Sunday, June 8, 2008

Newsweek: Why It's Worse than you Think

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Thanks to a reader for sending me this article from Newsweek; other than Fareed Zakaria [May 4: Weekend Reading], I don't really follow this magazine much. Essentially it touches on many of the themes I've been mocking for the better part of 10 months... it is good to see more and more mainstream media sources tell Americans what is really going on. One day it might even filter down to Wall Street. Until then, we'll keep pointing out the reality of what is going on in the "real economy" while ignoring (other than for obvious effect on our portfolio) the nonsense filtering out of the "official data". Remember folks, the highly paid, highly educated expert analyst community (who in general follow a small subset of companies and should know them inside and out) is still forecasting Quarter 4 2008 earnings as 60% HIGHER over Quarter 4 2007 - this verges on criminal in its stupidity. So either this upcoming quarter or the one after (October) we're going to see a bevy of slashed earnings estimates. Did someone say October? We don't like October.... bad things happen in October.

Unfortunately most of our economic leaders are cut from the same cloth - they constantly reassured us that as the US economy slowed, inflation would go away - like magic. (not that there is any inflation anyhow). This is still the 1980s narcissistic, the world revolves around the United States of Suprime ("if it doesn't happen on our soil, than it simply does not matter"). I typed almost daily at the time, how the World of Shortages has brought an age of global competition for resources - and in fact inflation will be rising due to structural shortages; in fact this is just step 1 of a multi decade situation. But unfortunately that requires a global view which apparently none of the higher ups has. If we're too poor to buy something, other players in the world economy will step up - especially those siphoning our money (and assets) off left and right to fund such outlays. As the greatest debtor nation the globe has ever seen, we're cool like that. I looked like an outlier at that ime, and even today we're pointing to "speculators" for rises in commodities across the board - the first part of fixing a problem is getting past denial - we're still in denial stage. So what our Federal Reserve has done is (not cause) but thrown gasoline onto a fire of structural deficits in natural resources, inflating money supply, and exaggerating trends that were already playing out slowly but surely. But frankly they had to do it, to bailout our entire financial system which has grown (as Bill Gross used the term) into a "shadow banking system" full of unchecked, and largely unregulated players and systems. A system derived from policies that said "regulation is evil" and stoked by a Federal Reserve that believed creating easy credit and masses of paper money was the fix to all problems. So it was either sacrifice the banking system, or sacrifice the lower and middle class to the throes of rampant inflation over and beyond where it was already going. That was an easy choice - and here we are now enjoying the after effects. I was typing this thesis during the first of the Federal Reserve band aid programs (cuts) and I'm typing it now. Only then I was proposing a theory and looked like some "conspiracy theorist" nutjob; and now my theory looks plainly obvious with evidence everywhere. Unfortunately, short of a serious global slowdown, I don't see how the genie gets put back into the bottle. And even then, it will be a temporary respite - because in 2-3 years China will still be creating 1000 new automotive customers a day (in Beijing alone). As long as leadership believes the U.S. is the axis of the world and no one else matters, we'll continue to NOT understand what is happening TO and AROUND us...
  • For months, economic Pollyannas have looked beyond the dismal headlines and promised a quick recovery in the second half. They're dead wrong.
  • Yet hope springs eternal that the second half will be better than the first. Economists polled by the Federal Reserve Bank of Philadelphia in May believe the economy will grow at an annual rate of 1.7 percent and 1.8 percent in the third and fourth quarters, respectively. (Folks, we can make the economy grow at any rate you want if you misstate certain numbers - say for example one government agency reports inflation at 4%, but the one calculating GDP says, nah we'll make up a figure, say 2.4% instead and ta da - positive GDP!) [May 1: Was it an Official Recession? NY Post Says it Should Be]
  • Lawrence Yun, chief economist at the National Association of Realtors, tells NEWSWEEK that "home sales and prices in most of the country will improve during the second half of 2008." (Yun is the Little Orphan Annie of forecasters. He's always sure the sun will come out tomorrow.) (Yun is one of my personal favorites - after I fell off the chair laughing at some earlier predictions which I outlined how ridiculous they were in retrospect I've totally ignored every word coming from this industry paid "economist" - [Nov 14 2007: Housing Will be Flat next Year - Whew!]
  • Last month, Treasury Secretary Henry Paulson said, "We expect to see a faster pace of economic growth before the end of the year." (this from the guy who told us in spring 2007 that subprime is contained)
  • But this downturn is likely to last longer than the eight-month-long recession of 2001. While the U.S. financial system processes popped stock bubbles quickly, it has always taken longer to hack through the overhang of bad debt. The head winds that drove the economy into this dead calm— a housing and credit crisis, and rising energy and food prices—have strengthened rather than let up in recent months.
