A Special Comment About the Markets and Economy

It's been a terrible opening for the markets in 2008. While the new year is supposed to bring hope of god things to come, the markets have instead dropped like stones. Citigroup and Merrill Lynch announced massive writedowns in their respective portfolios, everyone from Congress to the Fed is talking about some type of stimulus plan and there is hope for rate cuts from the Federal Reserve. Finally, there is more and more talk about a recession - which is defined as two quarters of negative economic growth. So, the question on everybody's lips is what the hell is happening? Are we in a recession? Why are the markets tanking so hard? Below I will explain what is going on. I will caution up front this will be a long and fairly involved article.

Let me start with something I wrote in August 2007:

Since the beginning of 2001, the US consumer has accumulated a great deal of mortgage debt. According to the Federal Reserve, total mortgage debt outstanding increased from $4.9 trillion in the first quarter of 2001 to $9.8 trillion in the first quarter of 2007. To facilitate the creation of this debt, the US financial system has developed a system called "securitization", which I explained in this article. Central to this system is the willingness of certain financial parties such as investment banks, mutual funds and other large investment pools to buy and sell large pools of mortgage debt. This system has been around for about 20-25 years and has worked very well over that period.

However, over the last few years lending standards have deteriorated. In the past for example, a borrower had to put down 5% or more of the purchase price, the mortgage payment couldn't be more than x% of the borrowers income and the borrower had to have a decent credit history. These lending standards were lowered by a sub-section of the mortgage market called the "subprime market". "Subprime" simply means a person was not a prime risk, but instead was riskier to lend to.

The system of buying and selling mortgage securities and the mortgage underwriting business worked against themselves for the last few years. As the system of buying and selling mortgages wanted more mortgages to buy and sell, mortgage underwriters were happy to oblige by writing more mortgages. This was partially responsible for the lowering of lending standards. Because there were so many mortgage investors, it was thought the risk of the less credit-worthy borrowers was spread out among enough buyers that a default wouldn't seriously hurt anybody. However, we're learning that isn't exactly true:

"For years, people have taken the view that the strength of the modern financial system was that risks were widely spread, and so when something went wrong everybody had a small piece," says Lou Crandall of RH Wrightson & Assoc. "The problem now is, everybody's got a small piece, but those pieces are actually big enough to pull some players under, which means the fact that the risks are so diffused in the system means everybody is a suspect, and that's the flip side of what we saw as the strength."

Everything changed in late July. Bear Stearns announced that two hedge funds that invested in mortgage derivatives which had previously been worth about $6 billion were now worthless. I have publicly criticized the fund's manager before and I am doing so again. He was a fool. His fund was heavily leveraged and his investments were risky. So long as the market is going up, he was a genius. But the market turned against him, forcing margin calls and essentially bankrupting the fund in short time. He deserved to lose on his bet.

The Bear Stearns situation was the first in series of announcements from three continents (Australia, the US and Europe) where funds or investment managers announced their respective funds were losing value because of their investments in subprime mortgages. Since Bear made their announcement in late July a week has not gong by without another announcement of a problem at an investment fund, bank or financial company.

The Bear Stearns announced was the start of a process that continues to this day. According to the Wall Street Journal's Marketbeat:

According to figures calculated by MarketBeat, some $100 billion-plus in positions have been written down for 2007, as the world's investment banks recognize, en masse, that nobody wants this paper, not even made-up vehicles that have no choice but to buy it. Susanne Craig, David Reilly and Randall Smith reported in today's Wall Street Journal that banks are going back to basics, reducing risky loans as a result, but that requires that they set aside more capital on their balance sheet, which will hurt earnings.

In other words, the US markets have now experienced a continual drumbeat of negative news from the financial sector that has lasted about six months. This has created a growing concern about the health of the financial sector and the economy as a whole, which in turn negatively impacts investor sentiment. Hence, investors are selling securities. I wrote about the overall problem in more detail here.

Let's take a look at the markets to see what exactly is going on.

Since their top in late September around 156, the SPYs have fallen 15%.

