Saturday, October 20, 2007

Et tu Redux!

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Back on August 31st, I penned an entry called Et, tu September? in which I outlined the real issues affecting the economy. The market proceeded to ignore everything I outlined and rally for 6-7 weeks straight, given its most juice by the 9/18 Fed cuts. So while keeping those economic thoughts in mind, I realized I had to switch to a "let the market dictate your moves" thought process, or risk being left behind. But I like to revisit these thoughts every few weeks to see what has improved/gotten worse since then. I really don't see much improvement in the vast majority of the line items listed below.

Since August 31st the changes have been
  1. Housing correction continues, and continues to intensify
  2. Home builders are now doing "Sales of the century" to slash prices, and get rid of inventory - this pressures current home owners to lower their prices - home owners who previously were in denial about what their house should sell for.
  3. As the 3rd party market for securitized mortgages dries up, lenders are forced to keep loans on their books as opposed to slicing/dicing and packaging to some fool in a European bank or a hedge fund, so they become MUCH more conservative and hence the SUPPLY of buyers (those with both ABILITY and WILL to buy a house) drops considerably.
  4. Bush had come out with a limited bailout scheme at the time; since nothing gets done in this country politically that has dropped off the face of the earth. Has anyone heard more about it?
  5. House as ATM drag is now starting to show in retailers numbers; Credit Card as ATM is now what stressed consumers has changed to. This cannot end well.
  6. Grocery inflation now showing even in the government numbers which massively understate the situation. European central bankers acknowledge this, but US central bankers continue to deny any (major) problem. But real people with real budgets know what is happening.
  7. Commercial paper market did improve but now appears to be slowing again. Treasury yields dropping like a rock again this past week as credit crunch concerns mount.
  8. "Free market" economics takes another hit, as large money center banks need to create a fake customer (themselves) to buy the crap that no one else in the world will buy. Once again showing free markets are great on the way up, but all the free market proponents scramble for "non free market" solutions, once the free markets (nearly free of regulation) screw things up. Who pays? Everyone. Who benefits? Those who took the massive risks. Paulson and co. continue to deny any moral hazard. Now we trot out the excuses that we must 'protect' these banks because any major blowups will hurt us all.
  9. I mentioned construction, mortgage, financial jobs - you are seeing the cuts. I am even seeing cuts in areas outside of this (did you see that even Intel was cutting jobs; it got lost in the hoopla about their earnings number). As the US economy slows even those multinationals who are benefiting from the flailing dollar are going to be cutting back their US operations. Who pays? US workers.
  10. One of my favorite calls was this: "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." Since then what happened? A few weeks ago the banks "came clean" and did their kitchen sink quarter, which I smugly laughed at to self. Market cheered; market went up - everything was 'contained', 'now we know the scope of the problem' they said. Not so much. This Monday we come up with Super Bailout fund; something we obviously would not need if everything was 'contained' and 'measurable'. And financial companies who don't have the black box mechanism and mark to model mechanisms of the investment banks are now showing us the reality. And again, how can they forecast the future when many don't even know what exactly their exposure is? Both Paulson AND Green...err Bernanke have said we need to better transparency in these 'innovative' financial products. Where were they 3-4 years ago in the middle of the party? Why did we not need better transparency then? Oh I know - in the middle of a party you don't want to do anything to break it up.
  11. China bubble only inflating more. A market based on earnings that if based on US GAAP would have 40%? 50%? less earnings? And with companies inflating their earnings by investments in stocks - not operations. Like I said the next drumbeat you will hear in the upcoming months is "can emerging markets continue this growth level with a possibly US recession" Bulls will tell you the US is irrelevent or close to it for emerging markets; and bears will say look for negative growth in China/India/Brazil with US recession. Obviously the truth is in the middle, but the question is, is this market pricing "in the middle"? Or is the Chinese market pricing it? For that matter the Chinese market is not pricing in any negative and with its closed market we cannot use it to try to make sense of anything, but we can use Hong Kong which has DOUBLED since August. See my post here from August "The Case for Hong Kong" Well at this moment I am going to change my stance near term; with the market up 50% since August and the mania in China, any fears of US slowdown effecting emerging markets won't necessarily hit Shanghai because people there apparently live in their own world (see "Shanghia the Mystical Land of Premium Valuations", but it will effect an open international market like Hong Kong. Hence while bullish long term, I am pulling in the reigns near term on Hong Kong.
Below is the original post. (please note at the time Ben had not cut by 50 basis on the Fed funds/discount)

But this is the ledger as I see it, and the roadmap ahead:

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.

I could go on, but I am getting depressed....

The Good
* Big Ben has a mighty white horse and has been shining his armor and is ready to arrive and with a simple few cuts, will solve all problems
* Presidential candidates will be jostling to propose bailout after bailout, inciting moral hazard issues up the wazoo. (It was a stretch to put this on the good side but I needed at least 2 items to consider this an official list)

And I think that's about it for that side. I guess you can throw out the 'natural resiliency of the US financial markets and economy' but will that really be a salve in next 6 months?

Conclusions
Now I like Ben; in fact so far, I like Ben a lot. I think "come to the rescue" Al would of cut at least twice by now and maybe even a 50 basis thrown in there for 1 of the cuts for good measure. Heck, the market could of been at 15K by now if Al was still around. But that would not erase what is going on behind the scenes.

The one pillar that has been the bullish bedrock is employment. It's still at a high level; the unemployment rate still is low (granted many people are underemployed and working 2 jobs to pay for groceries and energy costs), but this is the number in my book to watch. With the financial industry from mortgages, to construction, to fancy investment bankers all at risk now.... hmmm. And with every lost job is a small ripple effect on other parts of their local economies.

So I guess it comes down to:
101 reasons things that could cause downward dislocation and potential 08 recession or at least dramatic slowdown

vs

Ben on a white horse along with government bailouts by frantic politicos who keep asking why does something like this happen every 5 years (answer: because the people buying you... err paying for your election drives generally profit from these excesses, and hence we never get preventative measures, just reactive and far more expensive 'solutions' after the fact).

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