Reviewing December 2007's Roadmap & Views

Every so often I like to build a roadmap of thoughts - generally geared to a 6-9 months outlook on the economy as a whole. This is actually a good check for me because it forces me to consistently update my thoughts and create very broad thesis that I want to have a lot of belief in before I present them to readers. It also serves as a good historical data point so as readers come to the blog later in it's life they can see we have not just been throwing random darts and getting lucky but there has been a whole framework behind our success. I pride myself on taking a top down view of both the economy and specific sectors, in terms of positioning the portfolio and expectations for the market as a whole. So far so good.

I've been meaning to do a more recent update but there are so many things to hit on, sitting down and devoting a few hours to one of these posts is going to take some serious time investment. But for now I thought I'd review our December 2007 Roadmap [Dec 4: Et tu, 1st half 2008? Predictions for the Coming 6 Months] to see how accurate we were.

To see how we did on our first round of views back when the blog was born you can review the original roadmap here [Aug 31, Et tu, September?] and my review of the results [May 11: Reviewing August 2007's Roadmap & Views] Considering the blissful ignorance of the markets back then, we did very well.

Now let's remember how the market/economy was looking in December 2007. We were still coming off the "that was the kitchen sink quarter" in financials, only the first of the investment banks economists had finally come around to the proposition that a recession was probable, the Federal Reserve had begun cutting rates but had not panicked yet (that came in January 08), Bear Stearns was still alive, everyone thought the mortgage problems were just a "subprime thing", this was before the SocGen bottom, and the historical moves of American government/Federal Reserve towards socialism. No one was talking about inflation outside of higher oil prices - food was not on anyone's radar; there was no talk of rebate checks, and the first primaries had not begun. After the first Federal Reserve cuts in late summer, the market had rallied hard (reaching all time highs on the S&P) in September and October 2007 on the "Don't fight the Fed" thinking and the "economy will be rebounding by 1st half 2008 - even though there was nothing to rebound from since everything was fine outside of financials". So keep that backdrop in mind when you read the comments below, because it's easy to overlay what we are now mired in and forget the Kool Aid that was running in the streets last fall and early winter.

I'll shade/italic what I wrote in December and then make comments below

Section 1: The Consumer/Housing/Inflation

First and foremost I think this focus on subprime is misguided. The subprime borrower is a relatively small piece of the puzzle and truth be told as a heartless capitalist, many of those who bought homes of the subprime category should never of gotten homes. Many would not of under 6% fixed rate mortgages with income documentation. So while it is correct to say, this is a smaller slice of the mortgage market, and why should they effect the economy as a whole, my arguement is their troubles are not the central issue facing us. It is "everyone else" (excluding the top 5%)

Current view: I think that was an accurate assessment. Alt A mortgages and prime mortgages will be the next to suffer - and these are much bigger markets than "subprime". In fact, at this point I'd estimate we are actually 80%+ done with our subprime problems. On to everyone else...

I keep hearing how housing is 4.5% of the economy.... baloney. There are so many related jobs to housing that this figure is laughable. Estimates I've read are 1 in 5 jobs in California are related to housing in 1 fashion or another. And California is a huge part of the US economy. This is also why I find laughable when I read the housing issue is contained to California, Florida, Michigan, Ohio. Well even if you believe that line of hooey, those are 4 of our top 10 biggest states by population. California alone as a stand alone country I believe would be 7th largest in the world (by GDP). We are a SERVICE economy - yes we have some exports still but nothing like 20 years, 30 years, or 40 years ago. When a huge part of our service economy implodes that effects far more than 4.5%.

Current view: I think that was an accurate assessment. Obviously so much of our economy is based on building homes - from local tax revenues to countless related jobs. But this was the line of horse radish the pundits and government officials were feeding the public.

Going back to point 1, I think the consumer (not subprime) is in trouble. Many people bought over their heads in the past 5 years (housing) all across many income strata. To pay for the consumption they drew down equity out of their house. And now the homes are not rising in value and in fact falling in most cases. *This* is where my main fears lie, not with the subprime. These are the people who have driven the economy over the years - the 'middle class' and 'lower upper income' class. I've read countless times (who knows the exact number) that 70% of people live paycheck to paycheck, regardless of income. To cover their shortfalls, they'd dip into the house equity (those who owned homes). Now that spigot is turned off and not coming back anytime soon. Now what?

Current view: I think that was an accurate assessment. Now what = bankruptcies in 2009 once the credit cards are used up.

Now what indeed - you live paycheck to paycheck, you have very little buffer and savings so either you draw down consumption or you head towards bankruptcy. This is where our real troubles lie in my opinion. In the past half decade especially, anytime there was trouble there was always a 2nd mortgage, a HELOC, etc. Now those are gone. And even when the mortgage market comes back, without RISING home prices you don't have equity to draw on.

