Friday, April 3, 2009

The Current (and Coming) Disassociation Between Economics and Stock Markets

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This is going to be a quite interesting period we have ahead of us - as I wrote entering 2009 we will swing wildly from hope to reality in 2009; and we've now had the full 180 degrees. We started off with hope for President He Who Walk on Water Who Shall Single Swoop in To Save Us (by the way the guy is working his rear off no matter what you think of his policies), then that quickly faded by week 2 of the year - we slumped for 2 months in epic fashion, and now we've come to love our Nanny State again, as she shall protect us. From ourselves. Again. Groundhog Day.

So please forgive me as we go down a bifurcated path - I'll be talking all crazy; saying things that sound like complete nonsense, doom - gloom (with a little boom) as I focus on the "reality" out there. Not the "2nd derivative improvements that if you squint and pray really hard, you can make a bull case out of it" songs of joy. Although I'll point those out to you because that's all the market focuses on. Everything I say will be refuted by the punditry as "backwards looking" and "missing the silver linings". The market will rally during these periods; many of the greatest runs in the stock market came during the Great Depression. That didn't mean the economy was in any state of health. This denial is ok; I sounded like a fool in 2007 when I began the blog as I posted such "nonsense" and the market "refuted me" by "price action" in the opposite direction (the efficient market knows best!). The S&P raced to all time highs in October 2007. Gosh, I looked silly - thankfully my audience was a mere tiny fraction of what it is today, so I only looked like a "clown" to those few. A few readers stuck around to see most of these claims come to fruition. You can see a compilation of such posts in the Economic Forecast / Track Record tab at the top of the blog. I am posting this not as a bragging point but to give readers who were not around in the early days some evidence of history - especially as the Kool Aid shall overwhelm us in the days/weeks/months/indeed quarters to come.

Much of what I say in the coming months will be dismissed (again!) by the "oh so very efficient markets" who "price things better than any 1 human". Most of the punditry and investment managers flailing their arms in dramatic fashion - calling bottoms, speaking of economic recoveries, tasting the sweet essence of mustard seeds - completely missed it 2 years ago. Surely we must listen to their siren songs now. Did I get everything correct? Certainly not (completely missed the dollar rebound as safe haven) .... frankly as I thought through what could come, I almost could not believe how it was playing out - could it really ever get *THAT* bad? But the accuracy of what I laid out is far more than most of the 'experts' paraded on TV and in print media on a daily basis. I'll take my track record over theirs; even if it's hidden in shadows and darkness in this dark nook of the internets.

Behold August 2007, [Aug 31, 2007 Et, Tu September?] 2 months before the market peaked at ALL time highs and we were told 'subprime is contained', 'none of the economic data support your downbeat analysis' and 'Don't fight the Fed - you will never win' I made crazed comments as
  • We are in inning 2? 3? of a housing correction. 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.
  • 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?
  • 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
  • The retail "my house is my ATM" play, seems to be over. 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.
  • Construction jobs - they are going to be accelerating into an abyss.
  • 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?
  • 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?
And that was me being "bullish" and almost not believing part of what my analytic mind was laying out (this is America! It just can't happen to *us*. could it?) By early December 07 I was downright Roubini-ish even before HE hit the big time in early 2008 [Dec 4, 2007: Et Tu, 1st Half 2008? Predictions for the Coming 6 Months]

Back when I wrote the late August post, the politicos were mostly dismissing the issue of a housing crunch but finally relented with a breathless speech by President Bush on a plan to help out a whopping 100K home owners. We had just had our 'surprise' 50 basis point Fed/discount cut and people were cheery as the Fed was going to fix everything.

We now have the next bailout...err, solution by the politicos. Now its up to "2 million" home owners, with proposals to freeze their rates. And people are cheer that the Fed is going to fix everything.

