As trading began following the Thanksgiving weekend, two issues weighed heavily on investors’ minds: 1) the potential default of government-controlled Dubai World, and 2) the early indications for weekend holiday sales. Each issue had the potential to serve as the cops showing up at a party that has been going on since the market lows on March 9, 2009. The Dubai crisis sparked fears of contagion and another round of bank write-offs to add to the $1.7 trillion sustained by financial companies around the world since the credit crisis erupted. The weekend sales data stirred fears about a skittish US consumer faced with 10+% unemployment, lack of access to credit, and massive loss of wealth in the stock and housing markets. Unsurprisingly, I suppose, it seems that these issues have effectively been laid to rest despite some potential red flags. Stocks ended the day higher yesterday and we are sharply higher again today. The question arises, can anything derail this market?
Our cursory analysis of the Dubai situation suggests the problem should be fairly easy to contain. While $59 billion is nothing to sneeze at (a WSJ article yesterday pointed out that Dubai’s problem debt is much greater than the $32.6 billion in commercial real estate exposure that toppled Lehman Brothers and similar in size to the $72 billion exposure to credit default swaps that crippled AIG), the powers that be have acted quickly to address the situation. Since requesting a standstill agreement with its creditors last week, Dubai World has announced it is in talks to restructure only some of its $59 billion in debt, and various governmental authorities have pledged varying degrees of support in an effort to contain the problem. In other words, it is highly unlikely that Abu Dhabi and the UAE will permit this problem from inhibiting future capital flows to the region. Nevertheless, the seemingly minor crisis should serve as a reminder that there may be numerous additional problems lurking within the global financial system that nobody fully appreciates. Whether it be commercial real estate in the US or sovereign credits in Eastern Europe (or something altogether unforeseen), there is still plenty to worry about going forward. The market needs to assign some probability of future problems arising. Investors’ willingness to shrug off the Dubai fiasco is a pretty stark indicator of the irrational exuberance in today’s markets, in our opinion.
An additional concern regarding the Dubai situation is that investors may become emboldened yet again by what could turn out to be another government bailout. While Dubai officials are saying that the emirate does not back Dubai World’s debt and that bondholders will have to take some losses in restructuring, it also appears the resolution could, to some extent, turn out to involve some sort of government assistance. This is no small issue. We believe that many investors have come to expect that their errant investments will be supported by government intervention. A situation whereby investors feel they effectively own a “put option” can result in excessive speculation. Ultimately, investors must be weaned off this type of implicit government support, especially within the US financial sector.
With regard to retail sales, we also believe that investors are being unwise in ignoring some potential red flags. While sales over the holiday weekend were relatively flat compared to last year (up 0.5%, according to the National Retail Federation), the preponderance of evidence suggests that consumers are being exceedingly thrifty and only spending on heavily discounted items. Average spending per consumer was down 8% to $343.31, and a surge in shoppers over the weekend (up 13% to 195 million) may suggest that we can expect lackluster spending for the remainder of the holiday season. We would also remind everyone that total holiday spending fell sharply last year even after a significant rise in spending over Thanksgiving weekend. If this were to occur again, investors may reassess the dramatic rise in consumer discretionary stocks, and the stock market at large, since the March 9 lows.
In our last market commentary (November 18), we expressed our surprise at how abruptly market sentiment has changed since the depths of the market lows in March. This morning we get fresh evidence of this change. According to Institutional Investor magazine, only 17.6% of investment professionals are now “bearish”, which is one of the lowest readings since the market crash. At the same time, 51% of institutional investors now say they are “bullish”. Any contrarion will tell you this is not a positive sign. But the more worrisome trend, in our opinion, is the ability of investors to paint the rosiest of pictures in the face of potentially unsettling evidence.