Subprime and housing woes lead to wider asset repricing.
Subprime mortgage worries and a general real estate meltdown led to volatility and a "repricing of risk" in the financial markets during the third quarter of 2007. In other words, investors reconsidered their previous attachment to speculative stocks and low-rated bonds, sending their prices down and effectively demanding greater yields, or returns, from them in relation to safer instruments. Still, the Morningstar US Market Index finished the volatile trailing 13 weeks through Sept. 25 with a modest gain of 1.4%, and it remains up a healthy 8.7% for the year.
Volatility didn't visit all stocks equally. While mortgage companies like Countrywide
The repricing of risk was also apparent in the bond market, as investors piling into high-quality bonds drove the Lehman Brothers US Aggregate Bond Index up 2.8% for the trailing 13 weeks through Sept. 25. The yield on the U.S. 10-year Treasury note settled at around 4.5%, down from about 5.2% in mid-June, as investors sought the safety of lending to the government. (Because bonds offer a fixed coupon, their yield--the coupon rate as a percentage of the price of the bond--shrinks as bond prices rise.) The popularity of Treasuries also caused the Merrill Lynch U.S. High Yield Master Index, an index of low-rated corporate bonds, to post a modest 0.12% loss for the quarter.
The increased difficulty of borrowing money along with a crippled housing market encouraged the Federal Reserve to decrease the discount rate twice during the third quarter and the federal funds rate by a surprising 50 basis points on Sept. 18. Still, Fed Chairman Ben Bernanke remains concerned about inflation, especially as energy prices continue to skyrocket, and investors are far from certain about the Fed's future moves.
Notwithstanding the surprising magnitude of the September cut, the rising cost of borrowed capital has put a damper on the takeover frenzy that characterized the first half of 2007. Additionally, although it's unusual for agreed-upon takeovers to wind up collapsing, the buyouts of PHH Corp.
Still, capital-flush financiers and investors such as Carl Icahn and Warren Buffett remained mostly quiet for the quarter, with Icahn taking a stake in software company BEA Systems
Surveying the Sectors and Industries
The tightening of credit caused distress in financial stocks. The financial-services sector dropped 0.63% for the trailing three months through Sept. 25, but many banks, brokers, and real estate firms suffered worse. Mortgage lender Countrywide shed a whopping 51% for the trailing three months on concerns that it had engaged in more subprime lending than previously thought. Nevertheless, analyst Erin Swanson thinks the embattled firm is prepared to weather the storm because of its leadership position in the mortgage origination and servicing businesses, with a considerable scale advantage in servicing.
Many large and super-regional banks also suffered because of mortgage concerns. However, Morningstar financials analysts have judged the stock price declines to be overreactions in many instances. Consequently, Morningstar ETFInvestor editor Sonya Morris thinks financials ETFs KBW Bank
If financials suffered, the credit crunch left industrial materials and technology stocks virtually unharmed. Industrial materials rose 11% for the trailing three months through Sept. 25, and, showing that it can thrive in uncertain times, the hardware sector also surged ahead 11%. In industrials, mining concern BHP Billiton
In technology, Texas Instruments
Among the industries, online retail surged 23% for the trailing three months through Sept. 25. Amazon.com
Homebuilders again brought up the rear, dropping 33% for the trailing three months through Sept. 25. Lennar
John Coumarianos is an analyst with Morningstar.
Get mutual fund and stock information from our analyst team delivered to your e-mailbox every Tuesday. Sign up for our free Investment Insights e-newsletter.