Subprime is Officially Melting Down

Those of us who have been saying for a while that our subprime problems are far from done have been feeling validated over the past few weeks. Here's why:

• Two weeks ago a Bear Stearns hedge fund blew up forcing Bear into a $1.6 billion bailout. That sent Bear's stock tumbling and Bear's CEO James Cayne to the golf course? Yes, that's right Mr. Cayne dealt with a tough situation by pulling out his driver. Check out his scores over the past few weeks below: If you look at Cayne's scorecard you will notice that on June 21st, the day several big lenders were pressuring Bear to increase collateral, Cayne shot a 98. On the 22nd when Bear announced what was then a $2 billion bailout, Cayne shot a 97. How he found 8 hours over those two days to play golf is incredible! I have to admit I admire his persistence, even after this story appeared in the press Cayne has continued golfing and his scores are actually improving!
  
• The ABX BBB Index has fallen consistently from its highs in the 90's at the beginning of the year and is now trading in the 40's with no signs of stopping. No one wants to hang on to subprime debt . . .
• Moody's and S&P completely missed the subprime fiasco, and they are now furiously downgrading subprime bonds and the CDO's that hold them. Moody's said today they are going to cut the credit rating on slices of $5 billion worth of CDO's. This a day after S&P decided to cut ratings on $12 billion of bonds and revamp their entire rating methodology. Fitch also sounded an alarm today about commercial real estate, predicting rising defaults in the months to come. Below is a graph of the number of bonds Moody's has downgraded over the years. Too little too late if you ask me:
• The National Association of Realtors is lowering its 2007 sales predictions again! What good is a prediction if you lower it every single month?
  

Yes folks this subprime thing isn't over yet. The foreclosure statistics for June come out this week and as of two weeks into the month San Diego was on pace for a 36% rise in foreclosures from an already elevated number. Yes, folks, the bottom is falling out of the housing market.

Emerging Market ETF Options

Vanguard's Emerging Markets ETF (VWO) is beatings its iShares rival (EEM) by 3.18% YTD. Vanguard's VWO is up 23.87% on the year, the MSCI EM Index is up 22.31% and EEM is up 20.89%. Since both funds supposedly track the same index -- the MSCI Emerging Markets Free index -- the high tracking error is bad news for both companies, but is particularly bad for iShares as investors typically are more accomodative if the tracking error leaves them ahead. The Vanguard fund has one other advantage, its expense ratio is 0.30% vs. 0.75% for the iShares fund. But, in spite of these apparent advantages the iShares fund is still 9.5 times larger than the Vanguard fund, proving once again that it is notoriously hard for ETF providers to make up ground on the market leader. We were early adopters of the iShares EEM ETF but are currently looking at VWO as a viable alternative.

The source of the difference may well be the allocation of each ETF to each emerging market country. If you look at the Vanguard fund you will notice that it has slightly more exposure to India, Russia, Brazil, Taiwan and South Korea and less exposure to Mexico, South Africa and China.


While I don't think that the VWO outperformance will necessarily persist, its low expense ratio is attractive. The iShares fund has to beat Vanguard's VWO by 45 basis points a year in order to overcome the difference. That alone may be a good reason for the switch. Since we usually supplement our MSCI EM exposure with country specific ETF's the specific country allocations become less important and the need to obtain cheap beta more important.

San Diego Gas Price Convergence

Gas prices in San Diego are typically 20-40 cents above the national average. However, in the past 3 months prices in San Diego have converged upon the national price. The last time the prices converged was briefly in late 2005. If anyone has any explanation for why this has occurred I am all ears. Oh, and I do anticipate that prices have one more upward spike in them during late summer before retreating back under $3 in November/December.

Asset Allocation with Commodities and TIPs

In a post from June 8th about Bill Gross I discussed the importance of commodity and TIPS exposure in a portfolio. Today's market provided a brilliant example of why commodities and TIPS work as diversifiers. In a day where most equity indexes were down over 1% two ETF's performed quite well: the Powershares DB Commodity Index (DBC) and iShares TIPS (TIP).