Since their top in early November at 54.50, the QQQQs (NAASDAQ) has fallen 16.8%

Since their top in mid-Septemter around 84, the Russell 2000 has fallen 20%.

All of these charts are extremely bearish. Prices are below the 200 day simple moving average (SMA), the shorter SMAs are below the longer SMAs, all the shorter SMAs are moving lower and the 200 day SMAs are starting move lower as well.

But now in addition to concerns about the financial sector's health there is concern about a recession developing. Recent economic news has not helped in this matter.

The most devastating piece of news was the most recent employment report:

The unemployment rate rose to 5.0 percent in December, while nonfarm payroll employment was essentially unchanged (+18,000), the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Job growth in several service-providing industries, including professional and technical services, health care, and food services, was largely offset by job losses in construction and manufacturing. Average hourly earnings rose by 7 cents, or 0.4 percent.

Before this report, the bulls strongest argument was employment gains would continue to fuel consumer spending. This report basically blew that argument out of the water. Here is a chart of the year-over-year change in employment, which shows a clear downtrend over the last few years:

Then there was the disappointing retail sales report from the Census Bureau:

The U.S. Census Bureau announced today that advance estimates of U.S. retail and food services sales for December, adjusted for seasonal variation and holiday and trading-day differences, but not for price changes, were $382.9 billion, a decrease of 0.4 percent (±0.7%)* from the previous month, but 4.1 percent (±0.7%) above December 2006. Total sales for the 12 months of 2007 were up 4.2 percent (±0.4%) from 2006. Total sales for the October through December 2007 period were up 4.9 percent (±0.5%) from the same period a year ago. The October to November 2007 percent change was revised from +1.2 percent (±0.7%) to +1.0 percent (±0.2%).

And retailers are reacting thusly:

The retail industry appears to be skidding toward its first big wreck in 17 years. Chains are slamming the brakes on store openings, cutting back on inventory and girding for leaner times as consumer spending chills. The speed with which sales slowed during the holidays caught even cautious retailers off-guard, prompting a flurry of profit warnings.

Considering that consumer spending is responsible for 70% of US GDP growth this news adds to the "Wall of Worry."

There are several reasons for the decline in retail sales. The first was mentioned above - weakening job growth. The second is the continued increase in gas and food prices. Here is a chart of oil for the last few years:

And here is a chart of agricultural prices:

In other words, the price of necessary expenses is hampering the consumer's ability to purchase non-necessary goods and services. These price increases are also hampering the ability of the Federal Reserve as they indicate inflation is rising. And inflation is now at multi-year highs:

US inflation for all of 2007 hit the highest rate for 17 years, as surging energy and food costs pushed up prices, official data has shown. Consumer prices rose by 4.1% for all of 2007, up sharply from a 2.5% increase in 2006, the US Labor Department said.

While there has been some talk of stagflation recently (high inflation and slow growth) I think it's way too early to be making that call. If year-over-year inflation hits 7-8% then stagflation talk is warranted, but not until then.

So, the basic overall economy situation is not good.

-- The employment report indicates that employment growth is slowing. This indicates businesses are not confident about the future.
-- Christmas sales were OK, but not great.
-- The consumer is hemmed in by rising oil and food prices
-- The Federal Reserve is hemmed in by high gas and food prices.
-- The financial sector is still dealing with the fallout of the sub-prime mortgage mess and probably will be for the foreseeable future.

In short, things do not look good right now.

Comments

[Kantinflas]

Ours is essentially a political democracy and a market economy. Americans unhappy with either the political or economic situations should begin their search for scapegoats by looking in the mirror.

