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February 8, 2007

Sub-Primal Fears

Just in case you didn't get the memo 7 months ago: stocks are not allowed to go down. Despite today's weak opening, the lows of the day were met within the first hour of trading. The S&P 500 lingered until about mid-session at a support level tested twice before in the last 5 days, then turned north and erased the morning losses. The Russell 2000, which is up more than 5% in the last 10 days, moved into new record territory.

The amazing part of today's recovery is the reason behind the early swoon. New Century Financial spooked the financial world by announcing it will have to restate three quarters of last year's financials in order to "correct errors" in its accounting for early-payment defaults. HSBC also announced it will have to increase expenses to cover sub-prime loans that have gone bad. In other words, the sub-prime market is in a world of hurt. New Century shares lost a third of their value on the news and drug down shares of other companies with sub-prime exposure, such as Novastar, Washington Mutual, and Countrywide Financial.

Naturally, erosion in the sub-prime market has nothing to do with the rest of the economy, right? Wrong! The housing market is dragging down the economy very quickly. The writing has been on the wall for months, and the news in the sub-prime arena simply represents a few more bricks popping out of the dike. Adding to the sub-prime woes, Toll Brothers announced this morning that first-quarter orders plunged 33%. Note: there is no decimal point between those threes. That is thirty-three percent. Toll also revealed it would be increasing expenses related to land write-offs, and home builder shares got sold to the tune of 2%.

Despite incessant bottom-calling by vacuous twits passing as analysts, the news continues to deteriorate. Why people are not running for the hills is anyone's guess. Maybe there is simply too much emotion and/or capital committed being long equities for anything to matter until we have a full economic breakdown. Certainly, we are no longer missing a catalyst for the return of volatility and proper risk accounting, but the catalyst has yet to induce a reaction.

Precious metals traders, however, appeared to pick up on cue. If the economy is eroding rapidly, Bernanke & Co. are going to have to do something about it... and soon. I believe today's 1% gains in gold and silver are an anticipatory reaction to rate cuts and the devaluation of the dollar. Miners also did quite well, gaining 1.6%, and an unlikely hero in today's action was Newmont Mining, which popped better than 2%. For my part, a few shares of Silver Wheaton were added back into the mix. It still has a very attractive ascending triangle, and positive resolution is supported by both fundamental and technical developments.

Disclosure: Long CFC Puts, NEM Calls, SLW

 

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