The Market Meltdown, The Economy & More

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
March 6, 2007

IN THIS ISSUE:

1. A Wild Week To Remember In The Markets

2. The Much Anticipated “Correction” In One Day?

3. The Economy – Slow Growth To Continue

4. The Housing Market – What To Expect Now?

5. Sub-Prime Mortgages – How Bad Can It Get?

Introduction

This week, we have a lot of ground to cover in light of last week’s near-meltdown in the stock markets and the mostly disappointing economic reports over the last few weeks. Bearish views on both the equity markets and the economy have certainly become more widespread in the last week or so, but the question is, are they warranted? I don’t think so.

We will begin this week by examining what happened in the US and global stock markets last week and ponder whether we should be heading for the exits, or whether another good buying opportunity is finally in the making. I would suggest the latter. In any event, I suspect that more than a few readers may have decided in the last week to consider professional managers for at least a part of their equity portfolios.

Next, we will peruse the latest economic reports and see if we can reach some meaningful conclusions about what the economy is likely to do for the rest of the year. The bottom line is that the US economy is still growing, albeit at a relatively slow pace, and consumer spending and confidence remain quite healthy. A recession is not likely this year, but the so-called “soft patch” in the economy is likely to continue for another 2-3 quarters.

Let’s start with a postscript on what happened in the last week in the stock markets, since it’s gotten so much attention.

A Week To Remember In The Markets

Last week was highlighted, of course, by the huge sell-off in the equity markets on Tuesday, February 27 when the Dow Jones plunged more than 400 points. The week began on Monday with some arguably ill-advised comments by none other than former Federal Reserve chairman Alan Greenspan. Greenspan was speaking via satellite link to a business conference in Hong Kong.

The conference at which Greenspan was a speaker was not open to the public, but rumors quickly circulated regarding what the powerful former Fed chairman reportedly said regarding the US economy. Stories reported in the media late Monday and early Tuesday morning quoted Greenspan as saying:

When you get this far away from a recession, invariably forces build up for the next recession, and indeed we are beginning to see that sign… By the end of the year, there is the possibility, but not the probability, of the U.S. moving into recession.

While Greenspan retired as Federal Reserve chairman over a year ago, he remains a godlike figure among financial market analysts. So it was no surprise that the media and many market analysts and traders reacted immediately upon hearing his remarks that were interpreted to mean that Greenspan now believes the US economy is heading for a recession this year.

As I comment so frequently, there is no shortage of perma-bears and gloom-and-doomers out there, regardless of how wrong they have been for the last 25 years or longer. Fortunately, they do not make up the majority of economic and market participants. However, when the former head of the Federal Reserve even hints at the – possibility, but not the probability – of a recession, warning bells go off everywhere.

So, the stage was set for a bad day in the equity markets on Tuesday of last week. Hours before the US markets opened at 9:00 a.m. that day, the Chinese stock market, which has been in a meteoric upward spiral, plunged 9%, the worst single day loss in over a decade. (Footnote: China’s Shenzhen/Shanghai Index of 300 stocks rose by 13% in the six trading days leading up to last Tuesday’s plunge and a reported +130% in 2006.)

Making matters worse, the government released its latest durable goods report last Tuesday, just 30 minutes before the US stock markets opened. Orders for durable goods sank a much sharper than expected 7.8% in January as non-defense goods orders saw their biggest monthly decline ever, according to the Commerce Department.

Not surprisingly, all of the major stock markets in the US opened sharply lower. Trading volume exploded as the day went on, leaving little question that large institutional investors and hedge funds were unloading major holdings. In less than four minutes around 3:00 p.m. EST, the Dow plummeted 254 points (an unheard of drop in such a short time); a glitch in the NYSE’s electronic order system caused a huge backlog of sell orders that hit the market at once.

