We are very much convinced that the stock market has not come close to discounting the recession we believe our economy is in presently. We have discussed in the past why we thought that the next recession and deflationary bear market would be sparked by a housing bust, not withstanding strong counter trend rallies. And when the market and economy continue unraveling, the Fed will find it very difficult to turn things around.
The reason we felt so strongly (and continue to feel strongly) about a housing related catalyst to the weak economy and bear market was the fact that the housing market in 2000-2001 was selling at record levels in relation to income and rents (the two best metrics of housing values). It was at this time that the Fed started printing money and reducing Fed Funds in a virtual panic in order to stop the economic repercussions that surely would have resulted from the dot com bubble bursting. This bubble coincided with the largest financial mania in history and instead of letting the markets work to stop the consumer binge; this easy money resulted in the housing market rising at unprecedented rates. The price of single family homes rose about 85% from 2000 to 2006 to much higher record levels relative to wages. We do believe that the economy and stock market will decline until the housing market bottoms out at levels that would be considered normal relative to median family income. This would take a decline of anywhere from 15% to 35% from present levels depending upon the pricing source (Case-Shiller, NAR, or OFHEO). Another major negative to the consumer's resilience is the fact that on average homeowners borrowed $700,000 from their homes each year from 2004, 2005, and 2006. They borrowed $450,000 in 2007 and are expected to borrow less than $200,000 this year. Since the savings rate is close to zero what are consumers going to hock next in order to keep up their consumption binge?
Today the FDIC released their first quarter bank report of 8500 institutions that they insure. It wasn't pretty! They raised the number of banks that they consider to be "in trouble" to 90 from 76. The net income dropped 46% from $35.6 billion to $19.3 billion, home equity charge offs rose substantially as did charge offs for construction, commercial, individual, and credit card loans. It is hard to believe that consumers will find anything to borrow against to maintain their spending binge. The home equity loans are essentially unsecured lending according to David Wyss, S&P economist. According to Mr. Wyss, "the banks can't afford to foreclose since all the money will go to the first lien holder and the home equity lender will just be stuck with the legal bills. The banks should have never have been lending home owners 98 cents on the dollar. With almost any decline the home equity lender and second mortgage holders will be under water." It will take a very long period of time before the banks come close to providing loans anywhere near 100% of home value.
You have to wonder how this market continues going up or even remains so overvalued with all the problems mentioned in the 5/15/08 comment "Headwinds vs. Tailwinds" with no new news to hang the bull's case on? In fact the news has been worse. These are the releases since the "Headwinds"; the leading economic index (LEI) has been up slightly the last 2 months, but has been rolling over since 2005. The University of Michigan Consumer Sentiment fell to the lowest level (59.5) since 1980. Sales of existing homes fell 1% in April which wasn't too bad, but inventories of unsold homes surged to 10.5% according to NAR to 4.55 million units. The inventory number is much worse news for the economy than the sales number since the unsold homes must be sold in order to have sustained starts and any chance of the home price decline ending.
The PPI came out last week and showed the headline to be 3% while the core showed gains of 6.5% (both on an annual basis). Doesn't that blow your mind -the Core PPI that doesn't include food and energy (the 2 main categories of commodities that have skyrocketed to almost cause a consumer panic) are not included in the PPI index (core) that rose 6.5%. Wait until the next report that will have to include the rise of food and energy in the headline number. We don't understand how the core could possibly be higher than the headline (that includes food and energy), but in any case the Fed has its job cut out for them.
The news this week was just a little better. The Conference Board reported that May consumer confidence fell for the fifth straight month to 57.2, the lowest since October 1992 when the economy was coming out of a recession. The Case-Shiller index of National housing fell 14.1% in the first quarter compared to a year earlier. This is the lowest since its inception in 1988. Prices nationwide are at levels not seen since the third quarter of 2004. However, the index is still up 60% relative to the index in 2000. Some would consider this a positive, while we think the fact that the bubble bursting still has a ways to go is a major negative. Last week OFHEO announced that home prices fell 3.1% in the first quarter and, although a record decline, not nearly as severe as the Case-Shiller reported decline. The reason is due to the fact that their index is narrower in scope. This government agency measures mortgages of $417,000 or less that are bought or backed by Fannie Mae or Freddie Mac. Therefore, properties bought with some of the riskier type of loans are excluded from their data base. The durable goods orders were better than expected yesterday (but still negative) and this statistic has always been very volatile. The GDP was revised up from 0.6% to 0.9% but even that was not as good as the expectations.
Many investors believe the market can't go down with the "Fed Put" in place. In other words they expect the Fed to ease in the face of economic weakness and to bail out any major company that gets into financial trouble. After the Bear Stearns bail out investors have become convinced that the Fed will act to prevent any deflationary episodes that may take place in the future. It is hard to blame investors, since the Fed has allowed not just Commercial Banks but also Investment Banks, to borrow at the Fed window. Even worse, is for the Fed to allow all of these entities to exchange their questionable securities (including mortgage paper) through the "alphabet soup auctions" of the Fed for Treasury securities. The Term Securities Lending Facility (TSLF) has been set up for just brokerage firms to exchange their "paper" for Treasury securities. The only problem with this is that the investors think the Fed is the lender of last resort when actually the taxpayers are the ones that have to pick up the bill if the paper the Fed is holding goes bad.
If the market is depending upon the Fed to continue lowering rates, the release of the Fed's minutes last week wasn't inspiring. It looks like the last meeting was spent with the dilemma of lowering rates, but only if the economy falls off a cliff, and potentially raising rates if the inflation rate rises above their projection of 3.1 to 3.4 % in 2008. At the same time, they predicted the rate of overall economic growth would significantly slow, to an anemic annual rate of 0.3 to 1.2% (we think much lower).
As our regular readers know we have predicted the Fed will discover they are locked into a very large box that will be very difficult to escape. As we stated earlier, the stock market has resumed the major bear market trend and it is not at all clear that the "Fed Put" will continue to act, as much as it has in the past, as a psychologically bullish factor.