Friday, November 14, 2008

November 2008 Thoughts/Roadmap

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Every so often I write an economic forecast/predictions for a 6 month period ahead, but have not updated my latest calls from December 2007 because frankly they have pretty much all hit on the head and there has not been much to update. But since it has been nearly a year, and government involvement has changed the landscape so radically it is time to do another look ahead.

To see my history of calls I will refer you to my original roadmap in August 2007 [Aug 31, Et tu, September?] and then a review of those calls [May 11: Reviewing August 2007's Roadmap & Views]

... and then my next roadmap in December 2007 [Dec 4: Et tu, 1st half 2008? Predictions for the Coming 6 Months] and then a review of those calls [Jul 14: Reviewing December 2007's Roadmaps & Views]

Frankly the accuracy has been dead on, as I took a very contrarian view to what the vast majority of Kool Aid drinking pundits were touting at the time. At this time Wall Street has finally "caught on" but I am still painting a far darker picture than the consensus as I look ahead. You might think the below is a very drastic outlook but I am using the same thought process that led me to my assumptions in August and December 2007, and if you take the time to read those posts over you will see the accuracy rate was 95%+. I think in America people are used to hearing the "best case" instead of the "realistic case" and that has led to many very poor decisions as a nation. Perhaps we are not ready for the truth. Personally, I hope I am wrong in much of this but I hoped that last year too...

In a big picture sense 2007 was the year of subprime, and 2008 was the year of major credit contraction and banks blowing up. 2009 will be the year Main Street truly takes the major hits, and state budgets will become a national emergency. 2009 will continue our bailouts but we will move from corporate (I should not use the word move... we will parallel) bailouts and it will be the year of personal bailouts and state bailouts. The wild card is the credit crisis - it is hard to tell right now how much credit issues will improve on a global basis. I am base lining in a scenario that credit will begin to flow to some degree but obviously nowhere near the levels of 2004-2006. If credit remains as tight as it is now, or indeed worsens my quite dark predictions below will look Pollyannish. I also expect the Obama socialism to be a lot more pervasive than the Bush socialism and I imagine that I cannot even imagine today what forms of 'assistance' will be offered....

The Consumer/Housing/Inflation

#1: Mortgages - A year ago all the focus was on subprime - I wrote many times subprime is the tip of the iceburg; literally. An iceburg is mostly underwater and those were the Alt A mortgages, option ARMs, prime mortgages below the surface. Those began going bad as we moved through 2008. 2009 will be worse despite the governments interference. People will be 'saved' but many of those saved will only be extending the period they stay in their house before they eventually default. We already see this, 1/3rd of modified mortgages thus far already have borrowers who are late on payments.
The problems are multiple
  • (a) homes in many parts of the country are still overvalued versus incomes [What Should Median Home Prices Be Today?] - basic affordibility is still an issue; prices detached from the traditional 2.6-3.0 income to home value ratio that dominated for decades. Further, home prices in many parts of the country completely detached in their ratios from rentals - that will revert to a mean.
  • (b) mortgage rates despite the Federal Reserves best efforts remain over 6% [they don't control the long term rate, only the short term rate] - in theory the more money we print and more risk we take as a country to our national balance sheet the higher long term interest rates should go (which are what mortgages are based on) - so the more we bailout, the perverse effect is it should increase mortgage rates - this makes mortgages even more expensive and goes back to point (a) - affordability becomes more of an issue at 6.5% rather than 5.25% mortgage rate. I'd argue interest rates should be even higher for all the debt we are amassing - mortgages should be north of 7% and
  • (c) "underwater issue" - it simply does not make economic sense to stay in homes where you are underwater. I do expect the federal government to interfere here in 2009 and unlike the Bush era somehow force modifications on principal in a vast way - certainly through Freddie and Fannie. But as home prices continue to decrease that will again only reduce a problem, not eliminate it. Homes will continue to fall in price and people will again be underwater even after the principal modification. Why?
  • (d) unemployment - this is the first housing crisis that led the recession not followed. Usually unemployment LEADS to housing issues. People lose jobs, can't make payments, a region's housing gets into trouble. This time we did it backwards - housing caused the national emergency. So as we are now well into the housing emergency only now are we beginning to see the front end wave of serious unemployment - no matter what modifications you make to principal, interest, or the like - if you don't have a job it matters little. So that will, instead of causing the housing crisis as happened in the past, pile onto it.
#2: Home Prices - speaking of home prices, it's tough to make a national call since each state has it's own specific issues. I will say we have had horrific drops in many of the hottest markets (30% year over year) and that is "good" in terms of getting to a bottom. I expect a similar year in 2009 in those hot markets but by the last quarter of 2009 to see "improvement" - i.e. a slower rate of decreases (maybe 15% year over year in the hottest markets) as finally home prices begin to fall in line with incomes. Wall Street will absolutely love this since it will signal a bottom in their world; but this is still horrible for Main Street. Either way, there won't be a V bottom in housing (a quick bounce after a sharp drop) - we'll go from a drastic drop in prices, to a slow drop and then in our "recovery" years (2010-2013) a lot of sideways actions as people rebuild savings and the pool of buyers is rebuilt. What a lot of people miss is we "drew in" many of the natural buyers from 2009-2011 into the frenzy of the housing market in 2006-2007. Many people that should be ready to buy next year and the year after already jumped in a few years ago - so that pool won't be there in force as it should be. That said, foreclosure pricing (50% discount to market) can draw in many others who would otherwise be locked out. Foreclosures are already about 50% of the market in California for example - and I expect this to be a sizeable amount of all purchases in 2009 - unfortunately that pricing will continue to wreck havoc for natural home sellers who are not foreclosures, along with new home pricing.

