Although the pace of economic decline has slowed, the economy is still falling-and merely "less bad" is not good enough to justify the robust stock market rally of the last few months. When the massive fiscal and monetary stimulus started last fall, we stated in our comments that the program would probably prevent a systemic collapse of the global financial and economic system, but would not prevent a long and deep recession. In our view that is turning out to be the case.
While the fiscal and monetary stimulus is on a scale never before seen, it is likely to be offset by the debt deleveraging of consumers, the still deteriorating housing situation and credit problems in non-housing areas. Consumers are still up to their eyeballs in debt at the same time that unemployment is rising, wages are stagnating, net worth has plunged and mortgage equity withdrawals have dwindled away to nothing from an annualized rate of $1.1 trillion.
During the boom years consumers cut their savings rate to zero and used the increase in stocks and houses to fund their lavish spending habits. With those sources of funds no longer available consumers have cut back spending and lifted their savings rate to 5.8%. In the period ahead it is probable that households will keep increasing their savings rate to a more normal 10% by keeping their spending mostly confined to essentials and a generally less lavish living style. While this is advantageous for the economy on a long-term basis, it is negative for the economy in the period ahead. Although consumer confidence has increased from extremely low levels, consumer spending is still declining. Since consumer spending still accounts for about 70% of GDP, continued restraint will also reduce production, employment, incomes and capital expenditures.
Adding to the problems, we think it's unlikely that the housing slump is over. Inventories of homes for sale are still rising while a third wave of foreclosures is now underway-this time in prime mortgages. Nationwide, 12% of first mortgages are overdue including 5.7% in prime and 49% in subprime. Typically, a high percentage of overdue mortgages end up in foreclosure within a few months. In addition as we pointed out in last week's comment the ratio of median family income to home prices is still substantially above the long-term average. This means that housing prices will continue to decline. The latest Case/Shiller numbers show that home prices have declined 19% year-over-year and 32% from the peak. This will put more homeowners under water on their houses and add to current inventories. We also note that official inventory numbers are probably understated as a result of both banks and individual homeowners temporarily keeping homes off the market.
There are other important credit problems as well in credit cards, auto loans, home equity loans, other consumer loans and commercial real estate loans. Together with continued distress for housing, these problems will lead to further write-offs for bank loans and a continuing reluctance to lend.
The stock market rally started on the realization that the much-feared meltdown of the global financial system would not occur and that the economy was no longer falling off a cliff. However, survival alone is not recovery, and we think that the market is now way ahead of itself. In order for the market rally to be sustained from this point and not at least retest the bottom, less worse is not good enough. The S&P 500 is selling at 35 times estimated 2009 reported earnings of $27 and 22 times estimated 2009 operating earnings (top down)of $43, and 17.5 operating earning (bottom up) of $54. Even on our trendline 2009 earnings of $59 (which we think is quite generous) the market is at 16 times, whereas secular bear markets have tended to bottom at 8-to-10 times. In sum, we believe that the risk is now once again heavily to the downside.