As the backlog of sell orders was executed, the Dow plunged to a low of 12,087 – down over 540 points on the day – before rebounding modestly before the close. At the close last Tuesday, the DJIA closed down 416 points at 12,216 – losing 3.3% of its value in one day. For the week, the Dow lost 533 points or 4.2% of its value. For the year-to-date, as of yesterday (Monday), the Dow is down 3.3%. The Nasdaq lost even more, 5.8% last week, and is down 3.1% for the year. Last week was the worst week for US stocks in over four years.

The Much Anticipated “Correction” In One Day?

The US and most global equity markets have been on an upward tear since July of last year, without a hint of a downward correction in most cases. The powerful advance in US stocks has been led by the Dow Jones Industrial Average which gained over 17% since the low point last summer. The Dow has set new record high after new record high over the last several months.

Much has been written and said about the powerful advance in the equity markets over the last 6-8 months. Many have speculated about when the stock markets would experience a downward correction. Even some of the perma-bulls have been suggesting that a “correction” was overdue.

Yet the severity of last week’s decline has many analysts wondering if we’re headed for a new bear market. The editors of the Bank Credit Analyst don’t think so. Given the widespread concerns about last Tuesday’s market meltdown, BCA hosted a special teleconference for its many subscribers around the world on Thursday, March 1. As a subscriber, I listened in on the live teleconference.

BCA takes the view that the plunge in equities last week was merely a long-overdue correction, which may or may not be over. However, BCA argues that the bull market is not over, and that US stocks not only will rebound from the large losses last week, but also will go on to deliver reasonably attractive returns for all of 2007.

While BCA may be correct as usual, it will not surprise me if the US equity markets correct more on the downside in the next few weeks. Based on the upward trend lines, the Dow should find good support around 11,500 and the S&P 500 around 1,350 if not before. If we do see more weakness, this should lead to a buying opportunity for those who are not fully invested.

There are some interesting statistics surrounding days in which stocks plunge 3% or more as we saw last Tuesday. Analysts at Legg Mason Capital Management studied all of the past days when the Dow Jones, the S&P 500 and the Nasdaq fell by 3% or more on the same day. According to Legg Mason, there have been 27 such drops in the market since 1974, including last Tuesday.

The interesting part is what happened after those big down days. Legg Mason found that one month after the big down days, the three indexes were virtually unchanged. However, Legg Mason found that one year later, the indexes had gained at least 14% following each of the instances where the indexes fell 3% or more in a single day. That’s impressive!

Of course, there is no guarantee that the markets will do the same thing this time around. However, if BCA is correct, we should consider further weakness as a potential buying opportunity.

One final note before we leave the discussion of the stock markets. Our Absolute Return Portfolios performed far better than the major market indexes last Tuesday; in fact, they lost less than half of what the Dow and the S&P 500 lost last Tuesday. Past results are not necessarily indicative of future results.

Our Absolute Return Portfolios are three groups of carefully selected mutual funds which have performed well in both up and down markets in the past. If you have not considered these portfolios before, I invite you to click on the link above.

The Economy – Slow Growth To Continue

Despite some disappointing economic reports of late, and despite the plunge in the stock markets last week, there is still no indication we are headed for a recession anytime soon, despite the renewed energy of the gloom-and-doom crowd. While most of the latest economic reports have been on the negative side, consumer confidence has continued to rise for the last several months, and the government’s Consumer Confidence Index hit a 5½-year high in February, despite the ongoing slump in the housing market. Consumer spending remains robust as I will discuss below.

On the economic side, I noted earlier that orders of durable goods fell a more than expected 7.8% in January. Last week, the government revised its estimate of 4Q GDP to +2.2% (annual rate), down from +3.5% in its advance report last month. The latest GDP number represents a significant adjustment. The Commerce Department said that the downward revision was largely due to a drop in inventories which, in the big picture, is a good thing going forward for the manufacturing sector. Nevertheless, expectations of a downward revision in the 4Q GDP report likely played a role in the market sell-off on Tuesday.

For all of 2006, the US economy grew at the rate of 3.3% according to the Commerce Department. But that number is skewed by the very strong rate of growth in the 1Q of last year. The economy grew at an annual rate of 5.6% in the 1Q, but then slowed significantly to 2.6% in the 2Q, 2.0% in the 3Q and 2.2% in the 4Q.