#3 Consumer Spending - if you followed this website for more than a week you know my thoughts on the consumer. We are going through a historic reversion to the mean. We are overbuilt in retail throughout the country and as we move back from a 0% savings rate to even 4% (we used to save 8-9% at some points earlier in our national history) the after effects in a country where 2/3rds of GDP (Gross Domestic Product) is consumer spending will be momentous. But this is a lot bigger than numbers - I truly think we have a half decade ahead of us where attitudes to spending change, a much more serious tone emerges, flamboyant spending is frowned upon, and excess is no longer celebrated as every 3rd reality TV show now portrays. That is because so many in the country will be struggling. I wrote countless times how many surveys show Americans, regardless of income live paycheck to paycheck - budgeting is simply not something many do - now they will be forced to get serious since lifestyles across the board are threatened. As the job losses mount, first half 2009 is going to be a disaster in spending. I said in 2007, 2008 will be a 20 year low in auto spending - I believe 2009 will be another huge dud. Next Christmas will also be poor, much like this one.

#4 Personal Credit/Bankruptcies - 2009 will be when the first real wave of personal bankruptcies hit Americans. Credit cards were the last place people were hiding their debt as all other avenues were extinguished but there is only so long you can move debt from under one shell to another. Further, credit card companies are proactively lowering credit limits for people and hiding debt in your house at 6-9% is less punitive than on your credit card at 15-27%. Again, the bankruptcy laws were changed after heavy lobbying by the credit card companies a few years ago so it's become more difficult - but it will happen. As for the credit card companies? Of course their delinquency rates will skyrocket but it appears they will now be getting our tax money since like American Express they are now "bank holding companies!"

#5 Unemployment - again if you've been reading along the site for any period of time you know the farce that is government employment statistics [Nov 7: October's Unemployment Rate is Rises to 6.5%"] I was thinking (I have not studied it) how government statistics for unemployment were in the 1930s versus now. Many said in the Great Depression we had 25% unemployment rates... I'd argue we are already in the mid teens or perhaps upper teens. So are we really that far off? As for "official statistics" in the 6 months ahead we will begin the climb to 8% - by end of 2009 8-9% should be very real but again, the wild card is how many fake jobs the government creates in its reports. Job losses will be widespread especially hitting the service sector as many more retail outlets go under, from larger chains to small mom and pops. The mom and pops won't be counted in a lot of these unemployment statistics and remember, once you exhaust your unemployment benefits you no longer are unemployed by this government, you disappear! My hope is people who do continue to work still get 3-3.5% wage increases and deflation does not begin to hit wages - otherwise even more trouble.

#6 Inflation/Deflation - I saw a chart a few weeks ago by someone in the investment business and it looks now that oil has a good chance to fall as low as $40. But more importantly we are going through a general deflationary spiral. I'm in the camp that this will eventually lead to an inflationary spiral as the lack of infrastructure spending that we will see in the next 12-24 months will cause shortages once again in the out years, along with the natural global population growth and modernization that we talked about countless times. So the timing of when we flip from deflation to inflation is farther out; for the purposes of time frame of this entry expect continued deflation which we already have in housing, stock market, commodities, just about every asset class. The Fed is increasing the money supply like mad (literally it looks like a hockey stick the past 2 months) but that is simply filling a hole of capital destruction. So capital is being destroyed in 1 place (housing/equity markets) and the Fed is creating money to offset it - it's still deflationary until they reach a point they create more than is being destroyed. At some point capital destruction finishes and the Fed will still be printing money and will overshoot... that's when we begin the inflation spiral. But it won't be in the next 6 months.