  • As it seeks to regain its footing in the second half, the U.S. economy faces two significant obstacles, neither of which was evident in 2001. The first is entirely homegrown: the self-inflicted wounds of the promiscuous extension and abuse of credit in the housing and financial sectors. The second is a global phenomenon that has comparatively little to do with American behavior: rampant inflation in commodities such as oil, food, and steel.
  • While the treatment of the current malaise has been essentially identical to the reaction to the 2001 slump—aggressive Federal Reserve rate cuts and tax rebates—the symptoms are quite different. In 2001, an implosion in the technology sector and a slump in business investment pushed the economy over the edge. Even though some 3 million jobs were shed between 2001 and 2003, consumers soldiered on through the downturn. "We had a massive reduction in both long- and short-term interest rates, which set off the housing and consumption boom," says Ian Morris, chief U.S. economist at HSBC. (Remember zero-percent car loans?) This time, it's the opposite. While businesses—especially those that export—are holding up, the economy is being dragged down by the cement shoes of a freaked-out consumer and a punk housing market. (I type this often; almost everyone under the age of 50 on Wall Street has been conditioned to 1 thing; a business led recession which fixes itself in short duration - they simply do not entertain the thought of a potential of a consumer led recession which has led to very very long periods of stagnation - hence we get these hopeful rallies in "early cycle" sectors every 7-8 weeks, because Pavlov's dog has taught them that in the early 90s and early 00s you buy "half way" through a recession and we're fine 6 months from then - well this is not the early 90s or early 00s - the consumer has been on a 25 year binge, and the last 8 have been excessive; it is finally time to pay the piper in consumer land - but the conditioning remains in the traders)
  • The fall (in housing) has also removed an important source of support for consumer spending, as Americans who grew accustomed to borrowing against rising home equity to finance car purchases or vacations now find themselves bereft.
  • Despite repeated claims that the damage has been contained ("the bottom is in, in finacials" repeated every 4 weeks for your enjoyment on CNBC since August 2007 - "it's the kitchen sink quarter - no we promise this time"), the banks that recklessly financed the housing boom—and then traded mortgage debt even more recklessly—are still cleaning up the mess. But it turns out (surprise!) the same sort of clouded judgment led banks to excesses in commercial lending, and in loans to private-equity firms. (I also wrote this in the fall when everyone pointed to subprime and said once we get through subprime we are off to the races - no its EVERY loan problem - in mortgages, we need to get through subprime, then alt A loans, then up to prime loans - almost everyone buying from 2006-2008 is going to be underwater in home value in 80% of the country by Dec 31, 2008 - then in 2009 will start hitting people who bought in 2005; then we have car loans, then student loans, then home equity lines of credit, then credit cards, then 401k loans, then commercial loans - it's all coming - in fact the one thing we HAVE worked most through or will by end of year is suprime loans - first in, first out - now we have to work through everything else)
  • Economists say it generally takes nine to 12 months for Federal Reserve interest-rate cuts to work their way into the system. By contrast, sending checks to consumers tends to produce quick results. Some retailers have reported a surge of business spurred by the tax rebates. But consumers are shopping for necessities, not discretionary items. Sales at Wal-Mart and Costco were up in May, while sales at Kohl's and Nordstrom were down.
  • The rebate checks will total about $120 billion. Studies suggest that about 40 percent of that total, or about $48 billion, will be spent in short order; the rest will be saved or spent later. Rosenberg reckons that higher energy costs—crude-oil prices are up 40 percent so far in 2008—are draining about $30 billion out of household cash flow per quarter, and that food inflation, running at a 9 percent annualized rate, drains another $20 billion per quarter. "So instead of the stimulus being filtered into real economic activity, it's being diverted into the checkout counter at Albertson's and the gas station," he says.
  • Historically, or at least since the end of World War II, if the U.S. sneezed, the world caught a cold. When we used more gas, oil prices rose, and when we used less gas, oil prices fell. As GM vice chairman Bob Lutz points out, "Usually petroleum prices were the first to react to a severe U.S. slowdown." In the past it would have been unthinkable for oil to spike if Americans were cutting back.
  • But at root, $4-per-gallon gasoline and $20-per-pound steaks are largely a function of the changing economic geography, and the diminished stature of the U.S. The world is growing without us.
  • The realization that the U.S. no longer controls its economic destiny is contributing to the widespread feeling of unease and crisis of confidence. Economically speaking, the 1990s belonged to the U.S. and New York and Silicon Valley. But as this decade motors toward its close, it seems powered by China, and Russia, and Dubai and Mumbai. It's as though we're home watching reruns while everybody else is out partying.
  • It's not all doom and gloom. Businesses that thrive on a weak dollar are holding up nicely. (as shown by the earnings prowess of multinationals last quarter where daily I was writing "US sales stunk, but hey things overseas are booming")
Conclusion: Buy stocks. This is all priced in, and frankly who needs Americans anymore - certainly not multinationals. And even if we did need Americans, they'll be back in 3 weeks as July 1, 2008 marks day 1 of the "2nd half recovery" thesis I've been hearing for 6 months now. I cannot wait.

