Where's the Bottom?

As housing woes spread to the corporate credit market, the economic outlook is sure to decline. Just how much further down do we have to go?

News from credit markets and economic data on July 26 toppled the "wall of worry" that stocks had been climbing on the way to record highs earlier in July. With the Dow falling 311.5 points and the Standard & Poor's 500-stock index off 2.33%, how much worse can things get before they get better?

The problem for those making predictions is that crises in the debt and housing markets are playing out in slow motion. The full effects of a credit crunch or an even deeper housing slowdown aren't yet clear.

Private Equity Deals at Risk

On July 26, the idea that worries about subprime mortgage loans really were spreading to corporate debt seemed to sink in for investors. That threatened the boom in mergers and acquisitions that has fueled the market's rally. The renewed worries were sparked when traders learned two big private equity deals, the buyouts of Chrysler (DCX) in the U.S. and Alliance Boots in Britain, were having trouble finding financing from public debt markets.

If bond investors are staying away from riskier deals, says Bill Larkin, portfolio manager of fixed income at Cabot Money Management, it could lead to a spike in the interest rates for all riskier debt. He warned of "a drastic re-pricing of risk, which is going to have an impact on anyone who needs to borrow money."

This could threaten the cheap, easy money that private equity firms have relied on to make M&A deals. More than $1.5 trillion in M&A was announced in the second quarter, up from $763.4 billion the year before, according to the research firm CapitalIQ (which, like BusinessWeek, is owned by The McGraw-Hill Companies (MHP)). Higher rates could also slow down corporate stock buybacks, another pillar supporting the stock market rally. The July 26 sell-off hurt all stocks, but particularly the small-cap companies more likely to be bought out by private equity investors, says Ryan Detrick, senior technical strategist at Schaeffer's Investment Research.

Many forms of debt are thinly traded, so it's hard to get a handle on how high interest rates will go. Also, private equity may delay deal financing until the fall, when firms hope that the debt markets will have stabilized.

Larkin points out that problems in the debt markets can create a trend that's "self-fulfilling," as more and more lenders pull back from risky loans, hurting borrowers. "There is a potential for continued softness for a while," Larkin says.

Ho-Hum Earnings

Just as the credit crunch is playing out slowly, so too may the troubles in the housing market.

New- and existing-home sales data released July 25 and July 26 suggested the U.S. housing market is nowhere near a bottom. New-home sales plunged 6.6% in June, five percentage points more than the Street's expectations. Existing-home sales fell 3.8% last month; sales were down 11.4% from a year ago. That crunched the stocks of homebuilders, including Beazer Homes (BZH), WCI Communities (WCI), and Pulte Homes (PHM).

"Housing will provide a slow-burn source of economic damage well into 2008," Charles Dumas of Lombard Street Research wrote on July 26. The full effects of a drop in housing prices and a decline for the housing sector may not be apparent for months. Many worry housing woes could force consumers to slow down their spending. Also, job losses in housing-related industries could hurt the strong U.S. labor market.

Will the market find a bottom soon? No one knows, but don't expect much support from corporate earnings. Much of the way into second-quarter earnings season, profits are looking good but not great, according to Ashwani Kaul, a senior research analyst at Reuters Estimates (RTRSY). "It's pretty much a ho-hum earnings season," he says. Taking into account both actual results and analysts' expectations, he projects earnings to rise 6.8% this quarter, up from 6% at the beginning of the week. Overall, he says, expect earnings to beat estimates by about 3%, which is typical but well below the 6% surprise that sparked a rally after first-quarter results.

On July 27, markets will get an advance look at second-quarter economic growth. The initial gross domestic product number is also unlikely to impress investors.The number is frequently revised up or down later, and many investors are already looking forward to the second half of the year and to 2008.

Buying Opportunities, Rate Hopes

Legendary mutual fund manager Ken Heebner, of CGM Funds, told CNBC (GE) on July 26 that "the hedge fund industry is going to be severely damaged by this." However, he said the credit crunch still could be a good time to buy. "To the extent that it creates fear, maybe it will create buying opportunities," he said.

One bright spot on the horizon may be a possible rate cut by the Federal Reserve. Several analysts have predicted that a debt crisis could prompt the Federal Reserve to lower interest rates sooner rather than later. The Fed has resisted making any moves due to inflation worries, but a rate cut could help revive growth later this year. The problem is that conditions might have to get pretty bad before the Fed is persuaded to abandon its hawkish stance on inflation.

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