Current view: I think that was an accurate assessment

Wages are rising on average 3-3.5% a year. Inflation? Far higher. The consumer, living paycheck to paycheck, with little buffer in their budget, fought this by drawing down on their credit cards and house. That game is getting long in the tooth. Inflation? Rising far higher than government tells you, and far higher than 3-3.5%. Many would cite 8-11% as real inflation. Health care, energy, tuition, and now food - you name it.

Current view: I think that was an accurate assessment

Food inflation is going to be the next killer - it has started the past year, and it will continue; food inflation is due to factors outside our general control - in part worldwide demographics (emerging markets middle class moving from rural to urban lifestyle), food habits changing worldwide (a push to more western diets heavy on meats) and a misguided push to ethanol (diverting corn from food chain to energy chain). In short a world of shortages. And this does not change if China and India drop from 11% GDP growth to 3%. These factors are here, and staying. Yes, food will ebb and flow - it cannot continue at the pace of 'inflation' it is going now - but it has already started to create demand destruction and for the countless people living paycheck to paycheck, they don't have the wiggle room to add $40 a week to their weekly grocery bill. We are going to a world of shortages (with ebbs and flows over time) and the world is not set up for 4-5 billion urbanized.

Current view: I was not only accurate but one of the only voices talking about food inflation (agflation) at the time - period.

Jobs will remain the main wildcard - we are already seeing the losses in mortgages, housing, and "some" financial - to what level this spreads through the rest of the economy as the economy slows will be a key driver in how bad this slowdown gets. If job losses are contained it could be relatively shallow of a drop; if corporations really start cutting due to profit margin erosion it could be ugly.

Current view: I was vague at the time and did not take a strong enough stand on how things would spread. We are seeing it now spread to all parts of the economy and the government assessements of the unemployment rate (which we did mock since fund inception) continue to be a farce. It will get worse from here.

Returning full circle to homes - prices are TOO HIGH. The average American cannot buy a home in many parts of the country (major urban areas) at 6% fixed rates. Prices detached from rents and wages due to the 'innovative' financial products cheered by Uncle Alan. If those innovative products had not been produced, asset prices (home prices) would never of risen like they did... now that we are in a 'unrealistic' home price environment relative to wages, those prices need to come down and in many cases severely to adjust back to reality. When this happens we will be near the bottom. We are not close.

Current view: We nailed this as Case Schiller home index has degraded impressively since last December. We were still being told at the time that home prices could never go down on a national scale. They lied.

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Section 2: Corporate America and the Markets

Next shoes to drop? Corporate profit margins. I found this yesterday on Realmoney.com and have been saying this would happen for months "Three months ago, Wall Street forecast Q4 operating earnings growth for the S&P 500 of 8.8%. Today that number is down to 1.1%. " I still believe 2008 profits are far too high in most industries. And as they get cut, in theory stock prices which are in essence a reflection of profits, should be cut. Look for a slew of warnings on 2008 profits come January... (I am still incredibly curious on how a cut back in ad spending will affect Google)

Current view: I am correct in direction but it did not happen quite as quickly as I predicted (i.e. January) It started to happen a lot more in the following quarter, and I contend the back half of 2008 (earnings estimates) are as much of a fantasy as most of the government reports.

Energy prices will pressure many industries and those industries dealing with food are already seeing massive pressure on profits. While consumer related stocks have already taken a hit and are starting to price in recession - corporate related stocks have thus far held up relatively well - I believe this changes in the next 2 earnings seasons (January and April)

Current view: Nailed it.

The transportation companies are already telling us we are heading to recession. YRC Worldwide CEO was saying it 3 months ago, now Fedex CEO is saying a "slowdown, but not precipitous decline".

Current view: Nailed it. These companies have in fact warned again and again in the 2 quarters since. We were early - we always are.

Auto sales will see a horrid 2008 for all the same reasons mentioned above - negative wealth effect, lack of confidence, inability to finance via home, wage stagnation in the face of real inflation.

Current view: Nailed this 10x to Sunday. In other posts I said 2008 will be the worst sales year for autos in 20 years. We're on the way.

Commercial real estate will start to drop. Thus far it has held up, but in a slowing economy why would rental rates hold up? They won't. It won't be as bad as residential real estate, but it will be far worse than it is today.

Current view: I think that was an accurate assessment. Commercial has held up pretty well in the middle of winter but has now begun to degrade since spring.

Housing companies will begin to go bust. I don't know if it will be in the next 6 months, because they are beginning to take desperate steps (note Lennar's sale of their land stock at 60% off to Morgan Stanley), but it will come to the weaker players sooner rather than later. To keep the boat floating, new home prices will be SLASHED - this has now begun, it will continue and accelerate - while stubborn home owners cling to the hope of inflated 2005 prices - the reality will be shown to them when brand new homes are built at 40% off the value of what hey paid for 2-3 years earlier. This is when the correction 'really begins'.

