And You Thought I Was Negative about the Economy

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 |  Includes: DIA, QQQ, SPY
by: TraderMark

For those who have been reading my articles, you know I've been negative on the coming year [Et tu, September].Sometimes having this type of position (especially in the summer) I felt like a lonely voice in the wilderness... but as each week passes, more and more things are coming to fruition. About 3-4 weeks ago two of the five major investment banks chief economists have turned quite negative on the 08 economy as well. I updated my thoughts a few weeks back. [Et tu, 1st Half 2008? Predictions for the Coming 6 months]. I found this article on Minyanville.com and boy, if you thought *I* was negative [What to Watch for in 2008]- I will highlight the points below. This is more of a long term prediction, going out a year from now and how we will feel on Christmas Day 2008.

  • A credit contraction is well underway, oil remains near its all-time high, the housing free-fall is accelerating, and central bankers are freaking out. So, who would have predicted that the Dow would reach an all-time high in October and still hover within about 6% of that number as the year drew to a close?
  • The market’s relative buoyancy reveals a touching faith in the powers of the Fed and other father figures of the financial landscape. Will this faith remain strong enough to surmount the tests that lie ahead?
  • With equity-free (not to mention upside-down) homes proliferating across the country, consumers turn to their retirement accounts and credit cards to keep afloat. This stop-gap proves very short-term, and consumer credit takes a trip down the subprime path.
  • The rush to sovereign wealth funds for rescue money slows dramatically as politicians and the public push back, alarmed about foreign government interference and the prospect of a Dr. Evil gaining access to American technology.
  • Xenophobia, economic stress, and – this is a sure thing – pandering politicians lead to resurgent protectionism. The march towards legislation is interrupted, however, as international investors remind politicians that the U.S. now works for them.
  • Counterparty risk moves to the foreground as banks and institutions discover that those companies from whom they bought CDS and other types of insurance were just kidding about their capital reserves.
  • The pendulum swing away from libertarianism and towards a more positive view of government and regulation accelerates as insolvent consumers and companies clamor for safety nets and bail-outs. Investors, scorched by hundreds of billions in losses on trillions in asset-backed securities and derivatives, urge regulators to slam shut barn doors across the financial landscape. With structured finance stuck in the penalty box, CDO-financed lending diminishes to a trickle.
  • A dollar crisis forces the Fed to halt interest rate cuts even as the economy moves deeper into recession (yes, the recession has already begun).
  • Corporate defaults and bankruptcies finally begin to rise as over-levered companies find that raw material costs remain stubbornly high (squeezing profit margins), demand continues to soften and that bankers have learned to say "no."
  • Continued drought in the U.S. Southeast and Southwest wrecks more economic harm than Katrina, and drives home the point that global warming's impact comes more from changes in precipitation than in temperatures. Atlanta becomes the poster child for the economic risks of water stress. As water tables fall, H2O rises as an investment theme.
  • Total oil production again fails to meaningfully exceed peaks established in late 2005 and mid 2006. Prices rise and stay above $100 a barrel despite a global slowdown. Emergent bubbles develop in companies specializing in energy conservation/efficiency and alternative energy. Event-driven, regional supply shortages scare the pants off politicians and consumers alike.
  • Faced with shrinking credit and falling asset prices, officials stop talking about inflation, and the dreaded D word resurfaces.
  • As the de-leveraging of the economy continues, the savings rate rises further, cutting corporate profits. With financial earnings under pressure, equity prices either have to fall or P/E ratios rise. You make the call!

So it's nice to read someone who is more negative than me. I have touched on most of the points above - however some things I have not stressed quite so severely. I have mentioned that consumers are now turning to credit cards to replace the house ATM, and we are seeing the first signs of 401ks being raided to help sustain people. I should mention I expect the latter issue to accelerate and while that will help "bouy" the near term economy, what does it mean for the long term of our country?

Nothing good. As with many things in this country, especially in our political decisions we focus on kicking the can down the road - just trying to make sure things don't get bad now, and the future will somehow "take care of itself". Myself? I worry about a lot of people working as Walmart greeters until they literally keel over - instead of enjoying a traditional retirement.

