This being the Autumn Equinox, and with what I see are changing, difficult, unusual times in financial markets, I thought a good exercise would be formulate my thoughts and outlook on various topics effecting asset prices. So, I set my alarm early this Sunday morning and went to a local bagel shop where I spent two hours scribbling non-stop, my perceptions of issues that will effect stocks, and other asset classes going forward. There are holes in my thoughts, and it is not meant to be all-encompassing. Plus, my hand was getting tired, and I wanted to get back for the Manchester United v. Chelsea match.
The global economy continues to be strong, but the American economy may be heading into a recession. One key for the sustainability of the global expansion may be the European consumer, since it has been the American consumer that has been the driving force behind the global economy the past several years. However, the American consumer is slowing, and as a result, growth must come from elsewhere. That growth can, and is being pushed by the global infrastructure build. However , how long can the global infrastructure play run if the American consumer is weak?
It is the American consumer that has been driving demand for products from the emerging countries, and it is the emerging economies that are driving infrastructure demand. There is some evidence that the global infrastructure, and the global economy may be slowing due to the weakness in base metals. However, with over a trillion dollars in reserves, the Chinese, and to a lesser extent, India, can continue to fund such expenditures for some time. The flip side is that any decrease in foreign reserves will pressure the dollar. So, it's a double-edged sword to rely on infrastructure spending over the long-term if the consumer is weak. But now isn't the long-term, now is the short-term.
Conclusion: Expect GDP growth to slow. It would be a downside surprise if growth were slower than expected.
The U.S. Consumer
The death of the American consumer is greatly exaggerated. However, it is likely consumer spending will be below trend for some time. Consumer spending is driven primarily by employment, and employment is weakening, as evidenced by the 600,000 who dropped off the government survey in the last employment report. On the other hand, unemployment is still 4.6%, which is still very low by historical standards. And, historically, when the economy began to weaken, corporations cut jobs. However, in this cycle, corporate America is swimming in cash, and margins are at record highs. Therefore, except for a few sectors, unemployment may not rise as much as it has in the past. It is rising in construction and financial services, so there will be pressure in the job market. If this thesis is correct, then consumer spending will not be as hard hit as some expect. On the flip side, the home equity extraction is over. With consumers taking up to $600 billion out of their homes - and roughly two-thirds going towards consumption - the drag on economic growth from this could be as high as 0.5% for the foreseeable future, which would mean that GDP should also be slower.
Conclusion: Consumer spending will slow but it will not collapse. Thus, avoid consumer stocks for the the near-term but be willing to buy when valuations get cheap.
The Fed and Interest Rates
Short-term rates are going down, long-term rates are going up. The Fed cut rates to unwind problems in the credit markets. Despite protestations to the contrary, this increases moral hazard in the financial markets. However, this is only bad if the moral hazard becomes too large for the Fed to deal with. I am highly suspicious of this assertion. However, the banking system has been underwritten by the federal government for decades, and it has not collapsed. That analogy may or may not be irrelevant. The best example of moral hazard was the Fed-led bailout of LTCM. Today, the size of the derivatives markets dwarfs the size it was 10 years ago. After the Tech Bubble deflated, risk-taking exploded. Thus, the Bernanke Put is alive and well. I think it is a bit unfair to label a Greenspan Put, considering the Nasdaq fell 77% top to bottom, and the S&P 500 declined 43% after 2000. However, there is a perception of a Bernanke Put at the moment, and because of it, the Fed has provided a back-stop to the market in the near-term. The Fed's actions of late can make one draw this conclusion. It had its governors out talking about inflation a week before they cut 50 bps. Actions speak louder than words, and the Fed sandbagged those who believed what they were saying. Fed cuts did not work in 2000 to support the market because of over-capacity in the technology industry, and it will not work in housing. There is little evidence there is over-capacity elsewhere, other than in financial services.
Conclusion: The Fed's actions support the market in the near-term.
