Six Calls for 2008

It is said that attempting to predict the future is the province of fools. In this vein, I would like to offer my prognostications guesses for 2008.

1) The Consumer

Stop.

Go no further.

If you can successfully predict what the consumer is going to do, then you will have cracked the code for the year. As obvious as that may sound – given that consumer spending is 70% of the U.S. economy and has risen since the dawn of time – there has not been as uncertain of a year for the consumer as 2008 will be.

The crosscurrents are many, both supporting and slowing consumer spending. Foreigners often marvel at the propensity of Americans to spend, spend, spend! However, a significant portion of spending this decade has been driven by mortgage equity withdrawals [MEW], which are no more given the stresses in the housing market unseen since the Great Depression. The emphasis on asset appreciation on consumer confidence is overblown but MEW added as much as half trillion dollars to consumer expenditures each year. With the effects of MEW finished (for now), consumers must look to other sources of cash to support their spending habits.

Rising incomes are most important. However, real wages have barely budged over the past seven years. Will future wage growth rise appreciably to offset the loss of the home ATM? There is some evidence that wages were beginning to rise, although it is not at a pace to offset the decline in housing. And with the economy slowing at the very least, it is difficult to envision incomes accelerating.

Perhaps the consumer will rely more on credit card debt? At this stage, rising credit card debt is not healthy, especially considering that home equity loans cost 5% after-tax whereas interest on credit card debt is pushing 20%. The consumer can stay afloat on credit card debt if the bridge between the last expansion and the next one is short. However, with credit card defaults rising substantially, albeit off lows, the bridge over the chasm may not be long enough.

As always, consumer spending depends on employment. But unemployment is rising, initial jobless claims are rising, continuous jobless claims are rising, and the employment participation rate is falling. It is fair to say that employment is weakening.

Goldman Sachs (GS) is predicting the unemployment rate will rise to at least 5.5%. If 5.5% is the peak unemployment rate, then the consumer will not fall off a cliff. Consumer spending will slow, but it may not fall. In the 2001-02 recession, unemployment rose to 6.2%, yet consumer spending never went negative. It may be different this time, as the economy is in unchartered waters with all the problems in the structured credit markets, but underestimating the resilience of the American consumer has been a loser’s game.

Anecdotally, I still see “For Hire” signs where I live, and I live in a state that is in recession due to being ground zero for the housing collapse. But the economy can stop dead in its tracks, which is what happened in 2000-01 when the Liscio Report noted that state income tax receipts, and thus the economy, suddenly fell off a cliff.

A market indicator that is worrisome is the utter beating the retailers have taken. Many retailers are down 50%, 60%, even 70% off their highs last Spring. If the consumer is healthy, why are so many retailers getting hammered?

I think the consumer will muddle on in 2008, but consumer sluggishness will drag on much longer than analysts and economists expect. If unemployment begins to rise sharply, the market will get hammered.

2) The Economy

The debate on the economy seems to be whether we are going to slow, or enter a recession. Frankly, I believe much of this debate is semantics. To me, whether the economy is growing 1% or contracting slightly is less important than whether the economy is growing fast, declining significantly, or flatlining.

Currently, we are flatlining. We are not going to grow fast anytime soon, and we may go into a hard recession, although I think it is unlikely. It is more likely in 2008, however, than breakneck growth.

The surprise will be the duration of the sluggish growth. Many economists are predicting the economy will slow in the first half of the year then pick up during the second. That is, in my opinion, optimistic.

Consumption is 70% of the economy, and consumption growth will be anemic for some time. Paul Kasriel at Northern Trust (NTRS) has estimated that up to 40% of the jobs created directly and indirectly this decade were due to the boom in residential construction. Even if the true figure is half that, job creation in residential construction has turned decidedly negative, and the job market will need another source merely to sustain the recent pace. But where? What other boom will be created to make up for the lost growth in the residential real estate boom?

Corporate spending is 15% of the economy. Corporate cash flow lagged earnings last year. Debt increased, but not to increase productive capacity as much as to buy back stock. If corporations did not see the need to ramp up capacity when times were good, instead choosing instead to leverage up their balance sheets to return capital to shareholders, why would they increase productive capacity with the economy slowing? There is no evidence of overcapacity in the United States outside of finance and residential housing, but neither is there undercapacity. Thus, it is difficult to see corporate spending driving growth in the second half of the year.

Government spending is 15% of the economy. It is possible that government spending could accelerate in 2008, given that it is an election year. However, President Bush has been hammered by conservatives for allowing non-defense government spending to skyrocket. The President’s conservative legacy on spending is in tatters. As he looks towards his legacy, Bush may choose to slow spending, especially by a Democratic Congress. Bush did not show much restraint during the first seven years of his term though, so one should be skeptical that he shall significantly do so in his last. Thus, the White House may provide a headwind to Congress but will not stop it.

Net exports (exports minus imports) are 0% of the economy. Net exports have been increasing, but if I am correct about the dollar bottoming, job creation in the export sector may also slow.

