A Longer Term View: What Will We Wake Up To Tomorrow

That must be the first time I have used 4 words that started with the letter 'W' in a row... anyhow, I digress.

I am reviewing the longer term picture from my post Et tu, September to see what changes with a 25 basis point Fed funds cut, and 50 basis points cut discount. Other than some near term confidence, and some decent improvement in the commercical paper market - I don't see much. Since that post on Aug 31st, we have had (among other things)

• the financial earnings revisions downward (which they are now 'beating')
• a bank run in the UK: Northern Rock - and an implicit bailout by the Bank of England
  
• a desperate Hovnanian housing sale to get inventory off the books, driving down prices in those locales - and I believe just the first of this type
  
• China reporting inflation approaching 7% (humorous to see many days of late Asian markets down across the board but seeing Shanghai up 2% - I know, I know... it's different this time)
• Consumers locked out of housing ATM, now moving to credit cards to finance spending in much heavier ways the past 60-90 days.
  
• the bad news last night from Bank of America (BAC) which was quickly forgotten due to Lehman Brothers (LEH)
• Etrade (ET) sucking serious wind (do you know that stock has been cut in half in recent weeks?)
• Legg Mason (LM) is down 20% with no rebound, but apparently if we can bail out the 5 large investment banks all the ills are cured. Since they control so many levers in the economy it's a good thing when they do well, but I still see a lot of weakness in other places.

The more this market rallies into the Fed, the more I get shorter term bearish; this is the case the market is currently outlining. On the flipside, everyone expects a correction so the traditional thing the market will do, to cause the most chaos is a 8% rally from here. :)

While some individual stocks have taken a beating, the indexes are roughly 5% off all time highs. So the scenario laid out is (a) all this bad news and future ill effects are worth 5% from all time highs (b) earnings growth projections we had in June/July are no different from those we have now (otherwise to stay even flat with where we were in July the PE of the entire market would have to expand) and (c) the consumer will bring us out of this. While arguing with the market, which is generally a herd mentality, is not a good thing - it's hard to see this being the correct scenario playing out in the mid term. Short term, anything goes. If CEO's are so cautious that they go on CNBC to plead their cases for interest rate cuts, how can they provide solid guidance for the next year? Guidance the market relies on for ever increasing prices? Hmmm.... a strange dichotomy. I remain open mentally to a huge run upward just because the market will do it's own thing, with or without you. However, outside of a few select sectors with an economy driven 70% by consumers.... hmmm...

Tomorrow's CPI - well since the statistic is useless it's hard to take any serious stake in it - although it will move the market most likely. The true CPI is what people feel when they pay heating bills, gas or go grocery shopping. I guess this is offset by the fact they can buy high end TVs for 30% less than last year. Do you think perhaps the fact people are migrating DOWN to McDonald's for coffee now (for half the price) instead of Starbucks means anything? Substitution effect? Next major labor report in early October, I see another bad report but a revision up in the September number. Will the market like that? I can't see how other than it will allow people to call on the fed to cut rates YET AGAIN in 6 weeks. (when does that drum beat start? at 2:16 pm today?)

So look at the list below and what changes to the positive or at least "a whole lot less negative" with a 25 basis point cut that will hit the economy around summer 2008. We still can't get banks to lend to each other because they don't trust the assets each other holds...

The Bad
* We are in inning 2? 3? of a housing correction
* Home prices are sticky; as homes are illiquid. We are just now seeing the first serious falls, and these drops so far, seem minor versus what should be coming down the pike in the most overheated of markets, as prices are so out of whack with income it's silly.
* The supply of buyers is constrained by much tighter mortgage standards - leading to pure economic theory, less supply of buyers, increasing supply of inventory = not good for prices. I mean really, who can afford a $500K mortgage in CA with a fixed rate of 6.25% fixed? That's a $3100 payment, before property taxes. There are only so many people in this country who can afford that. I'd argue a very small amount. Oh and did I mention jumbo rates are north of 7%? I am being generous with the 6.25% rate. The same example applies to the $400K mortgage in Seattle and northern Virginia, New Jersey, Hawaii, Boston, the $350K mortgage in Arizona, Nevada, Maryland, Chicago, Portland, Denver. Where will these people come from? When they cannot resort to interest only 2/28s?
* And after we bail these people out (not with Bush's plan, but with the next generation of Bush's plan that will need to be created), who is going to be able to afford to buy those homes when these bailed out owners want to sell? Or after the bailout will they be content to sell for $150K less?
* When people even in good financial shape see weakness in housing they also naturally get cautious and retrench on their plans to buy, and this feeds on itself (you go first... no you go first... no you... someone buy this house!)
* The retail "my house is my ATM" play, seems to be over. Retailers already foretelling this; remember stocks are discount mechanisms for the near future (6+ months out). Yes people have been calling this for years, but our consumption culture has always made them look like fools. But with the spigot of the ATM as a house now truly gone, people won't be able to refinance their credit card debt into a new mortgage. (and keep repeating every 2-3 years)
* Even those people who have no plans to sell their home, feel poorer on paper, and hence have natural tendency to tighten spending when feeling less flush in cash, even on paper.
* Same point above but in regards to stock market gains - how will they feel with a potential 15% correction in stocks? More retrenchment?
* Grocery inflation as this ill begotten push for ethanol (using inefficient corn) is rifling through feedstock, corn syrup and any of the thousands of items which use corn as a basis, and now seeping to the end consumer.
* Commercial paper market still extremely dysfunctional
* Bush's aid plan is going to help less than 100K out of millions who will be suffering in the home market
* The fact that free market Bush is even alarmed enough to come up with any sort of plan. Free markets are great... until something goes bad, I guess. Even for Republicans.
* Construction jobs - they are going to be accelerating into an abyss. Granted, some portion is illegal workers who were never on payrolls (official ones, that is) in the first place. But this is a trailing indicator. Who needs more homes when inventory is >9 months, on the way to ? 12?
* Mortgage jobs - huge cutbacks already announced and will be filtering through the future unemployment reports
* Financial jobs - we should start seeing lay off notices soon enough (next week?) I already read that across the pond there are cuts in credit departments already hitting. If we go back to pre 2004 levels of 'credit' (revert to the mean?) what does that mean?
* For those that remain, their year end bonuses will suffer. This year will be down, but NEXT year looks to be really down, as entire departments will no longer be needed/existing. What does this mean for the NYC and affiliated areas high end real estate market? I know, I know, those poor millionaires...
* Earnings cuts in the financials - just started getting downgraded this week by the analysts - how are they even going to be able to provide guidance in October when the location of all this credit risk is in many ways unknowable (how do you tell what % of loans in a CDO you own is going to default in the next 2 years?) We are probably looking at earnings revisions down #1 of a multi step downgrade program in these names.
* Internet ad spending down as financial companies provide a large bulk of it. Could Google disappoint? Psychological blow of all blows - the teflon stock of our era missing?
* China looking like an exact mirror to NASDAQ 1999-2001? New bubble? The Shanghia Index over 5000, was only 4000 just over a month ago, and almost 100% up in 6 months? 50 PE on an index? Oh and a large portion of those earnings are investment gains, not operational earnings. With a country full of newbie investors who have never been through any bear market? Remember what happened when China fell just 7% in Feb 2007.