Two Points of Economic Concern

From the current Kelly Letter research stream come these two points.

Doug Kass has been the man of the year as far as market forecasts go because he confidently called a generational low in early March, as most of the herd fretted slipping into the abyss. From 666 on the S&P 500, Kass said we'd see 1050 by late summer or early fall, then take another trip lower. He still thinks so, and says the time frame is right on track. From an article he wrote Wednesday at TheStreet.com:

Arguably, today investors face the polar opposite of conditions that existed only a few months ago, with economic optimism, improving valuations and positive sentiment.

To most investors, today the fear of being in has now been eclipsed by the fear of being out as the animal spirits are in full force. Bears are now scarce to nonexistent in the face of steady price gains in equity and credit prices.

The primary question to be asked is, Will the earnings cycle dominate the investment landscape and cause investors to overlook the chronic and secular challenges facing the world's economies, particularly as the public sector stimulus is eventually withdrawn and paid for and the economic consequences of the massive public sector intervention manifest themselves in the form of higher interest rates and marginal tax rates?

I expected a mini production boom and an asset allocation away from bonds and into stocks to be embraced and heralded by investors, who would only be disappointed again in the fall as it becomes clear that a self-sustaining economic recovery is unlikely to develop..

That becomes all the more meaningful in light of the announcement earlier this week that the Obama administration underestimated the deficit by $2 trillion. Higher taxes and cutbacks in government programs are inevitable. Those will reduce consumer spending, the heart of the U.S. credit based economy, which will make the business environment far less hospitable than we're used to seeing.

Another point of concern is housing, which is by no means fine, as some already contend. Half of homeowners are destined to be under water on their mortgages next year, as explained by these excerpts taken from an article at MSNBC:

More than 13 percent of homeowners with a mortgage are either behind on their payments or in foreclosure, the Mortgage Bankers Association said Thursday. As of June, more than 4 percent of all borrowers were in foreclosure and about 9 percent had missed at least one payment. A separate report found that more than 272,000 borrowers were at some stage of foreclosure in July, up 8 percent from June and 55 percent from July 2007, according to RealtyTrac, which maintains a national database of foreclosure filings.

The continuing rise in foreclosures delays any meaningful recovery in the U.S. economy, in part because housing typically leads the economy out of recession. Every new foreclosed home increases the unsold inventory on the market and cuts into demand for new construction.

Foreclosed homes push nearby home prices lower. Unless the pace of foreclosures can be slowed, millions more homeowners will be forced "under water". Roughly half of all U.S. homeowners will be under water by 2011.

That notion is confirmed daily in the Kelly Letter email inbox, where subscribers and other readers tell me financial stories about the people in their lives. It's ugly out there. People are hunkering down, some by choice but others out of necessity.

Neither is good for the economy.

Comments

[Roger Knights:]

Judging by today's action, Kass has nailed it (again).

Aug 27 11:53 AM

[CautiousInv...:]

The bond markets are at odds with the prospect we will have a recovery of any amplitude and duration, clearly suggesting one of the markets is wrong. Thus far, the global system and its constituent economies have been rescued through massive doses of financial opium which has stabilized the financial sector, improved certain indices and inflated the equities market into a zeppelin.

Until we are able to discriminate between the effects of opium and the signs of a real and sustainable recovery, nobody really knows what's on and what's in store for the economy and the sectors within it. I firmly believe the market has a built in bias to move up and with the massive policy action taken across different fronts, it's not surprising that the market is where it is. That, however, is not to say it is sustainable.

I for one do not believe we have recoverd from the financial shock and that, when the dust clears, we will see copious amounts of underutilized capacity and an amputated consumer who has learned from the past has forsworn not to repeat previous mistakes. In a deflationary environment with contained consumer spending, limited private investment owing to excess capacity, depressed world trade and increasing government encroachment in the private sector it is hard to make a case for a parabolic increase in corporate profits.

Once we are put on methadone and monetary easing is withdrawn....fiscal policy will be a train wreck as far as the eye can see.....we will see what this recovery is made of. Other points made by Doug Kass include:

1. Cost cuts are a corporate lifeline and so is fiscal stimulus, but both have a defined and limited life.
2. Cost cuts (exacerbated by wage deflation) pose an enduring threat to the consumer, which is still the most significant contributor to domestic growth.
3. The consumer entered the current downcycle exposed and levered to the hilt, and net worths have been damaged and will need to be repaired through higher savings and lower consumption.
4. The credit aftershock will continue to haunt the economy.
5. The effect of the Fed’s monetarist experiment and its impact on investing and spending still remain uncertain.
6. While the housing market has stabilized, its recovery will be muted, and there are few growth drivers to replace the important role taken by the real estate markets in the prior upturn.
7. Commercial real estate has only begun to enter a cyclical downturn.
8. While the public works component of public policy is a stimulant, the impact might be more muted than is generally recognized. There may be less than meets the eye as most of the current fiscal policy initiatives represent transfer payments that have a negative multiplier and create work disincentives.
9. Municipalities have historically provided economic stability — no more.
10. Federal, state and local taxes will be rising as the deficit must eventually be funded, and high-tax health and energy bills also loom

Aug 27 02:23 PM

[Mark Bern:]

I agree with the article that we should be neat a near-term top and that we will probably retest the March lows. It could get even worse if the H1N1 virus hits nearer the top of expectations with half the US population being infected this fall/winter season. With schools back is session and government officials telling school officials to keep schools open, the probability for the worst case scenario becomes more real. It all depends upon whether government officials will stick to their guns and keep schools open or if, when the virus hits, they'll suddenly come to their senses.

The impact of this virus could be significant. The survival rate is good, so deaths is not the problems. If schools close, parents will be forced to miss work and productivity will fall. Of course, BO doesn't want that to happen because it would slow the recovery. But, in this instance, I suspect the Fed, Administration and other market manipulators will realize the futility of propping up the market and try to provide support again at a lower level near the March low.

Aug 27 03:07 PM

[User 407030:]

Where are the stats or trendlines that predict more than 50% of homeowners will be underwater in the next year? That seems like a major increase from where we are now. What is the rationale for moving from 13% to +50%?

Gary

Aug 28 04:39 PM