The Fed will continue to cut interest rates, perhaps to as low as 3.0%. However, with inflationary pressures in parts of the economy, interest rates will not fall to 1.0% as they did in the last cycle.

The perma-bulls have been screaming for further rate cuts. But even if the Fed had cut an extra 50 bps last fall, it is unlikely the extra cuts would have had much effect. The problems in financial markets and the economy are related to transparency and supply, not aggregate demand. Lower rates do not increase transparency in the structured finance markets nor do they decrease supply of homes. Similar to the last interest rate cycle, when Greenspan cut the target rate 0.50% twice in January 2001 only to see the S&P 500 fall a further 40%, the problems are related to issues that interest rate cuts can effect only marginally, at least initially. Had the Fed cut an extra 50 bps, the most notable effect would have been to channel liquidity into agriculture stocks, Chinese stocks, gold and other hot speculative areas.

The economy will slow in the first half of 2008 and will remain sluggish through the second half of 2008. I think there is a better than even chance we are entering a recession. The economy will not enter a deep recession – at least not this year – but will not re-accelerate in the second half either.

3) The Market

It has been my contention that “something bad will happen” in the market in 2007 or 2008, which is akin to predicting that “it will rain somewhere.” However, the premise for my nebulous prediction is that given the excesses and complexity embedded in the financial markets, as well as idiotic valuations in housing, something had to break somewhere. I just did not know where.

It was fairly easy to predict that subprime would blow up. I did not, however, expect the quants to be a major catalyst for a meltdown, as they were last summer. Nor did I expect the convulsion in the cash market, supposedly the safest market around. Similarly, I have no idea where the next land mine awaits. However, if we hit one – and I believe we will – the stock market will crack.

The tight coupling of disparate asset classes and the secondary and tertiary effects of the unwindings are factors I believe many investors and commentators have failed to fully appreciate. Such misunderstanding manifests in statements such as “Housing is only 5% of the economy thus investors are over-reacting to the fall-out in the housing market.” Given that the economy has become so asset-driven, particularly housing – from the number of jobs created, to consumers using their homes as ATMs, to the proliferation of structured finance products reliant on mortgages – it is not surprising that a shock to one area of the financial system effected other seemingly unrelated areas. The continual unwinding of these relationships will continue to provide structural headwinds to stocks.

The economy is slowing. Profit margins, earnings estimates, and revenue projections are all rolling over. Earnings growth expectations for 2008 have fallen from 11% to 6%. I believe this is still too optimistic, and earnings will grow low to mid-single digits, if at all this year.

However, many problems are already discounted in the market. Fortunes will be made picking over the carcasses of stocks left for dead. Areas that will provide extra-ordinary opportunities will be commercial banks, brokers, homebuilders, semiconductors and consumer stocks, particularly the retailers. I have started to compile lists of financials, semis, and retailers to buy when the selling gets over-done. Many of these stocks will approach what I call “stupid value,” or the valuations become so stupid that you just have to buy, even if there is more downside to come. One will be richly rewarded buying "stupid value" when the market comes to its senses.

For some time, I have predicting a 20%-25% correction in the market from its highs. The market is currently down 10%. Thus, we are halfway through the bear market. I imagine, though, the market will not go straight down to the bottom, but will get there in fits and starts, rallying hard when the market gets oversold then selling off as investors look to get out. Thus, we are in the early innings of a bear market. The market may not end 2008 down 20%, but will trade downward in a range.

I own a semiconductor capital equipment stock and two consumer stocks.

4) Precious Metals

Gold will hit $1000 this year. The liquidity that will be created by lower interest rates will find its way to into precious metals. I expect that at some point, gold will hit its all-time inflation-adjusted high, which would put the metal at $1800-$2000 as speculative capital will rotate into gold, driving up the price. I doubt gold will hit its all-time inflation-adjusted high in 2008, but I did not think the price of oil would double and hit its all-time inflation-adjusted high in 2007, either.

I own gold.

5) Real Estate

I think the housing market is midway through its severe bear market, if not more. Residential real estate will bottom in price either this year or, more likely, in the first half of 2009. The number of housing starts has collapsed, and inventory is at multi-decade highs, which are both prerequisites for a bottom.

However, housing is an illiquid, discrete market, unlike the stock market, which is liquid and continuous. Thus, the bottom may take longer in housing simply because it takes longer for sellers to adjust their expectations downward. Therefore, the duration of the correction may last longer than I anticipate.

Banks are just beginning to liquidate their inventories of foreclosed homes. As foreclosures pile up, banks will sell properties below par, in some cases substantially, to jettison properties off the books.

Forced sales are beginning to occur, with Lennar (LEN) selling several thousand units well below book value. Anecdotally, I know of one bank in my state that sold property for $0.30 on the dollar. Forced selling will accelerate, and the market will not bottom until it peaks.

