Markets Are In for a World of Hurt This Fall

 |  Includes: EU, IYR, RWX, XLF
by: Craig Brown

A couple of months ago I made a rather generalized prediction that the markets would suffer a lot this fall. I based this largely on option ARM resets but there are a lot of other factors at play here. For one, the markets often do well in the summer only to collapse in the fall, especially in October. I personally do not think we will make it that far. I suspect by mid-to-late August and early September at the latest things will come to a head and we will see markets retesting their lows in March of 2009. So why, you ask.

I return to real estate first. Things seemed pretty good through the first quarter this year but folks were taking advantage of a rather significant tax credit (don't get me started on how much this benefit cost the rest of us). That credit is gone now, and we front loaded a lot of sales. Don't take my word for it, purchase mortgage applications were at a 13 year low last month after the expiration of the credit and lumber prices this past month are down 30%. Not signs that real estate is on a sustained recovery.

Still on real estate, we have a lot of adjustable rate mortgages [ARMs] resetting this fall. Now I know that a lot of people who could, refinanced to a fixed rate. Resets for most will not be that bad as rates are low and many of those with ARMs have already defaulted, so the impact is muted. However, there are still plenty out there and the defaults will likely peak in the last half of this year. Some option ARMs allowed buyers to only pay interest so even with low rates the resets will now require payments on principal, which will increase payments. Between that, homes under water, and high unemployment in a lot of states where the option ARMs were pushed, you have a toxic mix.

Let's go beyond real estate. In the U.S. the stimulus in many sectors is ending about now and the impacts of that will really start to hit home this fall. Now I suspect the administration may seek to prime the pump a bit more with more stimulus but the sovereign debt problems in the EU will lead to a lot of second thoughts on that and, at a minimum, will lead to less drastic stimulus. Governments have a new focus on deficits after the problems in the EU and rightly so. The economy in the U.S. and a good part of the world for the past year or so has all been stimulus, so when it is gone we will have to face reality and reality is not pleasant just yet. I suspect it will not be approaching pleasant for a generation or two, but what do I know.

Let's talk about banks. We bailed out the big players that delivered us to this mess and that in my book was a major mistake. I am of the Austrian school and believe we should have dismantled the culprits. Nonetheless, despite all the government support and the big press about how the key players have repaid the government, we nonetheless have some facts to face:

  • First, the big banks are looking good financially because the government has sanctioned them hiding a lot of the debt on their balance sheets. If they truly had to reflect assets at value - even difficult to value assets like mortgage backed securities - they would be screwed;
  • Second, local and regional banks that were not the recipients of government support are aching, in part because of government support of their corrupt competition. Some have significant commercial real estate loans, which are still peaking in terms of defaults, and virtually none have the government BS support the big boys received. Between 2000 and 20006 only 24 banks failed in the U.S., with none failing in 2005 or 2006. This year to date -as of today - we are up to 83. These are local and regional banks, but it shows the banks lending to small businesses and individuals are having problems. Indeed, the problem bank list continues to grow significantly, which cannot be a good sign. (Unofficial Problem Bank List increases to 781 Institutions). What I have seen is that banks, big and small, are really not lending a lot of money. Credit continues to be frozen in many sectors. The big players who got all our support to start lending are locked shut for anyone less than stellar wanting credit;
  • Third, is the EU. It is going to melt down late this year or next year. I am not expecting this to reach peak this fall but it well could in the fourth quarter or early next year. There are just too many issues there for them to continue as a union. I predicted the EU having these issues a year and a half ago and I still stand by my original prediction;
  • Fourth, to the limited extent that China has been a safe harbor in this storm, it is certainly entering into its own storm. Its GDP has always been too small in this economic crisis to have much impact but what little impact it has had - largely emotionally for the markets - is soon going the disappear as it lacks the real, sustained, economic activity it needs to continue; and
  • Fifth, debt! I keep going back to this. Debt in the U.S. on a personal level and government level is way too high, even before you factor in Social Security and Medicare. Debt on a personal level and sovereign level in the EU is obviously too high for the vast majority of countries there. The economy for a generation was built off debt and it will take a generation or two to get us off of our addiction.

This list is a lot longer than I have posted but these are enough to chew on for now. I am sticking by my prediction that the markets are in for a world of hurt this fall.

Disclosures: None.