Regarding sovereign wealth funds, while initially celebrated with constant references to how the 'bottom must be in' because sovereign wealth funds are 'buying' (i.e. smart money) what will the same pundits be saying when the next round of capital is necessary from these same players? Or a third? All at lower prices? Buffet certainly is not finding any value in financials:

Berkshire Hathaway Inc. Chairman Warren Buffett said Wednesday that he rebuffed financial firms that have approached him recently about buying stakes in their companies.

Just because you have a lot of money from one arena doesn't mean you are a smart investor, especially if your money is through no work of your own. We've seen many people (think Paul Allen of Microsoft fame) who took huge sums and proceeded to destroy much of their wealth in their future investments. Is that smart money? Are heirs of fortunes from their parents "smart money"? Do you think Paris Hilton's investing prowess is something to be excited about? Are people who just happen to be sitting on huge amounts of long dead dinosaurs suddenly "shrewd"?

Those are the talking points we are handed by the financial media. I'd rather listen to Buffet myself. Remember, when you print billions of dollars each day due to your dead dinosaurs you can afford to be "early" or "buy high" for the "very very long term". For the rest of us, we don't have those benefits, so we need to invest accordingly. As in the article above, I've stated to look for more and more bailouts from the politicians, as the economic situation worsens.

While I don't agree that a "more positive view of government" will emerge, I suppose in our short sighted manner if the government uses our tax dollars to bail out people, those people who got bailed out will see the government in a more positive light. I sure won't. I agree with the corporate defaults and bankruptcies increasing as I mentioned in my recent investments in two firms that specialize in such a thing (and their stocks have been reacting very positively of late as more people jump on the bandwagon) [Two New Recession Plays].

I agree with the stubbornly high input costs as I mention constantly in the blog [A World of Shortages]. In fact at this point I think in the larger macro sense we are going to be entering decades of higher inflation as our world is not currently suited (first) for so many people and (second) so many people trying to live urban Western lifestyles of consumption. While this will ebb and flow from year to year, its a long term issue. At some point technological innovation will help solve some fo these ills but we could be talking decades to solve some of the issues. And projections for worldwide human growth only continue to grow.

The drought issue is an interesting one. I've long though that water, not oil, will be the commodity that wars are fought over in the coming century. You are already seeing serious strains in the southeast of America and western regions. Unfortunately there are very few investable themes in this area and it is "very very long term," but one day I do think we will be talking about water like we talk about crude today.

As for crude, I will be curious to see how it reacts - if in a slower growth world economy crude stays high, this will lend credence to the peak oil theorists. Also keep in mind the USA has had 2 years without a major hurricane. Not sure how much longer we avoid that bullet, and it has a tendency to really spike energy prices if the right area of the country is hit (let's hope not).His last point is the one that I think will be the most important from the perspective of an investor.

All these other bad things he (and I) talk about - well that only affects us in our real lives. It only affects the 'real economy', and the vast majority of this country.... not the investor class (as much). Not until corporate profits actually fall do I suppose the top 5% really begin to care about the bigger issues because then their portfolios may actually fall. (gasp).

So, much like him, I suppose if one is a raging bull on the market in 2008 one must ask if P/E ratios are set to rise in the coming year as corporate profits fall? If so, the market should hold flat or heck make new all time highs. Certainly possible, but not the probable situation in my book....With that said, the stock market and the economy are at times two different things and with central banks worldwide committed to trying to 'inflate' assets to keep us out of a slowdown one could envision a scenario where markets hold up (or at least far better) than the real economy.

All this money circulating and being created needs to find a home - real estate in this country is not an option, and bonds yield almost nothing post inflation. So equities seem to be, by default, where money is going. As more money is being dropped on us, the more can go into equities. While on the surface this sounds "great," keep in mind this helps prod along inflation and when your equity return is 7% and real inflation is 2%, that is no different than when your equity return is 13% and real inflation is 8%. It just 'feels' better because your equity return is 'measurable' whereas real inflation is harder to assess.

I think this is the path we are on now. Further, with large parts of the market "un-investable" i.e. financials and most of retail, that eliminates about 25% (20% of S&P 500 was financials before this correction) of the choices to invest, except for those who enjoy trying to catch falling knives. So more and more of the new money goes into the other 75% of the market, further buoying those names. An interesting conundrum. But certainly this could be the case to be made for a sustained rally in the market - it is always important to see the other side of the fence, and opposing views to your own.