1. iShares TIPS (TIP) +0.79%
2. Powershares DB Commodity (DBC) +0.68%
   
3. Dow -1.09%
4. NASD -1.15%
5. S&P 500 -1.41%

Moody's Is Resilient

The feature article in the Money & Investing section of the Wall Street Journal this morning pointed the spotlight on Moody's Corp (MCO). The gist of the article is that Moody's and the other credit ratings agencies are taking heat for "missing" the subprime debt meltdown and short sellers are betting they will lose clients and revenue. Moody's (MCO) traded down all day on the news, closing down 1.11 to 60.39, a loss of 1.8%. In after hours trading it has dropped another 9 cents.

Personally I would be surprised if Moody's traded significantly below $60/share without the help of broader market declines. Why? Well, Moody's has been through this before. They took a lot of flak when they "missed" the problems at Enron and Worldcom; certainly this is no different. The stock may have already priced in future declines as it is already nearly 20% off of its 52-week moving average. On top of those factors Moody's is a resilient company. It has fat margins, rich clients and very little serious competition. I would watch this one closely in the days in months to come. Don't be surprised if Warren Buffett ups his 17.5% stake in the company if the stock dips into the 50's.

Clean Energy and Water

Two ETF offerings from PowerShares -- PBW and PHO -- have been core parts of the commodity allocation of our portfolios over the past 12 months and have performed very well.

We started buying the Powershares WilderHill Clean Energy ETF (PBW) around this time last year when the fund was trading in the 17's. At the time the fund had retreated almost 40% from its high on the year. It is up 28% so far YTD and we continue to feel that it is still well positioned to take advantage of investor interest in clean energy technology. It has accumulated roughly $900 million of investor money.

We started buying the Powershares Water Resources ETF (PHO) in 2006 as well, accumulating when PHO was trading under $19. The fund is up almost 16% YTD and has accumulated $1.54 billion of assets.

We still like PHO but we are currently analyzing a new Powershares ETF called the Global Water Portfolio (PIO). The fund just launched and only has $47.79MM of assets but due to its global slant it may be more attractive in the long run than PHO. The two ETF's are actually very similar and share 13 of the same holdings, which is about a third of each fund. (Shared holdings are highlighted, click to enlarge.)

The main advantage of PIO is that it offers broader international exposure. It has holding in Japan, the UK, Singapore, Canada, China, Austria, Germany, France and Finland as seen below:
I wouldn't be surprised that if PIO attracts enough assets it will show up in our portfolios sometime later this year. We have also looked at the Claymore Global Water ETF (CGW) and the First Trust ISE Water Index ETF (FIW).

Presidential (Un)Popularity and the Electronic Futures Markets

President George W. Bush's approval rating has been under 40% for quite some time now. This is not a good sign for Bush or for the Republican's in the next election. However, if you look at all the Presidents since Truman, each one -- with the notable exception of Dwight Eisenhower -- has spent at least part of their term with a rating near 40%. The one thing that is interesting about W however is the fact that since 9/11 he has been on a very steady downward slide. Thank you to the Wall Street Journal for the interesting analysis. (Hat Tip: Barry Ritholtz) Click the photo to enlarge.So who is lining up to replace W? For the Donkeys Hillary Clinton and Barack Obama are in a dead heat on InTrade, the political futures trading website:

For the Elephants it looks like Rudy Giuliani and late entrant Fred Thompson are racing neck in neck:

Add Hank Paulson to the Bottom Callers Casualty List

The latest victim of calling the housing bottom is Treasury Secretary Hank Paulson. It's a real shame too because I really do like Hank. But, earlier today Paulson repeated comments he made way back in April:

"In terms of looking at housing, most of us believe that it's at or near the bottom," he told Reuters. "It's had a significant impact on the economy. No one is forecasting when, with any degree of clarity, that the upturn is going to come other than it's at or near the bottom."

Well, its been 3 months since April and there hasn't been a single good data point on the housing market other than the strong employment numbers. In fact the crucial numbers like excess inventory and prices are still looking worse and worse. Check out this graph below which shows excess inventory and housing starts (click to enlarge).

Basically, until inventory drops housing starts will probably continue to fall which puts increased downward pressure on prices and GDP. If you ask me calling the bottom of home prices now could pose a serious threat to the integrity of one's professional opinion. I know I wouldn't do it! But of course I'm in a win-win position. If I'm right, I'll be right, which is gratifying. If I'm wrong, and housing is at the bottom then that is great for the economy, great for all you homeowners and great for all of our investments! (Hat Tip: Calculated Risk)