Sunday, May 11, 2008

Reviewing August 2007's Roadmap & Views

Every so often I try to put a collection of thoughts together as a big picture view of where things will be headed in the next 6, 12, 18 months. While most of these thoughts are constantly swimming in my head, it is fruitful to put them down on paper plus fun to look back and see how wrong or correct I was. When I had a fraction of today's amount of readers I outlined some thoughts at the tail end of August 2007 which can be found here [Aug 31: Et tu, September?] Since we have 3/4 of a year past now we can begin looking into these comments and see how they played out. I'll do a similar look at my early December outline [Dec 4: Et tu 1st half 2008? Predictions for the coming 6 months] (which was far more detailed) in mid summer. One day I'll get around to writing a new one for the coming 6-18 months ahead...

Now let's set the stage for late August since in hindsight everything looks predictable. A few key things to remember
  1. Fed Funds rates were still in 5%+ range; the market had begun its dislocations in late July through mid August and the Federal Reserve had come to its first "rescue" with a discount rate cut, in a surprise move that caught shorts with their pants down (free markets and all) on a Friday 8:30 AM when the market had plunged. (I was among those caught the wrong way as the first hints of socialized markets and "interference" was upon us)
  2. We were still being told, everything is fine in housing, this is only a subprime issue - and anyhow housing is only 4.5% of GDP, so even if it did fall off a cliff (which it would not) it is nothing to worry about. Housing will rebound "later in the fall"...
  3. We were told the financial issues were only subprime and the confessions at that point were "the kitchen sink" - it wouldn't get worse than that
  4. We were told there has never been a time when housing prices fell nationally so stop worrying
  5. We were told not to fight the Fed
  6. No one was talking about recession except Peter Schiff, Nouriel Roubini, TraderMark, and a handful of others. Every major brokerage house said no chance.... until December 2007 when many began changing their tune. Some still say no such thing ;) Ignorant bliss was everywhere back then; now it is less so but still in pockets
  7. Inflation was not on the table as even a discussion point; other than some throwaway lines in each Federal Reserve statement over the past few years.
  8. Clinton v Guiliani was the consensus for Election 2008... the first primary was many months away
Let's move on to my comments at the time

We were just embarking on the first of many homeowners bailout plants - Bush proposed some minor one that encompassed a whopping 100K people. Here were my comments on the housing bust

* 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!)
* 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.
* 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.

So all in all, relatively good calls. This was the first step in a long step towards socialization of losses onto the backs of the normal people and away from Wall Street - coming from Republicans no less. But what the government and Federal Reserve was doing then was a pebble in the ocean compared to what they did later in the year and into 2008, which I aptly said with the comments about "the next iteration of Bush's plan" (and Congress was even more hasty to create plans). I do believe the housing correction has moved to inning 3/4 now that new home builders are finally slashing prices... so 9 months later we've moved an inning up. Further, the early blips of home prices depreciation which I said would seem minor (and they were), pale in comparison to the 20%+ year over year drops we are now seeing.

Tighter mortgage standards *is* causing an issue - as it dries up potential buyers. We also seeing a retrenchment by buyers who can buy as they wait to see the housing market bottom before jumping in, as stated. People *are* feeling poorer across the nation as their home prices depreciate.

Onto the consumer...

* 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)
* Same point above but in regards to stock market gains - how will they feel with a potential 15% correction in stocks? More retrenchment?

The retail "my house is my ATM" play *IS* over. Retailers were foretelling this and their stocks went on to be crushed further into the fall and early winter. By mid January these stocks were obliterated [Jan 15: Will there be Anywhere Left to Shop?] As for the stock market, after the correction in the summer, we went onto new highs in the market under the illusion of everything was ok and the Federal Reserve is all powerful - into Sept/Oct 2007 - before a serious selloff in November and a beheading in January 08. But 401ks balances are not making people feeling any better nowadays.

Onto inflation - the one call I really rest my laurels on, especially food and the boondoggle that is corn ethanol... this came before anyone else was talking about it (except perhaps Coxe which I found out about many months later) [Jan 18: One Lonely Voice Agrees with me on Food Inflation] *Now* it is consensus...

* 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.

Job market? Well I was "wrong" here because the fantasy that is the government jobs reports has been showing GAINS in financial, construction and every other type of jobs due to the magic of the birth/death model (lovely) So while I believe I am correct in reality, if you use government reports I am wrong left and right ;)

* 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...

Credit market? Financial earnings? We were told everything is fine - the Fed was now on our side and once again - the kitchen sink confessions were now behind us, and financials were "safe" to buy and hey... "cheap" after their correction in summer 07 - I, on the other hand, was loaded up on Ultrashort Financial (SKF) - which in fact hurt me in September and October when the fantasy of belief was strong in the market - before reality hit later in the fall. As I stated, we saw MULTIPLE earnings revisions reductions. The credit markets? A complete disaster which only got worse as the year progressed and well into 08.

* Commercial paper market still extremely dysfunctional
* 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.

Google? I was correct on the stock (which got trashed starting in Jan 08) but not so much on the reasoning (yet)

* 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? Nailed this one - although it took about 6 weeks. China was cut in half starting in November 07. Keep in mind this was in the environment where "it is safe to buy Chinese stocks into the Olympics" - yada yada.

* 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.

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