The Index of Leading Economic Indicators (LEI) rose 0.1% in January (latest data available). The LEI has been marginally higher for the last several months, which is consistent with an economy that is continuing to grow, but in a sluggish mode.

On the manufacturing side, the latest reports were mixed. On the one hand, the Purchasing Managers Index fell to 47.9% in February, the lowest level since October 2002, and the third consecutive monthly decline in the PMI. On the other hand, the ISM manufacturing index bounced back to 52.3 in February, up from 49.3 in January. These conflicting reports make it unclear as to whether the manufacturing sector has bottomed or not.

Consumer spending continues to be the engine which is keeping growth on the positive side. The Commerce Department’s GDP report last week noted that personal consumption expenditures rose 4.2% in the 4Q, above expectations. Retail sales rose 0.7% in January according to the Census Bureau and were 2.3% above yearago levels.

Consumer spending now accounts for apprx. 70% of Gross Domestic Product. So American consumers are “king” in terms of driving US economic growth. A big part of the consumer spending element is consumer confidence, which as noted above reached a 5½-year high in February.

On the inflation front, the Consumer Price Index rose 0.3% in January and was up 2.1% for the 12 months ended January. The CPI ‘core rate’ (minus food and energy) was also up 0.3% in January and was up 2.7% for the 12 months ended January. A core rate of 2.7% for the last 12 months is still a bit higher than the Fed would like to see, but with the slump in the housing market, I expect the Fed to leave interest rates unchanged at least for the next several months.

The bottom line is that the economy continues to expand at a modest pace of 2-2½% in GDP. A recession is not likely this year unless there are some negative surprises. Consumer confidence remains quite strong, although latest stock market decline could have a negative affect, especially if prices continue to fall this week. Assuming the stock markets recover as discussed above, consumer spending should keep the economy in positive territory all year.

Most analysts agree that the housing market poses the greatest threat to the US economy this year, and I agree. Let’s now move onto the latest data on the housing market.

The Housing Market – What To Expect Now?

We all know that we’re in a housing slump – there’s no longer any debate. Over the past three quarters, we’ve seen a 25% drop in new home sales, a 35% plunge in housing starts, and an estimated 110,000 jobs lost in the residential construction industry. Applications for building permits plunged over 30% last year to a nine-year low according to the Census Bureau.

The questions are: 1) have we seen the worst in the housing market; 2) if not, how much worse will the housing slump get; and 3) will it be bad enough to tank the economy in general? I would argue that it is largely the housing market that slowed economic growth from 5.6% in the 1Q of last year to 2.6%, 2.0% and 2.2% in the last three quarters of last year.

The latest data would seem to suggest that we haven’t seen the worst of it. New home sales plunged 16.6% in January, the worst monthly drop in 13 years. The inventory of unsold homes rose from a 5.7 months supply in December to a 6.8 months supply in January.

It is important to keep in mind, however, that some of the negative news noted above is actually positive in terms of how bad the housing slump could get. For example, the huge declines in building permits and housing starts are definite indications that homebuilders have substantially cut back their activities. It is widely known that homebuilders are actively marketing their existing homes with deep discounts and extra incentives.

As a result, BCA believes that the inventory backlog of unsold homes is likely to decline in the months ahead, especially as we move into the spring and summer when home sales typically start to increase. Likewise, the latest drop in interest rates, and the bond market in particular, should make home financing more attractive in the months ahead. Mortgage rates are falling again. There was, in fact, a modest increase in sales of existing homes in January.

Thus, while the news for the housing market remains mostly negative, there are reasons to believe that the homebuilding industry is bottoming out and better news lies ahead, especially this spring and summer. However, that does not mean that home prices are about to bottom out. Because home prices increased so dramatically over the last decade, the median home price is likely to continue to fall (by differing amounts depending on the region) for at least the balance of this year. The median price for new home sales was $239,800 in January, down 2.1% from the same period a year ago.