Corporate America and the Global Markets

#1 Corporate Profits - I talked constantly over the past year how analysts projections for the 2nd half of 2008 were a mirage - we are now seeing what happens when a mirage and reality merge. 1st half 2009 will continue to be very poor and I expect more downside to what is currently published. Multiple companies in industries that normally ever do it, are now withdrawing all guidance since there are so many uncertainties ahead. This will continue to pressure stock prices and limit their upside.

#2 Energy Prices - energy prices should stay in a lower range through 1st half 2009 providing welcome relief to both consumers and producers. It will take time to filter through the production food chain but should provide some offset to costs in a meaningful way for corporations who use raw materials - unfortunately it will just be offsetting some steep price declines in what they can charge. I do believe the thesis that consumer staples might really benefit from this as for example food companies have kept prices the same but created smaller boxes and skimped on ingredients so as their inputs fall they can keep the prices elevated and pocket the difference. Consumers don't seem to fight back on this pricing the way companies would. And yes gasoline @ $2 or even $1.50 a gallon or will be a 'tax break' for consumers, but with all the other headwinds I'm laying out, an extra $15 a week won't be making much of a difference but all things equal - of course it's better than $4 gallon. Don't believe the permabulls who say $2 gas solves 90% of the ills.

#3 Commerical Real Estate - Commercial real estate was one of my big themes for latter 2008 - it will degrade even more sharply first half 2009. Mall rents, office rents, warehouse rents - all need to go down. The lack of access to credit is making these businesses even more scary. As for malls, it's still too early to make these calls in 1st half 09 but in the next 12-24 months I expect some weaker malls to go under as more and more retail space lays vacant.

#4 Emerging Markets - after seeing what is going on in Russia and reading a lot of information coming out of China I have to be more negative on emerging markets than I was even 3 months ago. I still believe the emerging markets especially Asian surplus countries will lead the eventual worldwide recovery - unlike the current consensus that the U.S. will - but it's going to take longer than I originally imagined and the drops in those countries could be steeper than I forecasted say 6 months ago. There seems to have been bubbles in Chinese manufacturing - while they ship just as much to Europe as they do the US ; you had the above mentioned consumer bubble in the US and just like it will profoundly change habits in the US - the same parallel of overbuilding US retail outlets can be found to a lesser degree in Chinese manufacturing. We also had consumer bubbles in certain Western European countries (i.e. UK) so that's another issue for China exports. China also had a real estate bubble - at least in coastal cities - so the recovery of this linchpin certainly has to be pushed out - thankfully for them they have huge national surpluses and a 30%+ personal savings rate so it's all relative. Brazil's a commodity based economy and as goes China, so goes Brazil. India is somewhere in the middle and I have not done enough reading to figure out their situation.

#5 Europe - Eastern Europe might cause some major issues in 2009 - Hungary already has had some major issues but many smaller eastern European countries followed the US model - borrow borrow borrow, spend spend spend. But unlike the US which somehow people still find the "safest country in the world" (the only country in the world who originates a global crisis and people flock to their currency) the Eastern European countries do not have this advantage. We could see multiple shock waves in smaller Eastern European countries in the year ahead especially if credit remains this impaired. As for Western Europe - you have to split it among the ones who did not do crazy home mortgages (France, Germany) and those that did (Spain, UK). Spain, UK are just mini USA's - big trouble - housing bubbles, consumer bubbles. Germany is a big exporter so despite relatively conservative national finances (a plus) will suffer as the global economy contracts.

#6 Central Banks - I expect the "Japanization" of much of the Western World - that is a low low low interest rate world where savers are sacrificed at the alter to try to get people to spend with free or nearly free money. It did not work in Japan; I expect no great short term results from this in the Western world. When people fear for jobs, their houses drop in price, their stocks fall 40% in a year, if you offer then money at 0% many don't want to take on ANY MORE debt at ANY price. So this will be the conundrum. But I do expect the Bank of England after that stunning 1.5% drop last week to continue this policy into 2009, and the ECB (Europe) to follow suit although slower and in smaller increments. Alan Greenspan will be happy - the whole world is going to follow his policies of 2002-2003. And this will lead to enormous bubbles in 2012-2014 that will wreck havoc elsewhere....