Are there any dollar bulls? I was inching towards being one until the Fed cut 50 bps, but the Fed cut has given investors the green light to shoot against the dollar. The 50 bp cut showed a blatant disregard for the value of the dollar. The problem with going long on the dollar is that central banks hold tremendous amounts of greenbacks, and as a result, hold a tremendous supply of potential dollar sales. If central banks decide to merely diversify their holdings, there will be a steady stream of selling. On top of the that, the administration and the Fed have given central banks every reason to not hold dollars, or at least to hold fewer dollars. Just like the consumer, the death of the dollar is greatly exaggerated. But like the consumer, the health of the dollar can rightly be called into question. Dollars will continue to be a big part of the global monetary system, but the composition of reserves in dollars will fall, from 65% to some other number, perhaps 50%. On the other hand, the dollar basket is less than a point away from being at least a 30-year low, and bearish sentiment on the dollar is at a high in my investment lifetime.
Conclusion: I'm bearish on the dollar in the near-term. Start looking to get bullish over the intermediate term, perhaps when the Fed is done cutting rates.
Gold and Silver
Both gold and silver will benefit from the dollar's weakness. They will, in the near-term, trade with the dollar. However, my original thesis maintains that the global economies cannot support a continuously deflating dollar. If the dollar continues to fall, other currencies will have to follow. This is bullish for precious metals, as it is for other real assets. In fact, there is evidence this is already happening given that gold has risen in terms of both the euro and yen. The negative is that central banks, despite the arguments from the gold bulls, continue to be sellers. There are something like 20,000 tons of gold sitting in central bank vaults. With Europeans selling 500 tons a year, there are 40 years of potential supply waiting to come onto the market. The central banks will continue to sell gold because central banks are run by economists, and economists believe that gold does not have intrinsic value, and there is a cost of carry, as opposed to bonds which pay interest. Gold has to appreciate 5%-6% per year just to stand still relative to bonds. Also, contrary to the bulls, the People's Bank of China is not buying gold in any size. The supply continues to moderate as gold is still less than half its all-time inflation-adjust high.
Conclusion: Buy gold and silver on dips.
Residential real estate continues to be a black hole, and prices will continue to decline. However, I'm not sure it will decline as much as the bears believe. Nationwide, absolute house prices will probably fall another 5%-10%. The bears aren't necessarily wrong, but unlike stocks, real estate is discrete, and not a continuous market. People do not have to sell if they don't want to, and will often stick to a price that they have in their minds, and are very reluctant to sell unless they are forced to do so. The biggest catalyst to such an event is rising unemployment. But, I don't think unemployment will rise as much as past slowdowns or recessions. The bears are certainly correct in that there will be real price declines, perhaps by as much as 30% over the next decade, as house prices do not rise while inflation does so. Also, even though the headline number is not going to decline much, the actual price realized by the seller will imply greater price declines. Incentives are high, which has the effect of keeping headline prices higher than actual prices. It is in the incentives of most to keep the headline number high, from banks to brokers to sellers to other homeowners in the neighborhood. In severely over-priced speculative markets, i.e. Florida condos, you will have a true depression, and prices will fall as much as 40%-50%, and take years to clear out the inventory. It will be similar to the teleconomy depression after the bubble burst beginning in 2000. Geographic areas with concentrations in finance and construction will be hard hit.
REITs are overvalued based on multiples, but many with a vested interest contend that REITs may be undervalued by 20%-30% based on net asset values. NAV is based on assumptions such as lease growth and interest rates. The assumptions used to calculate NAV has changed dramatically over the past five years, as investors assumed ever higher lease growth and ever lower interest rates. Lease growth will almost certainly disappoint as the US enters a slowdown if not a recession. But interest rates may remain low, and it is interest rates that are perhaps the prime determinant of NAV. The big question is the future risk premium investors assign to commercial real estate. An ocean of money has flooded into alternative asset classes, which has benefited REITs enormously. I believe returns will disappoint for institutional and REIT investors as lease rates fail to grow at the rate required. But that may not become evident for a year or three. Also, the Fed's anti-dollar stance supports real assets like real estate, though it might diminish flows from outside the country. Also, commercial real estate supply is nowhere near residential housing, though it is rising.
Conclusion: Maintain short position in REITs, though expect strength in near-term. I reduced my short-position by not replacing my September puts I have been liquidating the past few weeks, but will be looking to re-load, perhaps early next year. Avoid the homebuilders, though a tradeable bounce is coming. The history of financial markets is that booms are followed by busts. Even when the homebuilders bounce, they will move sideways for years. I think a great deal, maybe three-quarters, of the homebuilder downside is done.
