The Economy Surges, Stocks Plunge - What’s Up?

FORECASTS & TRENDS E-LETTER
Gary D. Halbert
July 31, 2007

IN THIS ISSUE:

1.   Economy Surges Ahead In The 2Q?

2.   Inflation – Some Good News For The Fed

3.   Other Economic Reports Of Late

4.  Stocks – A Correction, Or Something Worse?

5.  Ignore The Shocking Financial Media Headlines

Introduction

This is an interesting and challenging week to write an investment/financial/economic E-Letter, for a variety of reasons.  Last Friday, we got a much stronger than expected report on 2Q Gross Domestic Product, which confirmed that the US economy is not headed for a recession anytime soon.  Within that same GDP report, we got the best news on inflation in a long, long time, which should have assured the markets that the Fed is not going to raise interest rates anytime soon.  Even in the latest housing numbers just released, there was a hint of good news.

All of this, one would assume, should have sent the stock markets to new record highs.  What better news could one expect?  Yet the equity markets plunged late last week.  The Dow lost 4.2% for the week, while the S&P 500 lost 4%.  As this is written, it remains to be seen if this is just another garden-variety correction to be followed by new highs in another few weeks, or if something more serious is going on.

We have seen some well-known hedge funds blow up this month, largely due to the sub-prime mortgage debacle, as I will discuss below.  There are worries that more large hedge funds will be victims of the sub-prime dilemma, and there are even growing concerns that the major banks are going to face serious losses as they, and their large clients, unwind sub-prime portfolios and collateralized debt obligations (CDOs) over the months ahead.

The fear is that the sub-prime and CDO problems will lead to a serious “credit crunch,” which remains to be seen.  Dozens of large IPOs and LBOs have been postponed as liquidity has become scarce for the time being.  We need to watch the developments in this area closely.  I have been saying for some time now that the major equity markets were overdue for at least a 10% correction on the downside.  Maybe this is it, or maybe not.

Without a crystal ball to know what happens in the near-term, I will offer my usual analysis on the latest good economic and inflation news in the pages that follow; I will give you the low-down on the hedge funds that went belly up of late; and we will end this week’s discussion with my thoughts on the latest roller-coaster action in the stock markets.

Hopefully things will be clearer by next week. For now, let’s get started with what we do know.    

Economy Surges Ahead In The 2Q?

Last Friday, the Commerce Department reported that 2Q Gross Domestic Product surged by 3.4% (annual rate), well above most pre-report estimates.  That followed the anemic growth rate of only 0.6% in the 1Q, which was below most pre-report estimates.  According to the latest government report, the economic rebound in the 2Q was led by strong consumer spending, higher than expected exports, an increase in business inventories and increased spending by federal, state and local agencies.

The stronger than expected economic rebound in the 2Q will likely silence many of the forecasts for a recession in the last half of the year from several mainstream economists and financial writers (but not the gloom-and-doom crowd, of course).  The latest GDP report should confirm what I have been telling you for the last year, that a recession is not likely this year.

That said, however, I don’t think we should look at the latest strong GDP report and assume that the economy is off to the races.  Why not?  First of all, I think it is likely that the Commerce Department over-estimated 2Q growth at 3.4%, just as it is likely that the government under-estimated 1Q growth of 0.6%.  If we average the two reports, we had growth of 2% for the first half of the year, which seems about right.

Unlike some Wall Street cheerleaders who are now revising their second-half forecasts upward, in light of last Friday’s strong GDP report, I continue to believe we’ll see overall economic growth of less than 3% for the balance of this year, with at least a modest upturn in 2008, assuming there are no major negative surprises.  So, while it now seems clear that we have avoided a recession, I expect the economy to remain on the soft side for a couple more quarters.

Another reason I have this view is the fact that the rate of growth in consumer spending slowed in the 2Q according to the Commerce Department’s latest GDP report.  Real Personal Consumption Expenditures (PCE) rose only 1.3% in the 2Q versus 3.8% in the 1Q.  This confirms that consumers increased spending at a much slower pace in the 2Q.  This is also in line with the downward trend in consumer confidence in the April-June quarter. 

The good news is, the University of Michigan Consumer Sentiment Index turned markedly higher in July, another sign that a recession is not likely.  And this morning we got the latest Consumer Confidence Index from the Conference Board for July, which soared to the highest level in six years (112.6).  So, despite soaring oil prices and the roller-coaster stock market of late, consumer spending is not about to go in the tank, even though the rate of spending growth has slowed as discussed in the previous paragraph.