[themodernleader]

Bondad. As a society declines, masking that decline is disguised by the corruption of language. For example. the media headlines "Will Freedom Be Preserved" referring to fighting off governmental regulations and monitoring. And may I take exception to language you no doubt unwittingly used that betrays lucid and credible communication? "Retail industry" is no such entity. Retail monopolists, wall street retail businesses or simply retailing corporations or retailers, all are proper terms.
Industry and manufacturing or synonymous terms that refer to making and producing.
The disasterous destruction of our industrial base in the name of freedom of trade for the freedom of the few to undermine the welfare of the many is the core of our problem. All the first level Presidential candidates disgrace our Country by proclaiming that globalization and unhibited trade is here to stay and we can do nothing about it. Only educated, errudite dogmatists, imprisoned by their own puerile, self-serving words deny the stark numbers, and historical experience that one way trade is a one way road to national catasthrophe and destruction.
This Country is full to the brim with highly schooled, articulate and uneducated leaders.

[Unrepentantliberal]

Bush will prod Congress to throw a little money our way which will be spent to buy some trinkets from China resulting in no new jobs and no economic benefit to this country whatsoever. A total waste of time and money.....but that's something George was always good at......wasting other peoples money. What idiots elected this moron anyway? Republicans and fundamentalist Christians that's who. Too bad the rest of us get trampled as well instead of just them.

[isis]

All the deregulation comes back to haunt us.

[outnow]

The corporation is an instrument of power and wealth of the class that created it. Although the corporate class complained that health care was too expensive for them to compete globally because labor costs were too high here in the U.S. due to health care cost, when it came time to provide universal health care, the corporate class voted down universal health care because it was socialized medicine. The manufacturers withdrew their support from Bill Clinton. This is an example of class solidarity of the elites.

Even as the domestic steel industry collapsed, they said, "Reagan cut out taxes. We're a country club crowd."

Money's loyalty is to money, not to America.

[MuseScavenger]

Remember high yield junk bonds? Securitization of sub-prime mortgages simply creates a similar vehicle with similar results. Greed and the desire for ever higher yields plays a risky hand.

[oogabooga]

Look at Ireland as an example. It was basically a third world country 20 years ago, languishing under a socialist fatalism. Now it is a thriving, optimistic country. We have to do the same. Another thought: Check out the companies that are debt-free, the ones which eschewed the leveraged gearing craze. They're the ones keeping manufacturing here. The highly indebted companies that leveraged and borrowed to buy back stock are the ones moving production to China to save money. Servicing corporate debt is expensive, and layoffs are about the only way to cover it.

[chappelforpres]

Cheap money led to rampant speculation fueled by greedy, irrational lending/borrowing practices. Why did debt stay so cheap, for so long? Why did the Fed fail to foresee that the war and worldwide demand were creating an updraft in material, commodity and energy prices? How could they act so timidly, with housing prices and related consumer spending being such a tell?

One would have to conclude that Greenspan knowingly aided the current Administration by propping-up "trickle down economics", financing private equity, encouraging endless consumption and abetting the disastrous NeoCon agenda. In effect the Fed sheltered Bush from the harsh realities his wasteful spending, endless borrowing and special interest economics were creating, and has now shackled the incoming president with a multitude of sins.

[Shortyfuse]

THE ONLY WORKING SOLUTION IS TO BRING BACK TARIFFS, PRICE CAPS ,JOBS AND STIFF JAIL TERMS FOR CORPORATE TREASON. ALL THE THINGS THAT THE GLOBALIST HATE. HURRY, HURRY TIME IS A WASTING.
I MIGHT ADD THAT THERE SHOULD BE A STIFF FINE FOR RETURNING CORPORATIONS IF THEY WAIT FOR THESE OVERPOPULATED RAT HOLES TO EXPLODE IN WAR TO RETURN.
THE GLOBALIST ARE NOT ENDING POVERTY IN THE WORLD. THEY HAVE UNLEASHED THE GREED OF CAPITALISM ON AN OVERPOPULATED WORLD.

[GreedyOldPsychopaths]

Bonddad you said, "While the new year is supposed to bring hope of god things to come..."

"god things"? Initially I read this as a typo for "good things". But perhaps "god things" is more fitting, you know, as in "biblical proportions" or "apocalyptic"?

[kempis]

Interesting....I wonder, too, how much of a role the aging Boomer demographic has in the drop in consumer spending.

