August 25, 2008 LARGE STOCK FOCUS Bond Market Flashes Caution Signals for Stocks By E.S. BROWNING August 25, 2008; Page C1 Stock investors trying to see the market's future have begun monitoring indicators from the bond market -- and they don't like what they are seeing. Until the current bear market, stock investors often paid little attention to credit markets. But as troubled financial companies and bad mortgages have pulled the stock market down over the past year, stock investors have begun looking for signals from the mortgage market, the corporate bond market and even the interbank market. And lately, the signals have been flashing yellow and red. John Kattar, a Boston money manager, has been dismayed by those signals, so he is shrinking his stock exposure. Mr. Kattar is one of many investors who have concluded that stocks can't stabilize until the lending markets improve, and if anything, lending market indicators have recently been worsening. That helps explain why this summer's stock rally has proved so puny. Although the Dow Jones Industrial Average rose 197.85 points on Friday to 11628.06, it is up just 6% from its July 15 closing low and still is 18% off last October's record high. Mr. Kattar, chief investment officer at Eastern Investment Advisors, hoped creditmarket conditions would be improving by now, permitting him to jump back into stocks. Instead, he has pulled back from both stocks and bonds, increasing his typical client's cash position to roughly 10% -- an exceptionally high level for him. "We have lightened up during the recent stock rally," Mr. Kattar said. "We believe that we are in a bear market that will end some time in the second half of the year. Our target is for stocks to fall about 8% below where they are now" -- which would take major indexes to new lows since the bear market began last October. Mr. Kattar and other stock-portfolio managers are focused on spreads. These are classic bond indicators that measure the difference between the yields of low-risk U.S. Treasurys and those of other debt instruments. In particular, the managers home in on spreads for junk bonds, interbank loans, mortgage-backed securities and the bonds of government-sponsored mortgage companies Fannie Mae and Freddie Mac. Broadly speaking, spreads lately have been at their widest since Bear Stearns was rescued in March, and in some cases at their widest in a decade. Investors worry about widening spreads for two reasons. First, they reflect a lack of trust in the financial system -- a fear about borrowers' ability to repay. Spreads involving interbank loans suggest that banks sometimes even are nervous about lending to one another. Second, higher spreads typically mean higher borrowing costs for businesses and consumers, potentially damaging earnings. That makes economic recovery harder. A recently released Federal Reserve survey of big banks reported that banks have "tightened their lending standards and terms on all major loan categories over the previous three months." "We view higher spreads as a sign of stress in the financial markets, and we are worried about that," Mr. Kattar said. He and others worry that more banks, mortgage investors and brokerage firms might need government support in order to survive. On top of that, applications from people seeking new mortgages have continued to fall, suggesting that the consumers are still pulling back. Fannie and Freddie bonds are a special case because of uncertainty about a possible government rescue. It is possible that, if that crisis is resolved, lending markets will settle down and stocks will bottom out. Some investors have bought stocks in that hope, or in the hope that falling oil prices will help keep the economy out of recession. But those tracking spreads in bond markets have their doubts. Back in spring, Jason Trennert, founder of New York research firm Strategas, devised a checklist of things that had to improve for the stock market to recover. The list included items such as oil prices, the dollar, gold prices and lending markets. "A lot of those things have happened," including cheaper oil and a stronger dollar, Mr. Trennert said. But credit conditions have stayed so bad that Mr. Trennert has remained skeptical of the market's prospects. Mr. Trennert pointed in particular to the spread between rates for jumbo mortgages -- mortgages too big to be guaranteed by a government-sponsored company -- and Treasury bonds. If the housing market and lending markets were settling down, Mr. Trennert said, jumbo-mortgage spreads would be coming down. This is a profitable business that banks normally seek out, because borrowers tend to be high-quality and, because the loans aren't guaranteed, rates can be relatively high. But jumbo spreads have been widening in recent weeks, at or near their highest levels in a decade. "That suggests that banks are more focused on mending their own fences than on expanding the business," Mr. Trennert said. His conclusion: "The rally that we have seen since the July 15 low is not sustainable." He is urging clients to look at stocks of conservative companies with low debt and strong cash flow and that have been building market share. "Investors should pursue a very, very defensive kind of approach, really keeping powder dry," Mr. Trennert said. Michael Darda, chief economist at brokerage firm MKM Partners in Greenwich, Conn., keeps charts tracking spreads for mortgages, investment-grade bonds, junk bonds and interbank loans in London. "The most action has been in mortgage spreads," because of the threat to Fannie and Freddie, Mr. Darda said, but he is seeing wider spreads virtually across the board since May. He is concerned because credit markets have reacted negatively in the weeks since the Treasury Department and the Federal Reserve announced their willingness to support Fannie and Freddie, if needed. "The conclusion is that things are going to get worse before they get better," Mr. Darda said. "There is a period of weakness ahead." Write to E.S. Browning at jim.browning@wsj.com1 URL for this article: http://online.wsj.com/article/SB121960885525067165.html Hyperlinks in this Article: (1) mailto:jim.browning@wsj.com Copyright 2008 Dow Jones & Company, Inc. All Rights Reserved This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For nonpersonal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-8430008 or visit www.djreprints.com. 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