Leader to Laggard

Through the second half of 2007, to the collapse of Bear Stearns, US equity indexes were leading America into recession. Markets were discounting shares to reflect serious and prolonged earnings and profit reduction. Stock prices were indicating a long hard fall. Serious turmoil in the financial industry, housing collapse and macro economic weakness were seen as imminent and selling pressure was relentless. As little and late assistance was offered by The Fed, other central banks and governments, there were short reversals. Selling became buying for a few weeks to a few days. It never took long for markets to fall after the euphoria and false promise were sniffed out. The Federal Reserve led the world in offering monetary policy accommodation. Rates were slashed, credit was pumped, soothing words were shouted in any and all directions. This basically failed until late March. The public waited until the pain hit. Through the end of 2007, the overall economy was generating decent numbers and the public ignored the financial turmoil.

US market leadership has become the world's most celebrated laggardship. Since late March 2008, we have seen an unbroken series of worsening economic data. February, March and April saw net losses in US employment, stagnant to negative income growth, near zero GDP growth and rising inflation. The most recent 1Q 2008 GDP Advance Estimate from the Bureau of Economic Analysis (BEA) makes clear just how bad things are. Unplanned inventory investment and government spending (much on the military) are the primary providers of "growth." The inability of businesses to sell as much as planned is- in the short term- pushing up GDP. A rather tame looking 3.7% annualized inflation measure was used to turn nominal GDP into real GDP. Nominal GDP is the dollar sum total of all final goods spending done in the US. It becomes real GDP when we extract the increases in spending created only by rising prices, as opposed to more economic activity. If slightly higher inflation had been factored- as many feel it should have been- GDP would have actually fallen. Final estimates are very sensitive to the size of estimated inflation. Our official number, .6% growth, is so low that any meaningful increase in inflation estimate would create a negative GDP number.

Our labor market is defined by shrinkage. The American consumer is squeezed from above and below. Official jobs data offer a useful glimpse into a parallel universe. Here on planet earth, in the area called the United States of America, the following fun facts from the Bureau of Labor Statistics are never reported. 261,000 jobs have been officially lost since New Years Day 2008. There has been an 850,000 person increase in involuntary part-time employment over the last 12 months. There are 1.4 million people "marginally attached to the labor force." There has been an increase of 800,000 officially unemployed persons in the US over the last year. Thus, we are presiding over a 1.65 million person minimum increase in unemployed and underemployed persons since April 2007. All the while our population grows, even if the labor force does not. The average workweek and average weekly earnings both declined in April. All of this is before we consider rapidly rising prices.

The economy continues down led by housing, consumer sentiment, employment and earnings. As the market has clawed back up, data has made recessionary conditions increasingly clear. The S&P500 has gone from 1447 on 02 January 2008 to 1413.90 on 02 May 2008. In other words, the market is basically flat and is off by 2%. If adjusted for inflation, the loss would be greater than 5%. Since 17 March 2008 the markets have trended boldly higher amid rising public woe. The S&P500 is up 11% since the Bear Stearns low. As we entered this downturn we were in the process of breaking many old records. Household debt levels were massive. We have nearly $10.6 trillion in household debt. House price reductions already suggest $2-$3 trillion in paper real estate losses.

The recent recovery broke records for the greatest proportion of earnings for corporations and the lowest for households. It is hard to imagine a way for American firms to grow their earnings here despite household weakness. Folks already can't afford to be borrowing as much as they have and earning as little as they do. Staple items are somewhere between painfully expensive and out of reach for many. We have spiking food, energy and associated costs. This is a classic scissors crisis for America's middle class. They are being hit from the cash flow and earnings side. Years of stagnant earnings and now pinched firms mean few wage increases and rising unemployment. Houses can not be borrowed against as prices are falling and debt levels are too high. On the cost side, prices are rising much faster than wages. It is pretty hard to stop buying food, electricity, gas and things made with food or energy inputs!

The market is rising as the news turns worse. Stocks forecast a sharp recession, until one arrived. Now the markets are forecasting a short, shallow downturn. This would be easier to believe if something more serious had not already arrived for millions of households. There is no slack in the domestic household economy. Private consumption accounts for over 65% of GDP. Deeply indebted, fragile state, federal and family budgets can not absorb the blows already falling. For profits to hold recent record levels, let alone rise, firms would have to get miracle returns in foreign currency and then covert them to declining dollars. This would allow their numbers to grow. Even this unlikely case risks being overwhelmed by falling demand, rising anger and default in the US.

This election will be about the economy. Even if it is fought over other "issues" and focused on the usual meaningless micro-trends. The next 12-18 months will see a test of public response to an existential risk to a significant portion of the American middle class. Recent sentiment and market performance aside, there remains no question that serious economic weakness has arrived.

Beware the "buying opportunity" in real estate and equity markets. Be focused on the economic story.

Comments

[Cathexis]

Sound advice. I've already pulled out of Real Estate and most Equities, parking my funds in safer (albeit with no stellar returns) areas. The goal, at this time, is capital preservation, not growth!

[cylindar]

Yes, you are right. People should be aware that the whole story has not yet been revealed. They also should be aware that any investments at this time is at best precarious. There are much deeper problems to be brought to light in the next six to twelve months and people are not going to like what they hear and see. Things will change for the better however as they always do.

[joebaggadonuts]

Max, I share your concerns. What else I see however is the remarks from Fannie Mae, suggesting that they think they will be making tons of money soon. Maybe they know something we don't? What else concerns me is what they know (if indeed they know something) and how long it will take for me to find out about it. Have Ben and Bush already cut a deal to nationalize Freddie and Fannie or something of such magnitude and are they now selling it on the hill? Or maybe China or the Saudis will own them soon?

Here's what they said:
"We've got to get across a bridge where we don't miss the opportunities we have," Mudd said on Tuesday's call. "We will feast off this book of business we are putting on."

For instance, Fannie said the fees it takes to guarantee loans, as described by its weighted average G-fee, were up 24% in March from 2007 levels. Meanwhile, guaranty fee income rose to $1.75 billion in the first quarter from $1.1 billion a year earlier. Net revenue, reflecting guaranty, interest and other income, surged to $3.78 billion from $2.73 billion a year earlier. Like other financial institutions, Fannie is benefiting from the Fed's rate-cutting spree, which has created a bigger spread between the rates at which the company borrows and lends.

"Returns on our new business are well in excess of the cost of capital," finance chief Stephen Swad said.