Big Red Flags For The Economy And America's Well-Being

 |  Includes: C, DIA, QQQ, SPY, WFC
by: Bio Insights

One of the headlines on Friday, October 7th caught my attention as I was looking for fundamental data to support the rally. On Friday, the average 30-year mortgage broke its old record low. On average, if you're deemed "worthy" of a loan you can (on average) take out a 30-year 3.94% fixed mortgage. Here is a chart displaying the average mortgage rates in the United States during the last 5 years.


Indeed, interest rates have been declining across the board lately. Not only has the fed vowed to keep rates low until 2013 to encourage banks to give out more loans, but recent deflationary pressures from the fallout in Europe have driven some of the longer term treasury bills negative in real terms (as of 10/5/2011, 5-year Treasuries yield -.54% based on expected inflation). Capitulation tends to cause rates to plummet, but is this the early sign of another recession or a footnote in market history?

Another way of looking at the decline in mortgage rates is to say that demand for these loans is declining in a steady and well defined downtrend. There are many explanations for this, but the two most obvious factors have to do with unemployment and income distribution. The two factors can be pieced together to form a very dismal outlook for the future of the economy.

The official unemployment rate is 9.1%, which is bad enough to begin with. Then you have to factor in the real terms. As you might know, discouraged workers (workers who have stopped looking for a job out of hopelessness) are not included in the labor force. As of the latest unemployment report, there were 977,000 discouraged workers. If you include them in the labor force, the unemployment rate is actually closer to 9.8%. In addition, this does not indicate whether these people are gainfully employed or not. A McDonald's hiring 20 new hamburger makers would have as much of an effect on this statistic as the start of a successful 20-person boutique law firm. If you look at how incomes have changed, the real purchasing power of the lower and middle class has been in steady decline for decades.

Compensation costs have been hitting companies very hard lately, which only exacerbates the unemployment situation. It is generally agreed that the jobs growth has to come from the private sector, as our government must undergo austerity measures in the coming years to significantly reduce the deficit. Due to this, the rapid increase in compensation costs is an alarming sign for the unemployment picture. Consider the statistics below, which display the 3-month growth rate in nominal costs for employee benefits (not wages):

Sector December 2010 March 2011 June 2011
Government .7% .9% .5%
Private .5% 1.2% 1.6%
Click to enlarge

Source: BLS

This chart displays a medium term trend that should spook anyone that cares about the employment situation. Although the majority of the cost of an employee is still the wage, not only have wages been somewhat flat (not even keeping up with inflation) but there has been a tendency for employers to squeeze more labor out of its employees. People have been compliant of course, because in times like this jobs are scarce. Still, it is just a matter of time before the employed will cease to increase productivity any further. Companies may be hesitant to hire more labor as the costs increase, creating a situation where the nation is either overworked or unemployed.

As long as the cost of worker's benefits (especially healthcare costs) continue to rise, in addition to diminishing productivity of workers in an economic slowdown the employment situation has no reason to improve in the foreseeable future. Obama's jobs plan potentially throws a pretty big bone out to the unemployed, but not only is it on the verge of being killed by Congress but it would do little to help another monster of a problem our nation has to face - our debt.

The GDP growth number released on September 29th (1.3% actual vs. 1.2% consensus) was actually quite good. Yes, this is a sign that spending was ever so slightly above our expectations, but the problem with GDP that it is just a measure of how much we spend. If we increased our military involvement in Afghanistan, it would boost GDP immensely. This is numerically positive data, but does it really make us better off? The higher we stack our debt now, the harder it gets for us to just pay the interest on it.

The real double whammy comes from inevitable spikes in taxes that will be coming when our nation begins to deal with its debt situation. Not only will the jobs market continue to be in a pathetic state (if this pace continues), but the eventual higher income taxes will further diminish the purchasing power of the average American citizen. Simply put, we've been living the high life for one decade too many. Like the typical college graduate these days, we are in debt up to our eyeballs with no feasible way to pay it off.

Due to these headwinds, it is not a timely decision to invest in financial institutions that heavily depend on mortgages for income. Not only does the industry have unsustainable high compensation to begin with, but with these costs rising and with less mortgages being issued the earnings performance has no reason to improve until those detriments are fixed. One such bank is Wells Fargo (NYSE:WFC).

As of their Q2 2011 report, $1.6 billion worth of the bank's non-interest income was derived from the mortgage market. Mortgage escrow deposits have been shrinking at a surprising rate, another indicator of revenue loss from a weak housing market (down to 23.9 billion from almost 26 billion a year before that). Net Charge Offs on real estate mortgage and construction loans have been diminishing very quickly too, showing that those positive surprises from bad loans made in the past are disappearing. Diminishing these profits even more is the roughly $12 billion lost from litigation expenses, primarily from mortgage-related lawsuits. It is much easier to see the overall picture of the big-time loaner Wells Fargo from just one fact - as of Q2 2011, their net income may have shot up by 29%, but revenue has declined 4.7% and their net loans have dropped by 3%.

Citigroup (NYSE:C) is another prime example. The ostensible earnings growth of 21% over the last year sounds impressive. Then you consider the revenue, which has declined by 6.6% in the same time period. A lot of the damage comes from the securities and banking division, which includes loans. Loan revenue has declined by a whopping 33%, and fixed-income markets revenue dropped 18%. Yes, there is some positive data (in investment banking), but loan markets are much more fundamental measures of an economy. Can Citigroup still survive if loan demand gets worse every quarter?

This is the example of the fallacy that corporate earnings are inducing organic growth in the economy. When looking at the future, it should be aimed the other way around. A bottom-up view says that these earnings have simply been huge improvements in margin that haven't benefited the nation as a whole. Like stated before, increasing margin (whether it's by laying off workers or forcing more hours out of remaining workers) will only work for an extended period of time.

Real growth comes from the participation of the many and the production of tangible assets. While many stocks (especially financial stocks like WFC or C) are cheap by conventional earnings measures, there will come a point when earnings will reach their breaking point. An economy cannot grow without the production of more goods, just as a bank cannot grow without giving out more loans.

In terms of the general market, I believe that the direction of the loan market is a good way of measuring the real growth in the economy - which is negative in real terms. This is in line with the general well being of society too, which is what the "real economy" truly is. Judging by the increasing anger of the American people, things are simply not getting better. The 99% movement is an example of this - these are everyday people who are fed up with the failure of America's new version of capitalism. Companies will not be able to expand while more and more people are unemployed and the government constricts its budget further to hold back the tsunami-sized debtload. It is a grim concept that the market is hesitant to price in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.