It is my belief, though it is not strongly held, that the market wants to go higher. Despite the convulsions in the debt market, the S&P 500 was down a mere 12%. That is not much, considering the turmoil. However, I believe the market action in July and August, and that of March, are warning shots of what's to come. I maintain that "something bad" will happen by the end of 2008, which will cause a 20%-25% correction. Corporate profit margins have peaked, and profit growth is likely to disappoint. Estimates are too high for 2008, and will have to come down. That is not necessarily bad as estimates usually do come down as the year progresses, but a bull argument is that earnings will grow double-digits. I believe that because profits margins are at a peak, and growth is slowing, earnings growth will be single digits at best. On the positive side, a weaker dollar is good for profits, and companies have a lot of cash to buy back stock. Conversely, the private equity orgy is over. Problems in the debt market mean that companies are less likely to lever themselves up to buy back stock. Small caps are expensive while large caps are fairly valued, at least on current margins. Margins will begin contracting but will not collapse - at least operating margins will not. Expect charge-offs to accelerate since the Fed cut underwrites the market. I think there are a lot of cross-currents and the environment is potentially treacherous. Expect the market breadth to narrow, which is typical of the end of the bull market. It is possible we get a parabolic move up.
Conclusion: Without much conviction, I think the market is going higher into the end of the year. I plan on being an aggressive seller into the first few months of next year. However, "something bad" could happen and it is important to remain flexible.
The political environment is turning decidedly negative for stocks. Much of the prosperity of the past decade has skewed disproportionately towards the well-off. The majority of households have experienced stagnant wage growth (though they are wealthier because assets, particularly homes, have risen). This manifested itself in the 2006 elections, where populist, anti-trade politicians - primarily Democrats - were elected. However, the Republican Congress, though not particularly hostile to free trade, haven't exactly been at the barriers either. The disillusionment with the Republicans over the war in Iraq and corruption, and to a lesser extent incompetence and pandering to the xenophobic and Religious Right, will make the 2008 election a difficult one for the GOP. The Republicans will almost certainly lose seats in the Senate, will not regain control of the House, and I give Hillary (and it will be Hillary as the Democrat nominee) a 60/40 chance to be President. Although, contrary to the shrill cheerleaders in the right-wing press, Democrats have not necessarily bad for the market - as history shows. And if Hillary continues to policies of her husband, she unto herself is not bad for stocks. However, the forces that will drive the Democrats to power will generally be anti-market. This means potential conflicts over trade - a tremendously dangerous gambit considering the volume of dollars held overseas by our trading partners - as well as higher taxes. If the Democrats control everything after the 2008 election - as I expect they will - expect Bush's tax cuts to expire, with some compromise that gives lower and middle income earner some tax relief, and only a little, if any, tax relief for upper income earners.
Conclusion: The Democrats win everything. The market begins discounting in a Democrat sweep early to mid-2008, which weighs on the market.
Financial Services Industry
There are more problems coming in the financial services industry. The write-downs have only just begun. Credit will not be anywhere as available as it has been the past several years. I believe one of the reasons why the Fed cut by 50 bps was because of problems in the financial industry. Those problems have not been fixed, and there will be large loan write-downs, which will restrict credit growth in the U.S. Credit growth should will be healthier overseas, though much of the garbage packaged into CDOs resides overseas, which could have global ramifications. Initially, the problems in the credit markets will be seen by foreigners as a great "value" buying opportunity. But, true to form, foreigners will be the last to know and their investments will be misguided. The biggest source of bank revenues comes from real estate, which will be under pressure for some time. Expect problems for the brokers. Stocks are getting cheap, but the brokers were cheap in 2000 and went sideways or down for two years. Expect write-offs, litigation, and headline risk to weigh on the stocks. I also have a hard time believing U.S. stocks can continue rising if financial stocks are in trouble, at least over the long-term, and this could be the source of "something bad" happening in 2008.
Conclusion: Avoid financial stocks, but a great opportunity will arise in banks and perhaps the brokers, that might just provide a once in a generation opportunity.