Current view: I've been sonewhat incorrect on this one, but only because banks have been changing their terms with the homebuilders. Many ala Standard Pacific (SPF) should of been out of business by now; if not for the charity of the banks they would be. So I'll consider the bankruptcy portion a whiff, but the slashing of prices for new homes has happened - we've seen Hovnanian's "Sale of the Century" for example as we talked about in the spring. And yes, home owners are still relatively stubborn and clinging to hopes for 2005 prices. [What Should Median Home Prices be Today?]

Credit card debt, much like residential mortgage debt, is now being packaged into "ultra safe" instruments and sold on Wall Street as a way to squeeze out more yield. Don't these cats every learn? I don't know if it will be in 6 months, but in 2009 you should start hearing how these turned out to be pretty bad bets as the strapped consumer is turning to credit cards as a lifeboat now that the house ATM spigot is turned off. This will be a longer term play but truly the 'financial innovation' in this country never ceases to amaze.

Current view: This was a comment with longer than 6-9 month duration so too early to tell. We do see the consumer wilting, and turning to credit cards - the back half of this prediction will take time to play out. It is simply scary how every piece of American consumer debt is "packaged" into "safe" securities and sold to some sucker (thank you investment banks for all your "hard work and innovation") - if you thought it was just mortgages you have another thing coming.

The web that is credit will pop up in places we don't even know about yet - you are starting to see it in state governments in Florida (and Montana) You will see it in other places - credit is the lifeblood of the service economy, and these 'innovative' schemes, err I mean solutions will show themselves in many places we'd never expect. If we start seeing money market mutual funds needing to infuse cash to keep the $1 NAV, that will be an interesting time indeed....

Current view: I think that was an accurate assessment. We started to see a lot of places we never expected to hear about once the auction rate securities market froze up in early 08.

Credit is drying up worldwide - until banks are honest about their exposure this will continue to be the case. "Solutions" such as the Superfund, which simply moves hidden assets from 1 pocket to another only draw out the issue. Banks know best what dirty deeds they have done. And they know if they did it, a lot of other people did it. That's why they don't trust each other - LIBOR rates remain extremely high (a measure of rates banks use to lend to each other). The US banking system is a big black box of 'innovation' - until a lot more of the onion is pulled back and revealed we won't see the stink.

Current view: I think that was an accurate assessment, but I should of not used the word "worldwide" - it is drying up in developed nations (esp US, UK and most of Europe). Still expanding in some other parts of the world. However the banks are still not being honest, and with the government's/regulators implicit consent seem to be taking hits every quarter since they don't want all the bad news out at once. Hence you get the continuous "kitchen sink quarters". Folks, this is what we criticized Japan for doing, and we are doing the same thing here. Those in glass houses....

Corporations will become very conservative with cash, beginning to hoard it (less buybacks for example) just like the banks are doing now. This is never good - not for a financed based economy. Risk taking will be looked down upon.

Current view: I think that was an accurate assessment.

The world will slow down - I don't buy this decoupling one bit. Yes, foreign countries are BETTER equipped to handle slowdowns, but not immune. Their middle class is growing but has nowhere the consumption levels of the US or Western US. They will get hit, but its all a matter of 'relative'. They will still do 'relatively' well, but right now many markets are priced for perfection.

Current view: I think that was an accurate assessment. Inflation has done as much damage as the "exported" American financial innovations.

At this point other central banks are holding rates steady or in fact raising rates (i.e. Australia) to fight inflation. I think this changes once the reality of the US situation happens. After all we are all tied together, and a recessionary USA is not good for anyone. I think central banks in developed world by next year will begin cutting rates in unison as (a) Western Europe enters its own slowdown and (b) they are forced to, to bail out the USA for its mistakes. Inflation will have to be worried about another day. We will be going back to a world of easy money, so we can repeat this whole cycle once more (how sad)

Current view: Very wrong on this one. I have been impressed how the rest of the world does not follow us into the path of cutting rates (i.e. destroy middle class living standards) - Europe in particular has been holding fast, and now most of the rest of the world has been raising rates (too slowly) to combat inflation. Only we cut like mad men.

China - everyone says its safe to buy until Olympics 2008 - this tells me that is not going to happen. When everyone thinks something, it never happens. Either the bull will happen far after the Olympics or the bust will come sooner. I vote sooner. Again I am not speaking of the economy, but the market. The economy *IS* overheated in China and they need to take steps to slow it down to a more sustainable 7-8% type of growth. How that plays out is anyone's guess, but inflation is a real worry there (food especially).

Current view: Nailed it.