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Long time blog readers will know we've been hammering all these points home; and at times watched aghast as the market trudged higher ignoring reality. That's the problem with being early - if you think 2-3 steps ahead on Wall Street the bulls will trample you since they struggle looking even 1 step ahead. As long as government reports assure them that their Pavlov dog way of doing things is correct and the boom starts "within 6 months" they feast on stocks like greedy pigs at the trough (note the record highs in equities in October 2007 as we just began into the credit and housing crisis)

I'm hoping to write a similar view outlining thoughts for the next 6-9 months ahead as I did in August and December 2007 (see bottom of post) but I have so many thoughts to collect in 1 spot, it might take a full weekend just to get them all sorted out... but let me summarize by saying not only will 2nd half 2008 be an epic struggle, first half 2009 is not looking too positive in my cloudy crystal ball. If the globe goes into recession and crude drops back to $80 and housing prices drop another 30% by next spring/summer - then I'll actually be bullish (on America), because the Americans will actually be able to afford their lifestyle again (however the distribution of their income will still be heavily towards food and energy but at that point far less towards housing). Or if corporations suddenly become generous and return to 1970s thinking and start doling out 12% pay increases to compensate for 15% inflation (in things we need) I can also change to bullish on America - but with the government insisting inflation is tame, while Kimberly Clark raises prices twice in the span of 3 months, and Procter & Gamble increases prices for "essentials" and Dow Chemical raises prices 20% (which will be passed down to you in 6-9 months), with home heating prices next winter and the winter after moving to levels that will shock many - I still think you're going to be stuck with your 3% wage increases (since the gov't says inflation barely exists) and you will need to find a way to stretch it 10x to Sunday. This is the ultimate killer for the US consumer - in the 70s it was acknowledged by all parties that inflation was real and companies compensated employees as such. Nowadays? Inflation is just in your imagination - no need to give you raises to compensate for it, and if you complain your job is going to China anyhow. So quiet down and stretch your US peso farther - make it work, harder, longer, tougher - go go go! (did I mention buy stocks? - they are so cheap on 2008 estimates)

[Reviewing August 2007's Roadmap & Views]

[Et tu, 1st half 2008? Predictions for the Coming 6 Months]

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