Some specifics? (remember everything below was written was previous to Societe General, previous to Bear Stearns, previous to Bush rebate stimulus, back when oil was still in the double digits but on the way to mid triple digits) As you read these now, you see many are "consensus" - back then? Don't ever doubt the US consumer. It's only a subprime issue - once we are through those - we'll be back and running. We've never had a national downturn in pricing - simply cannot happen. Sovereign wealth funds have already saved the banks. And even if they did not - didn't I just say don't fight the Fed?
  • First and foremost I think this focus on subprime is misguided. The subprime borrower is a relatively small piece of the puzzle... my arguement is their troubles are not the central issue facing us. It is "everyone else" (excluding the top 5%)
  • 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.
  • This is also why I find laughable when I read the housing issue is containted to California, Florida, Michigan, Ohio.
  • 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. *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?
  • 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.
  • Next shoes to drop? Corporate profit margins. 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
  • Energy prices will pressure many industries and those industries dealing with food are already seeing massive pressure on profits.
  • 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".
  • 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.
  • 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.
  • 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.
  • 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....
  • 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.
  • 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.
  • 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.
  • 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.
  • 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.
  • 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.
  • 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.
  • 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.
  • 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.
  • 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.
  • Massive amounts of liquidity will be fed into the market.
  • Politicians will be talking in very protectionist terms - and as the economy worsens, it will only get worse.
  • The economy will become the #1 issue heading into the 2008 presidential race.
  • 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.
  • I do see a very serious retrenchment as global forces are now to the point they overwhelm "some" of what the Fed can do.
  • I do trust principles will be tossed out the door and the government will do everything in its power to stimulate, stimulate, stimulate - by any means possible. So as investors we can cheer that; as Americans and those living supposedly in a free market? I wouldn't say the same.
So as we journey forward I certainly could be proven wrong in my CONTINUED bearishness on the REAL economy (which is not a parallel to the stock market for long periods of time) - but I'll have a lot more credence than the flailing arm waving guys. But be prepared for longer periods of disassociation between "reality" and "the market's version of reality" as we are a hopeful people who cry out for any "signs" from the market gods that what we see around us in the real economy is not true OR more importantly is "soon over" and will change "in 6 months". (remember "the market" has roared higher, predicting 4 of the 0 previous economic rebounds in the past year). We, as peasants of poor vision and understanding, just can't see said rebound(s) yet... but the "all knowing market" does. The economy will have fits and starts as we bump along this economic bottom - we cannot keep dropping home prices 20% a year for 3-5 more years, or unit car sales dropping 40% year over year - there would be no economy by 2012 at this pace. So of course it will "plateau" at some level - and then we'll get the government induced bounce I've been speaking of the past 3-4 weeks. Ah -2% to 0.5% GDP will never feel so good; especially considering we wouldn't even be that well off if not for the tsunami of stealing from grandchildren to fund "prosperity" today. But this sugar high is far different from real growth; but the market shall celebrate the government sponsored mirage. Each fit & start will usher in the new era of calls of rebounds "in 6 months" that the market clearly sees - in its all knowing Oracle nature. I'm sticking with my double dip recession scenario - and then we'll eventually arrive at what I'm terming the "new normal" - a place where most growth will be based on "replacement rates" (eventually cars, refrigerators, TVs break down), Chinese growth, and prayer for a new U.S. bubble to stop the jobless recovery 2.0. And a populace realizing it finally needs to save at a realistic rate [Dec 29, 2008: What Happens if America Returns to a Historical Savings Rate?] - impairing much of our "new and innovative" service economy versus 2000s levels. How the stock market reacts to each shred of data is unknowable - human sentiment is impossible to gauge in advance.

Let's once more reinforce for newer readers the market is not the economy - not for long periods of time at least. The market is not about what is correct; it is about what the herd thinks is correct. This is the lesson it took me quite a few years to learn when I first started in the markets as I was a stubborn creature who relied on logic. Logic - a most useless trait in a stock market so dominated by emotions. So as I write these tales of economic dysfunction in the months ahead - some of which will be conterintuitive to the sugar high (government induced with tsunami of dollars) "better than expected" economic reports - please be aware of The Disassociation. And no, it won't mean I will not be trying to partake in the Kool Aid of the market during opportune times. I'm not dogmatic - nor do I believe the market cannot remain irrational longer than I can stay solvent.

So let's enjoy, together, another morning of close to 3/4 of a million Americans losing employment and seek the silver linings that the market is so wisely whispering to us about, shall we?

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