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Yola Edwards

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Bowed but not broken

Yola Edwards

While most investors were away enjoying their 2007 summer holidays, chaos reigned in the credit markets sending share prices reeling. Bank and brokerage stocks bore the brunt of the sub-prime mortgage debacle as concerns grew about their exposure to asset-based commercial paper (ABCP). Investors also feared that a potential slowdown in merger activity would negatively impact operating profits.

The iShares Dow Jones U.S. Broker-Dealers exchange-traded fund (ETF) reveals the brokerage group plunged 25 per cent from its June $58.47 (U.S.) high to its $43.88 August low, while the U.S. Banking Index dropped 17 per cent. By comparison, the Dow Jones Industrial Average dropped 11 per cent and the S&P/TSX Composite Index dropped 15 per cent in the same period.

The massive credit expansion, which began six years ago when the U.S. Federal Reserve Board started lowering interest rates to stimulate the economy, fuelled the housing market and consumer spending. In search of higher yields, financial institutions seized the opportunity to jump into risky asset-backed mortgages. These were packaged together and sold as riskier commercial paper both at home and abroad.

In August, three hedge funds run by France’s BNP Paribas and three hedge funds run by Bear Stearns in the U.S. announced that they could not allow investors to cash out because of difficulties in valuing sub-prime mortgage-backed securities. When the news broke, the markets swooned. Governments around the world stepped in and pumped short-term liquidity into the system and the U.S. Federal Reserve lowered its discount rate to help financial institutions meet their reserve requirements.

In Canada, banks originated $80-billion (Canadian) of the $120-billion Canadian asset-backed commercial paper market. On Aug. 21, the six banks stepped up and affirmed their commitment to work together to provide liquidity for bank-sponsored ABCP on maturity.

The markets’ freefall was halted but investors still remain jittery in the aftermath, resulting in extreme volatility.

The U.S. housing market slowdown, which is at the centre of the credit market’s problem, has been an on going story for over a year now. A September 2006 article published in the Financial Times noted that “Prices of existing homes fell for the first time in 11 years and the backlog of available homes for sale was at its highest since current measures began, underlining the significant slowdown in the housing market.” The seemingly sudden summer credit crunch was a wake-up call and experts suggest that collapsing confidence in U.S. home lending has reignited fears of a U.S. economic slowdown, recession, or possibly deflation, with other nations following suit.

However, U.S. economic activity picked up in the second quarter from the slow pace in the first quarter. GDP data released on Aug. 30 showed an annualized 4 per cent increase in the second quarter, beating the projected expectations of 3.4 per cent growth. The Bureau of Economic Analysis commented: “The acceleration in real GDP growth in the second quarter primarily reflected a downturn in imports, upturns in federal government spending and in private inventory investment, accelerations in exports and in nonresidential structures, and a smaller decrease in residential fixed investment that were partly offset by a notable deceleration in personal consumption expenditure (PCE).”

In short, it appears that the economy and corporate profits remain strong in spite of a housing slowdown.

The Canadian housing market, although also slowing, remains healthy. Price increases contracted for the eleventh month from the August 2006 peak of 12.1 per cent but they still managed to post a respectable 7.7 per cent increase in July. Additionally, housing starts rose 5.1 per cent in August after a two-month decline.

Further, Canada’s second-quarter growth of 3.4 per cent solidly topped the Bank of Canada’s projection of 2.8 per cent and first-quarter growth was revised upward to 3.9 per cent from 3.7%, though economists believe the pace will slow for the rest of the year if the U.S. economy continues to deteriorate. In view of the weakening U.S. housing market and in response to the credit market turmoil threatening the possibility of economic weakness, the Federal Reserve has changed its focus from an inflationary watch to an economic growth watch. As a result, investors believe that a round of U.S. rate cuts is now in the offing to stimulate the economy.

Speaking at the Financials Summit conference in Toronto on Sept. 11, and referencing the credit market malaise, Royal Bank of Canada CEO Gordon Nixon said: “This market presents opportunities for large, well capitalized, well diversified financial institutions.”

I believe it also presents opportunities for individual investors. It appears that the market’s drubbing of brokerage stocks has been excessive. A possible investment vehicle would be the previously-mentioned iShares Dow Jones U.S. Broker-Dealers Index Fund (NYSE: IAI), an ETF which invests in a representative sampling of companies from the investment services sector of the U.S. equities market. It includes companies that provide a range of specialized financial services such as securities brokers and dealers, online brokers, and securities or commodities exchanges. Top holdings are Goldman Sachs (10.6 per cent of the portfolio), Merrill Lynch (10.06 per cent), and Morgan Stanley (9.67 per cent).


Technical analysis of this ETF reveals that the share price is extremely oversold and that the daily MACD continues to issue a preliminary buy signal. The shorter moving averages are flattening out and turning positive with the 10-day MA having just crossed above the 20-day MA, suggesting further positive action ahead. Additionally, the ETF appears to have traced out a pennant pattern since the Aug. 16 low at $43.88. A daily close above $49.75 would suggest a rally to about $58.87 over the next three months.

Yola Edwards is a contributing writer and technical analyst for Bell Globemedia Interactive, providing options and technical analysis research on a variety of North American equities.

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