Ironically so many US investors are now piling into foreign markets as a safe haven - as always, those piling in last will get the hammer applied to them. While foreign markets (emerging) will be the place to be the coming decades, there will be ebbs and flows and the coming 6-12 months could be an ebb. And ebbs in those markets don't mean 5% corrections in their markets. Again, not a market fall but a "fear of global slowdown" could severely hurt these markets - even if there is little truth to a major slowdown in those specific markets (i.e. most countries would love to "slow down" to 6% GDP growth)

Current view: Nailed it - foreign markets have actually underperformed the US since Jan 1, 08 if you can believe it. Brazil and Russia really have been two of the few safe ports - the former highfliers China and India have been decimated. Europe, across the board, has been worse than the US market.

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Section 3: Corporate America and the Markets

I expect a lot more programs to "save" the banks, save the poor homeowners, save everyone. More government programs, more bailouts, more money printed out the wazoo at the Federal Reserve, perhaps a surprise cut here or there, perhaps a major discount rate cut. I've said at 2:31 PM Halloween when the Fed signaled they would go back to neutral, forget about it. We are going to mid 3%s by spring 2008 on the Fed funds - the more I see, the more I could be conservative. Maybe low 3%s or 3% by summer 2008. Anything and everything will be on the table to bail out the economy into an election year. That's just the reality folks. The long term be damned, whatever course of action is needed to be taken will be taken. Hence why its always dangerous to be too short the market - many forces will conspire to make sure serious damage is limited. Massive amounts of liquidity will be fed into the market. (and dollar will continue its death spiral, eventually bottoming but not "bouncing back" anytime soon)

Current view: Nailed it and frankly it's gone even farther than my imagination could take me. The complete changes in the powers of the Fed in March 2008 were unprecedented and they continue to this day. Fed funds actually went to 2% but I did not expect 1.25% in the span of 10 days in January 2008 (SocGen worldwide selloff in markets caused 0.75% in 1 day alone)

Foreign buyers will be flooding the US market by spring summer 2008- specifically sovereign foreign funds - it has already begun. But this is just the first steps - many US assets will be taken over. This time it is "for real", unlike the fears of Japan taking over in late 80s - petro dollars and massive trade imbalances make for very rich counter parties. In fact this is going to be an issue for many years as we have taken no steps to shore up our systematic issues of unfunded long term liabilities, trade imbalances, and petrol dependence.

Current view: Surprisingly this has not yet happened - U.S. product is now cheap - they've been doing some buying like the Chysler Building and Budweiser but I expected a lot more by now with how strong their currencies are compared to the U.S. peso and their huge pockets based on either petrol or trade. I still think this will happen over the coming 1-3 years in big swathes.

Politicians will be talking in very protectionist terms - and as the economy worsens, it will only get worse. I believe food inflation will be a major talking point in fact. Whom they will blame (considering the farming lobby is a major contributor to political coffers) will be interesting. The economy will become the #1 issue heading into the 2008 presidential race. President Paul will realize this.... oops, that's not reality. President Huckabee? Honestly I believe this man's populist talk of a 'fair tax' will gain a lot of ground into the type of economy we will be facing by spring 2008. So we could get an 'upset' results by a dark horse. In fact if the election were fall 2009 instead of fall 2008 I'd almost guarantee it, but by spring 2008 many of our economic problems will not have fully taken effect.

Current view: Nailed most of it. No one except Huckabee on the Republican side even considered the economy to be an "issue" during the debates at the time. It was kinda sorta an issue on the Democratic side but not even a fraction of what it is today (NAFTA? gas tax holidays?) Wrong on Huckabee ;)

Whatever solutions the politicians do, unfortunately will be focused on the near term - and be as always reactive instead of looking at the root cause and getting to the heart of the problem. If it's a matter of lack of will, lack of education, lack of vision - I don't know. I just see nothing being done for the long run. As with almost everything in this country on the political front, we will act in a reactionary measure after its created massive problems for us (social security is a small bone compared to Medicaid and we can't even address social security as a country) - so look for draconian measure perhaps in 15 years since we refuse to address it now. The 'solutions' will be mocked in this blog I am sure.

Current view: Almost impossible to not get this one right - that's just how politicians are.

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So there we have it. All in all, I think my (at the time) radical views played out. Much of what I said then (and a few others were saying) has now become the consensus. I will say I never imagined crude $150 would be an issue this early (was thinking more of 2009/2010) but I also never assumed the dollar would be literally p*ssed on to this degree. Anyhow, one day I'll get around to writing the next forward looking piece but unfortunately much of what I've said above will be repeated. I continue to believe we have a long period of "adjustment" in this country; if we had a national savings rate akin to ... well almost any other 1st world country I could make a different, more promising near term arguement. But as a nation of debtors (from government on down) it's going to be a long road to recovery.