Speaking as an aging Boomer, I know that at this point in my life, my goal is position myself for retirement--which means paying off debt and not accumulating more. I have a good job, but to pay for the excesses of my youth (plus interest), I've greatly reduced my spending in the past couple of years. And have rather enjoyed the benefits of less debt and less body weight (eating out is fattening).

But if I'm representative of many other Boomers who are reducing their spending while trying to position themselves for retirement, that's a lot of consumer spending being reduced just from that demographic.

[JohnCitizen]

THE SUPPLY-SIDE SCAM

George Bush’s $3 trillion dollar tax giveaway to the rich over the past 7 years has been a disaster for average Americans. Supply-side (trickle-down) economics is a bogus theory promoted by those who benefit from it. In a mature capitalist system, supply side never rules, it’s always the demand side of the equation that governs growth and well-being. Think about the 1930s Depression, General Motors had plenty of supply, but demand evaporated.

Previous U.S. economic downturns have been cured with only $200-300 billion in tax cuts targeted to the middle class, because the consumer (the great middle class and 2/3rds of the economy) spends that tax cut and primes the economic pump. But George Bush has raised the debt that our children and grandchildren will have to pay from $6 trillion to over $9 trillion for current economic growth (i.e. we all get trickled on, as the rich spend some small fraction of their gains). Unfortunately, this growth is largely and uniquely without wage gains, and so has shrunk the middle class that makes America strong and great. Also, this growth has already over ($3 trillion flushed down the toilet and gone!), as the FED has had to cut interest rates because recession is looming. Massive debt has led to a weak dollar, which is now at record lows vs. other major currencies because of FED interest rate cuts. In turn, the record low dollar has produced record oil prices ($100/barrel); and any additional needed FED interest rate cuts could cause a free fall in the value of the dollar, guaranteeing recession or worse, stagflation.

The middle class is slowly being tapped out, as home values (most of their net worth and the credit card of last resort) are falling in price, and a considerable number of homeowners are heading for foreclosure. With the rich-poor divide increasing, we’re headed toward previous shining examples of trickle-down economics: South America of the recent past and feudalism in the Middle Ages. SUPPY-SIDE ECONOMICS IS NEW FEUDALISM AND SERFDOM!

[Transit]

I remember a slogan that made the rounds back in the 70's in reference to class warfare. It went... "Eat The Rich". It hard not to be a pessimist, isn't it?

[Herrington]

Well at least the suspense is over. The economic philosophy and policies of the right have been shown to be fatally flawed in no uncertain terms.

Now we try and pick up the pieces, of what might be, due to our international debt and dependencies, a less salvageable situation than the Great Depression. I really, really, loathe having to say I told you so to all the supply side bastards and free marketeers. I’d rather we had not been ignorant greedy bastards and had husbanded the resources and greatness of our nation. It is done now.

The flaw, you see, is that increasing profits by cutting wages is suicidal to business. Who, after all wages for all workers have been stripped to the bone, will buy your product? The logical conclusion of supply side economics is no pay for anyone and all capital consolidated with one person. Try to think it through, it follows.

When we were the world’s center for manufacturing technology, engineering and science, we were a super power. In about ten years, these virtues have been given away for the sake of some senior businessman’s bonus, one manufacturing line, one computer lab, one data processing center at a time. It is a tide that has washed away the greatness of the best of all countries for the worst of reasons.

As the world’s greatest debtor nation, we must stop the bleeding now. Business has no allegiance to America, it has flown to the cheapest labor markets it could find. You know what must be done and it borders on revolution, a revolution against exploitation, much as were the reasons for that which we came to be in 1776.

[H8FascistCons]

Hale; Something that analysts never talk about is that we no longer have a demand side economy(Americans with a good paying job to purchase goods) we now have a supply side economy, low interest rates but Americans have no savings and now have to borrow and go deeper in debt to purchase goods. Americans are in debt up to their eyeballs. Since we do not make anything we consume thanks to the right wing Fascists in power, all money used to purchase goods now goes overseas. It's a lose, lose situation. The canary in the coal mine is Las Vegas, keep an eye on that town for further confirmation that America is in real trouble...