The greatest area of concern for the housing slump at the moment is the so-called “sub-prime mortgage” market, which I will discuss below.

Sub-Prime Mortgages – How Bad Can It Get?

One of the most hotly debated economic issues at present is the extent to which the current weakness in sub-prime mortgage lending, and rising sub-prime mortgage delinquencies and defaults, may spill over to the prime mortgage lenders, and to the economy as a whole.

Sub-prime lending is essentially the practice of extending mortgages to those to who cannot qualify for traditional mortgages. As a general rule, a mortgage loan is considered to be sub-prime if the so-called FICO credit score of the borrower is less than 620. The sub-prime lender is compensated for taking this additional risk by charging a higher rate of interest and fees.

Over the course of the housing boom, literally millions of homes have been sold to families that would never have qualified for a traditional home loan prior to the emergence of the sub-prime mortgage industry. Estimates I have seen say that all sub-prime mortgage lending amounts to over $600 billion of the $5.5 trillion of outstanding mortgages, approximately 11% of the total. So when you hear media reports on the “sub-prime crisis,” keep in mind that these mortgages represent a very small part of the total mortgage market.

Many of these sub-prime mortgages were sold as ARMs (Adjustable Rate Mortgages), meaning that the interest rate would start low and be adjusted higher over time. Some were even “interest-only” loans, a highly unwise practice where only the mortgage interest is paid in order to make homes more affordable. Mortgage industry analysts have long predicted that sub-prime mortgage defaults would skyrocket when interest rates rose and payments increased accordingly.

Sub-prime mortgage loan delinquencies and defaults have increased significantly recently, just as many had predicted. Morgan Stanley estimates that the overall sub-prime mortgage loan delinquency rate stood at 12.56% at the end of the 3rd Quarter of 2006, as compared to only 1.7% for prime mortgage loans. This, in turn, has put pressure on earnings of sub-prime lenders, and many have seen their stock prices plummet in recent weeks. Some have even filed for bankruptcy or folded. Consequently, the prices of asset-backed securities made up of sub-prime loans have also been pushed dramatically lower.

Thus, the question before us is, will the sub-prime mortgage problems be limited to just that industry, or will they spread to prime lenders and the economy as a whole?

On February 12, Morgan Stanley published a very good analysis of the sub-prime mortgage dilemma. I found it to be very informative because it presented both sides of the issue. On one side, Stephen Roach presented a scenario where the problems in the sub-prime lending could spill over to the economy as a whole, especially when combined with other market factors. Richard Berner, also of Morgan Stanley, presented the opposing view that the damage of rising sub-prime mortgage defaults will be contained to that industry. I’ll summarize both views below, and then cap it off with BCA’s outlook.

Roach seems to think that the problems in the sub-prime lending industry will spread to other areas of the economy. While he doesn’t dispute the fact that default rates for higher-quality mortgage loans are still largely unaffected and credit spreads are still small, he points to the recent profit warnings by larger, main-stream mortgage lenders to be an omen that the problems occurring in the sub-prime markets could spill over to the prime lenders.

Roach argues that sub-prime defaults and delinquencies could lead to a “credit crunch” where all lenders put on tighter restrictions, and fewer homebuyers will be able to qualify for mortgage loans. Roach believes that tighter credit restrictions will exacerbate the housing slump, and thereby negatively affect the overall economy.

Roach is wary of the market’s tendency to shake off major negative events such as rising energy prices, softening in the housing market, increased terrorism activity, etc. He says that investors have now come to largely disregard any spillover risk of major negative events because of the “Teflon-like” view of the world economy, and that history does not tend to treat such complacency kindly.

Richard Berner, on the other hand, points to sub-prime mortgage industry practices as more of the major cause of its problems, and therefore tends to think that any carnage will be limited to that segment of the industry. Sub-prime mortgage lenders have become increasingly more aggressive to remain competitive in recent years, which very likely has accounted for some of the increase in sub-prime defaults. In other words, the wounds may be largely self-inflicted.