#7 Foreign Takeovers - this was one of my major incorrect calls for 2008 - I expected a wake of foreign takeovers as our assets became very cheap. But with the credit crisis it seems to have created a risk aversion situation even for those with cash in hand. I will repeat this prediction for 2009 and one of these years I'll get this call right!

#8 Big Picture - now for all this doom and gloom I don't predict another Great Depression because the world is very different now. We are much more interconnected and specific countries have huge surpluses which they can use to buy up assets on the cheap in the impaired countries. But since we've sort of grown fat and happy here in the US it will feel like a Great Depression for some. And certain industries are simply being obliterated - you know the names - housing, finance, autos, newspapers, et al. It is a Great Depression for those industries.

#9 US Stock Market - your guess is as good as mine. I believe while the consensus economic view finally has some reality to it (after a year of denial), many people will constantly look for a "turn" in any economic report - and each time a few data points signal ANYTHING positive the market has potential for dramatic moves upward. But just as I was smirking at the "2nd half 2008" pundit talk, those same folks now are pointing to "2nd half 2009". Generally you want to buy halfway into a recession - prices are at their lowest and historically the first part of a move out of a trough is the most powerful. So if you believe the recession is half way through by say January 2009 and you see "2nd half 2009" recovery - you want to be buying hand over fist this late winter or spring. If you believe early 2010 you want to buy this summer, etc.

The point is we are an optimistic folk and Kool Aid abounds under the surface. Hopeful thoughts will constantly push people into stocks as they anticipate an "imminent rebound" two quarters out. I'm not in that camp - this is going to be a long drawn out, historic affair - the kind you will talk to your grandkids about. But it does not matter what one viewpoint is; in October 2007 the market was at an all time high as the "forward looking mechanism" that is the "wisdom of millions of investors" looked out 6 months ahead to March 2008... and missed the entire disaster that laid out in front of us. Those who called for said disaster in 2008 looked like fools in October 2007. So my point is PERCEPTION is REALITY - it really does not matter what happens economically 6-9 months out if the perception is things will be better. This stock market, more than anything is about perception and confidence - not reality. Many ridiculous rallies in 2008 showed us that (remember the "tech is safe" trade that hedge funds were in for 2 months this summer? that looks foolish now - but it worked for 2 months)

USA - Other

#1 State Budgets - I cannot reinforce enough the point I have made many times for the past 15 months. State budgets in 2009 are going to be a complete disaster. I truly think this will be one of the biggest emergencies in the year ahead - in the next 2 years I could see 15 or so states potentially defaulting. Remember state budgets are from middle of 1 year to the next. The bleep hits the fan in summer 2009 to summer 2010 budget year. Revenue comes from (a) real estate values (b) spending and (c) corporations. Based on my vision above - all these go into the tank - in fact they already have but rainy day funds and other things have been used to stem the flow. Next year many states won't have that option. We will have a disaster on our hands and unlike the federal government there will be no printing of money out of thin air to make up deficits. So you know the solution here - the federal government will be bailing out individual states. If not, we lose many services, we lose many schools, we lose many things people take for granted as a society. Main street will see this first in their local public schools (not every state) - I think the levels of cut backs necessary will simply stun many in the worse run districts. The other solution as we stated countless times aside from cutting services is raising taxes - on a populace already in a deep recession. This is a tsunami that many states are ill prepared for and much like federal government, they are reactive not proactive. Unlike the federal government who always has an ace in its back pocket (printing free money out of thin air) the states (and municipalities) just face an abyss. That abyss will be filled by your grandchildren's money.

#2 Sports - I predicted last year that sports will take their first hit in America - we discussed this in May , June, and October. By that I mean spending at stadiums, merchandise, and the like. I said it would start at the NASCAR crowd and move it's way up to other sports - remember much of middle class America has been priced out of many sporting events; it's now corporate driven. Based on the corporate retrenchment combined with economic stress moving up the food chain from poor to working poor to middle class to upper middle class to lower upper class... I see sports taking a real hit in 2009 and 2010. It would be a major outlier to call for salaries to ever take a hit but I will be interested to see if we ever reach a point like that (but not until 2010)

#3 Las Vegas - Las Vegas is really the canary in the coal mine for all things American - over abundance, excess, casino mentality, instant gratification, among others. I admit the place fascinates me as an economic and societal laboratory experiment - a city created out of thin air as a playground - can you imagine such a place in a 3rd or even 2nd world country? I predicted Las Vegas would take a damaging hit a year ago - it has. 2009 will continue to be a horrid year. I expect a lot of projects to be mothballed.