The downturn in commercial real estate has just begun. It will not be as long nor as deep as the bust in residential real estate since there was not as much over-building. Nonetheless, at the height of the frenzy, loans were written at ridiculous terms. The values of those loans are deteriorating, which is restricting credit in commercial real estate and causing a decline in the value of commercial property.

Beyond the problems wrought by poor underwriting standards, the value of commercial real estate is dependent on the state of the economy. If the economy avoids recession, then the downturn in commercial real estate will be manageable. If the economy slips into a significant recession, look out below.

I see more downside in pricing but do not see a catastrophe. I am short REITs, but have been reducing my position.

6) Politics

There is a political tide sweeping this country, and, unless something dramatically changes, the tide will sweep the Republicans out of the White House.

Historically, the fourth year of the Presidential cycle has been positive for stocks. Historically, a Democrat in the White House has also been positive for stocks. Thus, one would expect 2008 to be a good year for equities, all things being equal.

I have two problems with this logic. First, all things are not equal. The environment is horrible for stocks. Falling earnings, an unwinding housing and structured products market, uncertainty, high valuation overseas, commodity inflation, and a possible recession will continue to weigh on equities. Forget the calendar, fundamentally now is a poor time to be buying.

Second, though the political Right in America would have you believe Democratic administrations are bad for your investments, historically, this has not been the case. Stocks have done better under Democratic Presidents than Republican ones. Thus, simply because the country elects a Democratic President is no reason to sell every share you have.

However, what does worry me is the rise of economic populism, and the manifestation of economic populism has been most prevalent in the Democratic Party. Populism is also evident in GOP circles, particularly with the rise of Mike Huckabee. However, it is with the Democrats where populism is the loudest. For example, during the 2006 election, there were exactly zero newly elected free traders to Congress whereas there were dozens of new freshmen Democratic Congressmen and women espousing trade restrictions on the campaign trail who wound up in Washington.

The rise in populism has been fueled by growing income inequality and anxiety amongst the bottom four-fifths of earners. This anxiety is real, and policies to address the anxieties will be implemented in the legislative sessions in 2009, and beyond.

Contrary to the rhetoric of the Right, higher taxes and higher spending is not the end of the U.S. economy. However, poorly designed policies may have negative ramifications. For example, windfall taxes on “excessive profits” offers red meat to liberals at political rallies and on Internet forums but could have damaging effects regarding the allocation of capital within the economy. Trade restrictions designed to “protect jobs” usually wind up having the opposite effect, destroying jobs and stunting growth. Demonizing foreigners over their currency policies may cause demand for American financial assets to wane, which is enormously important given the size of the fiscal and trade deficits this country runs.

Of all the Democratic candidates, given her experience in the White House, I believe Hillary Clinton would be most able to resist the poisonous effects of economic populism. Her husband signed NAFTA, the WTO, and balanced the budget. (Though he did raise taxes, Bill Clinton understood that a balance sheet has two sides, unlike the blinkered ideologues in the Republican Party who think that cutting taxes is the cure for all of our economic woes, and the deficit will magically take care of itself.) Hillary may cave to the destructionist tendencies within her own party, but given what we know about the Clintons, there is reason to believe she would not.

Barrack Obama may turn out to be a fabulous President, but we have no idea how he will handle the pressures to satisfy parochial constituencies within the Democratic Party that may run counter to the long-term economic interests of the country. He is an unknown and may buckle to the special interests in the name of political expediency. Then again, he may not, but there is no evidence to suggest otherwise.

The Democrats will win the White House, and Barrack Obama will be the next President. The Democrats will increase their tally in the Senate by five to seven seats, and will win another 10 to 20 in the House.

Regardless of what I may think as a citizen, as an investor, I view this outcome as negative as economic populism is most likely to manifest in the Democratic Party. I prefer gridlock, but I think gridlock is unlikely given that the party that wins the Presidential election usually increases its seats in Congress. Thus, I believe the specter of a Democratic sweep will weigh on the markets, particularly as the year progresses.

Comments

[Valerie Malone:]

I signed up with a company called CreditCardZappers to lower my credit card debt.

They are awesome so far. Took off interest charges, an overlimit fee and a late fee from six months ago.

2008 Jan 07 10:51 AM

[JohnB:]

Great article and analysis. (despite the previous random comment :-)

2008 Jan 08 06:32 PM

[Phil Anthropy:]

Agree that this is a high quality article. But it misses the theme that is driving the current world economy, which I call the Roger principle, an acronym for Rich Oligarchs Getting Even Richer. If one looks at world events today, as opposed to several decades ago, there is no longer even the semblance of a free market. When liquidity is needed, by magic it is forthcoming immediately from government and commercial sources, to "save" banks that have probably been earning double digit returns for the past decade on their leveraged investments. Therefore, my bet's on Roger, and Roger doesn't want a recession (unless he's a short seller this time around). I predict Dow 14,500 just before the elections.

2008 Jan 09 06:01 AM