MoneySunday, October 21, 2007 9:52 PM CDT

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Investors need reality check if they think financial turmoil is over

The sugar rush that the Federal Reserve gave the stock market with a larger-than-expected interest rate cut surely has gone to investors’ heads. It’s time for a reality check.

Share purchasers seem to be betting that most of the bad news regarding the credit and housing crises is already out and better times are ahead — even though there is very little evidence pointing that way.

That explains all the rejoicing for banks taking huge write-downs on their mortgage and other asset-backed securities, and money pouring into homebuilding stocks as weak housing data continues to mount. Even with the threat of a recession looming, optimism is back in vogue, with those scooping up stocks counting on being able to tell their friends in a few months, “I told you so.”

Good for them, if it goes that way. But Wall Street isn’t known for its tidy turnarounds. History tells us that.

It’s no surprise that stocks are rising. It has happened 100 percent of the time in the first month after a Fed rate cut, and the average increase during that time is nearly 4 percent, according to Merrill Lynch.

We’re just above that now — since the Fed’s Sept. 18 surprisingly big half-point rate cut that brought its benchmark overnight bank loan rate to 4.75 percent, the Standard & Poor’s 500 index has climbed about 4.3 percent.

But after those initial gains, the market historically has tracked how the economy responds to the rate cut. And given today’s conditions — with housing and credit market stress still evident — much needs to change to arrest the economy’s slide. Ninety percent of the economic data released in the last month has come in below expectations, according to Merrill Lynch.

Investors still seem focused on the idea that the worst is behind us. That’s why they cheered when Citigroup Inc. and some other large banks took write-downs totaling more than $12 billion this month to account for the decline in value of their corporate loans and mortgage-related securities.

The market’s take was that the banks used a “kitchen sink” approach in calculating their huge write-downs, sticking with conservative valuation methods so that they dumped all their troubles at once. Citigroup’s CEO Chuck Prince fed those views by saying that the bank expects to “return to a more normal earnings environment” during the fourth quarter.

History shows that’s hardly a guarantee. In May 1987, Citigroup — really Citicorp, as it was known at the time — took a $1 billion write-off to ostensibly clean up its balance sheet from losses due to a debt crisis in Latin America.

Just like now, investors believed that Citigroup had erased its problems, and the stock rallied along with the broader market, according to Punk Ziegel & Co analyst Richard Bove. A month after what Bove calls the “write-down to end all write-downs” was announced, Citigroup’s shares were up more than 20 percent.

But the gains didn’t last for long, once it was clear such losses weren’t a one-time event. Citigroup was still taking write-downs four years later, and its debt troubles expanded to leveraged buyouts and commercial real estate, too.

“Those who believe that yesterday’s huge write-downs mean there are no more skeletons in the closet could be in for a rude surprise,” Merrill Lynch chief North American economist David Rosenberg said in a note to clients. “After all, at the root of the market volatility and weakness this summer was the U.S. housing market, and everything from sales to starts to inventories to pricing has become much worse in recent months.”

Despite such conditions, Citigroup analyst Stephen Kim fueled a major rally in homebuilding stocks this week after he upgraded Centex Corp., D.R. Horton Inc., Lennar Corp., Pulte Homes and Ryland Group Inc. from a rating of “hold” to “buy.” The S&P 500 Homebuilding index jumped 14 percent in the days following the influential analyst’s move.

Even stocks that he downgraded — including MDC Holdings Inc., Meritage Homes Corp. and Hovnanian Enterprises Inc. — saw gains after Kim’s report was issued.

While acknowledging that industry fundamentals might not improve soon and trends have never been worse, Kim points out that homebuilding stocks “have an established history of rallying well before industry fears have finished transitioning into fact,” he said in his report entitled “The Dark Before the Dawn.”

Kim looks at history to support his views: There have been four instances in the last two decades when homebuilding shares have declined nearly 40 percent over a three-month period and then rallied 31 percent in the next quarter.

The S&P 500 Homebuilding index dropped 40 percent during the just finished third quarter, and has lost more than 50 percent since last December, when Kim recommended investors buy homebuilding shares. It was clearly the wrong call, but it wasn’t until July that he downgraded his ratings on that sector.

Kim says he has suffered for his December miss, but that didn’t stop him from sticking his neck out this time around. He believes he has presented “well-reasoned, thorough analyses” in his current report, which offers up a different perspective than most of his Wall Street peers.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck@ap.org.

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