For example, Berner cites the statistic that early-payment defaults, which are loans that default shortly after their origination, have increased dramatically. However, he thinks this is largely because of the aggressive practices of some lenders that push the envelope of good business sense. For example, some aggressive sub-prime lenders originate “stated income” loans, where the borrower need not provide documentation of earnings, but merely provide a statement of annual income. Is it any wonder then that many borrowers fraudulently report a higher income than they actually earn to qualify for a mortgage, and then default on the loan? No.

Berner also points to the relatively small proportion of the sub-prime market to the total outstanding mortgage debt as an insulation of sorts from a spillover effect. He readily admits that credit spreads are likely to widen further, that more sub-prime lenders will likely go under, and that sub-prime lending rules will tighten in the near future, but he does not foresee tight credit spilling over to the prime lending markets.

BCA’s view of the effects of the sub-prime mortgage lending problems tend to be more in line with Richard Berner’s scenario. They do not anticipate much, if any, spillover effect in the overall economy that would create a credit crunch. While the liquidity so necessary in the sub-prime mortgage business model may dry up, BCA does not see this spreading beyond that industry. BCA states:

Sub-prime lenders are heavily reliant on liquidity and can remain in business for only a limited time once access to credit dries up. Ultimately however, we expect the damage will be contained to the sub-prime market. Most homeowners have little reason to fall behind in their mortgage payments so long as they have a job, and their income is growing. Corporate bond spreads confirm there has been limited contagion so far.

The biggest unknown, in my opinion, is the possibility of Congressional action to address the problems in the sub-prime lending industry. Berner and BCA seem to put a low probability on Congress stepping in to restrict credit by tightening the lending standards. However, I’m not so sure. Whenever there is a high-visibility problem, there’s always a politician or two (or ten, or fifty) that want to pass laws to address the problem.

If left alone, I think the markets will eventually take care of the abuses by overly aggressive sub-prime lenders by forcing them to tighten up their lending practices and/or go out of business entirely. This, in turn, may have some minor affect on the housing industry, but it’s important to not overstate this effect, since sub-prime loans account for only 11% of the current market. Before the market has time to work through its solution, however, we could see grandstanding politicians proposing to make the world safe from “predatory” mortgage loan originators, only to make matters worse.

Conclusions

It remains to be seen if the stock market correction is over. It will not surprise me if we see some additional weakness over the next few days or weeks. However, BCA continues to believe that US equity prices will recover and deliver relatively attractive returns over the next year. According to Legg Mason research, the broad equity indexes have returned an average of at least 14% over the next year following days where the Dow, the S&P 500 and the Nasdaq all lost 3% or more in a single day. So I would consider this pullback to be a buying opportunity.

The US economy remains on sound footing, even though recent reports have been mostly on the negative side. Consumer confidence hit a 5½-year high in January, and consumer spending remains robust. Overall, I would expect another 2-3 quarters of growth in the 2-2½% range in GDP. If so, the Fed is not likely to raise interest rates anytime soon, especially in light of the housing slump.

The Housing market remains in a downturn, but there is plenty of evidence that homebuilders have put on the brakes. With interest rates lower, and with the home buying season just ahead, the inventory of unsold homes should start to fall. The problems in the sub-prime mortgage market, which accounts for only 11% of all outstanding mortgages, are not likely to spill over into the prime mortgage market, and should not tank the economy.

All of this assumes, of course, that there are no major negative surprises lurking out there this year.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

Another analysis of the market decline last week.
http://business.timesonline.co.uk/tol/business/columnists/article1475242.ece

Views of a typical hand-wringer –
In Today’s Economy, All News Is Contagious
http://www.realclearpolitics.com/articles/2007/03/in_todays_economy_all_news_is.html

George Will: The Coming Backlash Against The Clintons (I wonder)
http://www.realclearpolitics.com/articles/2007/03/the_coming_backlash_against_th.html