Friday, August 17, 2007

Sub-prime mortgage worries trigger market correction

Market volatility has increased dramatically in recent weeks. The new high of 14,000 on the Dow Jones Industrial Average on July 19 didn’t last long as the index fell 5.5% by the end of the month. The decline for the broader S&P 500 index was even greater, 6.3% in that same span. The catalyst for the downdraft was the housing market, particularly questions about the impact of rising delinquencies and defaults among lower grade mortgage holders. While housing construction and sales have slowed gradually over the past year, housing’s effect on the overall economy and stock market has been small. Other business sectors have remained strong, particularly those taking advantage of the growing international markets. However, the risk of actual defaults by borrowers in sub-prime mortgages has triggered concerns of losses spreading to other parts of the higher-risk debt markets and severely hurting stocks as well. Other analysts believe investors were seeking a reason to take short-term stock profits after the recent new highs in the markets, and the mortgage market problems merely provided that spark.

While most business sectors experienced declines in the sell-off, most of the pain was focused on those companies that had benefited significantly and now could suffer direct losses from the extension of the sub-prime loan problems. Home builders, mortgage companies, banks, and brokerage/investment management companies led the decline. Mortgage companies and brokerage stocks were particularly vulnerable due to their more direct involvement in facilitating the development of the sub-prime lending trend. Most of the major banking institutions had long recognized the potential risk of these kinds of loans and avoided significant involvement with either generating or investing in them. Recent second quarter earnings announcements show that severe losses have been contained to relatively lesser quality firms.

Against the fairly isolated sub-prime mortgage problems, second quarter profit reports support the view of a relatively steady economy. Second quarter GDP was better than expected. Reports to date by companies of the S&P 500 show second quarter profits modestly ahead of expectations. Wage and job growth offer support to the continuation of economic growth continuing at least through the year. This in turn leads to greater confidence that mortgage delinquencies will not spread to prime mortgage holders. However, many market analysts believe that market psychology may stay disconnected from the economic data and more focused on headlines surrounding mortgage-related problems for a while longer. This could lead to continued uneasiness among investors and more market volatility in the short-term.

Prepared by: Martin Cosgrove, CFA, Director of Investment Research
Research Department/ING Advisors Network

The views are those of Martin Cosgrove, Research Department, ING Advisors Network, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. All economic and performance information is historical and not indicative of future results. Investors cannot invest directly in indices. Please consult your financial advisor for more information.

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