Today’s strong market rise was more likely due to the Rio Tinto offer for Alcan than to the exceedingly modest rise in June chain store sales. In any event the price jump is likely to be a one or two day affair as the ongoing reality of a slowing economy, rising long-term rates and continuing housing woes overtakes the Mr. Magoo mentality that has caused investors to overlook the dire-looking events that are swirling around them.
The long hoped-for bottom in the housing market continues to move further away as conditions worsen. This week DR Horton reported a 40% drop in orders and a 38% cancellation rate for the June quarter. The National Association of Realtors (NAR), reduced its housing sale forecast for the seventh consecutive month, blaming stricter mortgage standards, a glut of properties and high interest rates. NAR Chief Economist David Seiders stated "Most indicators point to further deterioration." In our view the credit crunch in the subprime is getting worse and the financial fallout has only begun.
In addition to the coming financial fallout, the housing market is impacting the real economy as well. Today’s retail sales reports were less bad than expected, but still mediocre. June chain store sales were up 2.4% year-over-year, down a full percentage from last year’s average. Keep in mind, too, that these are nominal figures. When adjusted for the ballooning PCE deflator, it likely that there was little or no growth at all. We have also seen warnings or lower guidance from retailers such as Best Buy, Circuit City, Bed Bath & Beyond, Home Depot and Sears Holdings as well as a number of leading restaurant chains. The main upward sales surprise was WalMart’s same store increase of 2.4%, but even then the company said grocery sales were stronger than general merchandise without breaking out the numbers. It would certainly be interesting to know how much of that increase was due to soaring grocery prices.
All in all consumers are coming under increasing pressure as a result of record debt, the billions of dollars due for ARMS resets this year and next, the sharp drop in mortgage equity withdrawals, lower house prices, high gasoline and food prices, and higher interest rates. The household debt service rate is near record highs, while the ratio of household total liabilities to total assets has soared to record levels despite the increase in asset values. Given the multitude of negative factors it is no surprise that the University of Michigan confidence survey has been in a steady downtrend.
Investors are also being sold a bill of goods by strategists and economists that employment is strong in order to show that consumers will keep spending despite the bleak housing picture This is simply not true. Payroll employment in June was up only 1.45% from a year earlier. Every time in the past 50 years that year-over-year employment was up by 1.5% or less, a recession followed without exception--and 56% of the current gain was the birth/death adjustment. It is really astounding that this number is being widely hailed as showing the strength of the employment situation.
It is also not likely that the economy will be bailed out by any strong growth in capital expenditures. The Conference Board Business Confidence Index fell 8 points to 45 in the 2nd quarter, down from 70 two years earlier. Even more disappointing was the fact that expectations of CEOs for their own industry over the next six months dropped 13 points to the lowest level since the 4th quarter of 2000 and that only 22% expected profits to increase. Studies by Ned Davis Research indicates that falling business confidence is highly correlated with lower capital expenditures and falling earnings.
In sum we think it is highly probable that the economy and earnings will slip significantly in the second half. In addition the financial fallout from the ongoing subprime mess is still a very real threat.
