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The U.S. economy has three ongoing major economic issues that will not go away soon:

  1. Housing bubble. Prices from 2000 to 2005 rose 160% nationwide. In many cases housing became unaffordable to most Americans. As housing prices continued to rise, mortgage lenders become more lax and started making more sub-prime loans. They believed that the lender would never default because as long as house prices continued to rise, the mortgage holder could refinance their loan to make the payments, even if they had no other income. In 2006 housing prices began to weaken and currently home prices are in free fall around the nation.
  2. Credit Crisis. The combination of low inflation, low interest rates, low oil prices, rising equity prices and rising real estate created an environment that stimulated risk taking. The difference between yields on U.S. Treasury securities and junk bonds narrowed to reflect this increased risk taking environment. Easy credit led to more leverage, especially at brokerage firms who sometimes lent up to 100 times underlying collateral securities. Brokerage companies began to securitize mortgages and other risky loans. Credit insurance companies blessed these new derivate securities with their highest AAA credit rating. Brokerage companies also took long term bonds (often new 50 year bonds) and created derivative short-term auction rate securities rated AAA by the rating agencies and fully insured. The current decline in real estate led to a rise in subprime credit defaults. This discredited the rating agencies and investors began to question what they previously believed to be safe investments. This led to financial institutions writing off over $300 billion of illiquid derivative securities that almost bankrupted Bear Stearns and other financial institutions. We are currently in an environment of more regulation, tighter credit, more disclosure and delevering.
  3. Global Inflation. Due to the rise of China, India and other third world nations; demand for goods and services has substantially increased. Inflation is rising at an alarming rate. No one believes the government’s 2% inflation line anymore. Dow Chemical Company recently announced a 20% across the board increase on all of its products. Oil prices have risen sharply. Food prices have risen by 20% to 25%. Movie prices have recently increased from $6 to $8. Recently, Fed Chairman Bernanke signaled the end of interest rate cuts, signaling a ‘fight inflation stance.’

Market Outlook

Interest rates will likely rise to fight inflation. This means that long-term bonds will likely fall in price. Equity multiples will likely contract, however, inflation will increase earnings. Equity prices will likely stay flat or decline.

Global delevering will continue. As brokerage firms and banks become more regulated, they will not be able to lever their equity positions. In addition, the write offs already taken and those in the future will further erode their ability to lend. Hedge funds have to sell their securities in response to lack of available credit. Wikipedia defines “a hedge fund is a private investment fund that charges a performance fee and management fee. Typically open only to qualified investors, hedge fund activity in the public securities markets has grown substantially, and accounts for approximately 10% of all U.S. fixed-income security transactions, 35% of U.S. activity in derivatives with investment-grade ratings, 55% of the trading volume for emerging-market bonds, as well as 30% of equity trades. Hedge Funds dominate certain specialty markets such as trading in derivatives with high-yield ratings, and distressed debt. Needless to say, the amount of possible delevering in all of the above investments is enormous. It will take years to unwind positions.

Investors have become more risk averse. Demand for hedge funds should decrease, putting more pressure on the underlying assets. This should put pressure on U.S. Treasuries, derivatives, emerging market debt and equities.

Inflation is hurting the consumer. The consumer accounts for 2/3rds of the U.S. economy’s profits. This should slow the growth of the economy and hence hurt the stock market.

Home prices will likely continue to fall. Like all bubbles, prices will go to extremes on the downside before the end of the slide in prices. In Japan, its real estate market rose 210% from 1979 to 1991. Then prices declined from 1992 to 2004 giving up all of its gains! Prices of real estate in Japan currently sells for less than it did in 1979! The U.S. real estate market peaked at 160% in 2006. Given the experience in Japan and the Great Depression, prices are likely to be soft for the next ten years.

Commodity cycles typically last a decade. By my observation, it appears the commodity cycle began in mid 2000. That would imply that commodities should peak in price by mid 2010.

Stock prices trend flat to down during a commodity up-cycle. Equity prices have been virtually flat since mid 2000. That would imply that a major buying opportunity for stocks should present itself between now and mid-2010.

Disclosure: Author has a short position in SPY

Source: 3 Economic Crises: My Take