbable heights.  Many used extreme leverage while doing so, often approaching 100:1

2. First many subprime mortgage companies went bankrupt, then their debt offerings blew up and then finally other ‘higher rated' debt market offerings started to smell bad.

3. As these leveraged bets ‘blew up' liquidity dried up and market participants suddenly remembered that risk is real and they started selling things.  Like stocks. 

In short, our stock markets sold off because of a brewing crisis centered around the magnificently risky lending and investing practices that pervaded the US housing market for the past 5 years.  Not because of a set of proposed modifications to the Chinese capital markets.  It is clear that market sentiment has shifted noticeably over this past week, from ebullient to cautious and it will be interesting to see if it heads all the way over to fear. 

How will this play out?  I certainly do not have a crystal ball but since this is unfolding pretty much as I've laid out in the past, I'll make a few predictions here as well. 

1. The pain in the US housing market has at least 2 years, but more likely 4 years to go before turning around.  I base this on the simple symmetry that exists in past bubbles - the amount of time they take to develop on the way up is matched by the amount of time they take to unwind.  I expect house prices to slide 20% to 50% over the next few years.  I expect the mortgage defaults to really skyrocket over the next 12-18 months if the economy holds together, and to become a national crisis if we enter a recession.

2. Some big leveraged players, probably hedge funds but possibly also a major investment bank or two, will ‘blow up' as a consequence of the market turmoil.  If the failure(s) is big enough, there's a chance that it could lead to what are known as cascading cross defaults (think of them as financial dominoes).  If this transpires, all bets are off.

3. The Federal Reserve is stuck between a rock (financial market weakness) and a hard place (still rising and persistent inflation and a weak dollar).  I expect them to hem and haw but once the financial markets really start to tank they will have to decide between lowering rates to rescue the stock market and keeping rates steady to preserve the dollar and keep inflation at bay.   I think their first rate cutting move, if it comes at all, will not be for several months.

4. I expect the financial market weakness to persist for at least 6-8 months and I would expect nearly all assets to sell off over that time.   This means commodities, stocks, lower grade bonds, houses, ... pretty much everything.

5. Once the Fed panics and begins cutting rates, I expect the dollar to begin to slide in earnest, and for gold (and many other commodities) to take off.  Mid to late summer is my thinking at this time.

Now is the time to be extremely defensive with your assets.  If I held stocks that I did not want to sell right now, I would hedge them with puts.  I would be heavily weighted to cash (held in 3 month T-Bills) and prepared to be patient and sit back to watch how this is all unfolds.  Now is the time to put off whatever purchases you can and to build your savings cushion.  Put as much money away as you can. Also, there were some persistent rumors floating on Wall Street last week that a major bank in the South East was in serious trouble, presumably because of bad real estate loans.  If true, this could be quite ominous for the banking industry.  I have my money in a small local bank that is very conservatively run.  If my money were in a large national bank, I would be sure that it's rating was "A" as given by the Weiss rating service.  If not, I'd move my accounts.  The FDIC has already had to step in and take over two failed financial institutions over the past few weeks and they simply do not have sufficient reserves to handle multiple bank failures.

Lastly, switching topics slightly, a report came out this week showing that Saudi Arabian crude oil production declined more than 8% in 2006.  Coupled to the declines in Mexican, North Sea and Kuwaiti oil production this could be serious news.  I find it hard to imagine that Saudi Arabia was willingly holding back production during a time of high oil prices and I'm left to speculate that they are now past peak.  If this is the case, then world peak oil is here and that has profound implications for humanity in general and the US in particular.  For the US the challenges will be shaped by our profound lack of investment in a non-petroleum based energy and transportation infrastructure.  However, while I'm keeping one eye glued to crude oil production figures I will be researching investment opportunities in mass transit companies (buses, barges and boxcars).  Profound changes always have embedded opportunities.

It's going to be an interesting couple of weeks.

Stay tuned...

All the best,

Chris