#4 Hedge Funds/Investing - As stated already I expect at least 1/3rd of hedge funds to be gone either by choice or by their investors decision within a year. Many will close shop by Dec 31, 2008 since their high water mark (where they generate their real income) will take years to recover. Unfortunately the two bear markets within 8 years along with the completely arbitrary and computer driven nature of this market will turn off many of the individual populace from investing. When computers algorithms mean more than any sense of fundamentals, people will lose faith as everything historically useful loses its use. Ironically many quant funds have held up quite well in this monster bear, which will only lead institutions to give them more money - only increasing their power on the market. This could lead to even more randomness and "casino" action.

Pathetically people who never invested in the stock market the past decade have made out like bandits versus most non trader types inside of it. And make no mistake, the vast majority of American investors are not following things day to day - they are passive investors. Those of us who follow the market daily or focus on specific niches tend to forget how the great masses view Wall Street - basically by the major companies or the indexes - many of those "safest" investments - the General Electrics, the Microsofts, the AIGs, the Fannie Mae's, the Merrill Lynchs, the local regional banks - have simply destroyed people. Many of those people who finally came back after the 2000-2002 debacle. I think many will never come back - keep in mind in other 1st world countries far fewer of the populace invests in the stock market - I believe I posted a few weeks ago 50%+ of Americans do while only 7% of Japanese do. (many here via 401ks of course since we have abandoned the pension model) Why should it not return to 25-35%? If so, Wall Street will begin to return to the old model where really only the rich, and upper middle class participate... that might take much longer to play out but when the odds are so stacked (as they have been under the sleepy SEC) for a certain few - the masses will lose the faith. Those few that have not already lost the money that is.

#5 Bailouts - They will continue. In force. This is an epic dislocation and we've seen things the past year none of us could ever imagine in terms of response from government. New Federal Reserve programs never thought of before. Shotgun weddings pushed ahead by government. Bailout funds of massive proportions. Takeovers of Fannie/Freddie. We will continue this and it will get bigger as we move to Main Street. We are taking incremental steps for a housing bailout but I expect a huge proposal in 2009 that will be sold as "a few hundred billion" but ultimately will cost multi trillion as we look back at it in 2012. I put nothing off the table - I was shocked to read there are behind the scenes machinations for programs to forgive 40% of credit card debt by those worst in hock. Are you kidding me? The moral hazard in this country is off the hook - with this sort of nanny state - everyone should buy the biggest house they can, take every credit card to maximum and then wait for the bailouts to begin. But this story, on top of everything else, tells me NOTHING is IMPOSSIBLE in the year ahead.

Non 2009 Commentary

Grandkids - I keep repeating this; this is a very sad situation for the people coming after us. As a country we've been reactionary and almost never proactive for the past 30 years. We've been excessive both at the personal level and national level. We've built up debts that foreign creditors allowed, and made promises to our people that (almost) everyone knows are a farce. But no one has the courage to address this. We kick the can down the road; that's been a national policy. Eventually someone will pay. With what we have layered on top of our already massive obligations from entitlements in the past year [Mar 26: Annual Spring Entitlement Warning Falls on Deaf Ears] , and will add to in the year ahead - well let's just hope our birth rate jumps to 4 kid for every family because the amount of debt per head for future generations is withering. I continue to say we are technically bankrupt as a nation, and when the day comes our foreign creditors pull the plug, we will have yet another crisis mirroring the current mess we've made. That might be in 5 years, 15, or 25 - depends on the goodwill of our creditors - we are at their mercy. Why we to be in that position that is beyond me. Until then, over the coming years I expect our long term interest rates to rise as the U.S. is seen as more and more of a risk and said creditors demand more interest to compensate for our growing risk of default; which only increases the cost to said grandchildren. Eventually the dam will burst. That won't be 2009 but food for thoughts on the long term. We did not get here by accident and the continued head burying in sand and saying "we'll get through this, we always do" has been the status quo solution for the past 3 decades - it's not working.

As for 2009, it's going to be a lot like one of those dark years from the 1970s or very early 1980s - which many of us in our 20s, 30s, and even 40s did not "feel" as adults. Compared to what we are used to during downtimes this will be a shock to the system for many. What is the ultimate solution to all these ills? Time. It's as simple as that - we have to work off all these ills, and refocus/shrink - it will take time. You can't force that although the government will try. From wherever we land, we should have a much more sturdy base to attempt the next leg of growth - as opposed to the mirage we've been living in much of the past 10 years.

We'll check back next summer to see how correct these predictions are...

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