The bottom line is that the advance GDP report for the 2Q was a welcome surprise, but was probably overstated a bit, as we may learn in the subsequent revisions.  In fact, I suspect the 3.4% number for the 2Q will be the highest number we will see for the year, with the 3Q and 4Q coming in at 3% or less.

Inflation – Some Good News For The Fed

In the latest GDP report, the price index for gross domestic purchases, which measures prices paid by US consumers, increased 3.9% (annual rate) in the 2Q, compared with an increase of 3.8% in the 1Q.  Yet while the headline inflation number was still quite high, the “core” rate actually fell significantly in the 2Q.  Excluding food and energy prices, the core price index for gross domestic purchases increased only 1.7% (annual rate) in the 2Q, compared with 3.1% in the 1Q.  This puts the core inflation rate within the Fed’s supposed target range of 1-2%.   The Consumer Price Index was only modestly higher in June (latest data available) at +0.2%, and was up 2.7% year-over-year.  The core CPI was also up only 0.2% in June, and was up 2.2% for the 12 months ended June.  So even the core CPI is getting closer to the Fed’s target range.  At the latest Fed policy meeting in late June, the FOMC minutes revealed that the members are feeling better about the prospects for keeping inflation in check:

"Members generally anticipated core inflation would remain relatively subdued but concurred a sustained moderation in inflation had not yet been convincingly demonstrated."

I suspect that the FOMC members are feeling even better with last week’s release of the GDP report and the latest CPI report.  This, of course, is fueling more debate over whether the Fed will lower interest rates later this year.  The minutes from the June 27-28 FOMC meeting suggest that the members viewed the economy as having recovered modestly in the 2Q, as was evidenced by the latest GDP report last Friday. 

Those same minutes also revealed the feeling on the part of the FOMC that the housing slump, while serious, is not going to drag the overall economy into a recession:

"Although the housing market remained a key source of uncertainty about the outlook, members thought it most likely that the overall economy would expand at a moderate pace over coming quarters."

Given this feeling by the FOMC members that the housing slump will not tank the overall economy, and given the very strong 2Q GDP report, I continue to believe the Fed will leave short-term rates unchanged at 5¼% for the rest of this year – unless there are some major negative surprises.

Other Economic Reports Of Late

To round-out our discussion on the economy, here are some of the other reports released over the last couple of weeks.  The Index of Leading Economic Indicators fell 0.3% in June following a 0.2% rise in May.  Retail sales were down 0.9% in June following a rise of 1.5% in May.  But as noted above, consumer confidence has rebounded strongly, so sales should rebound at least modestly later this year.

On the manufacturing side, the ISM Index rose to 56.0 in June, marking the third monthly increase.  Orders for durable goods rose 1.4% in June versus a decline of 2.8% in May.  Industrial production rose 0.5% in June following a small decline of 0.1% in May.  The factory operating rate (capacity utilization) was 81.7% in June versus 81.4% in May.

On the housing front, the general slump continues.  Sales of new and existing homes were down again in June, as were applications for building permits. But there was some good news in the housing reports for last month, at long last.  According to the National Association of Realtors, the median sales price for existing homes actually rose 0.3% in June to $230,100 as compared to $229,300 in June of last year.  The median number is a typical market price where half of the homes sold for more and half sold for less.

Perhaps more importantly, the inventory of unsold homes declined 4.2% in June to 4.20 million units for sale, which represents an 8.8-month supply at the current sales pace.  This is good news, especially in light of the increase in mortgage rates over the last several months.

While the housing slump certainly is not over, and probably won’t be for at least another year, there are signs that we may have seen the worst of it, at least in some markets.

Hedge Funds Feeling Sub-Prime Woes

On July 18, the financial world learned that two large hedge funds managed by Bear Stearns had blown up.  In a letter to the investors in these two funds, Bear Stearns advised clients that the High-Grade Structured Credit Strategies Fund was down 91% so far this year at the end of June, and that its High-Grade Structured Credit Strategies Enhanced Leverage Fund was worth nothing.  It has been reported that these two funds had roughly $16 billion in assets at one point in the past.

Both of these hedge funds invested primarily in portfolios of sub-prime mortgages and collateralized debt obligations (CDOs) which also invest in sub-prime mortgages.  Bear Stearns reportedly loaned the High-Grade Fund, which was down 91%, $1.5-$1.6 billion of its own money in an effort to revive it.  But the Enhanced Leverage fund (the more aggressive of the two) is now dead – a complete loss of the investors’ money as well as earlier profits.

Figures on how many hedge funds are heavily invested in sub-prime loans and CDOs are not widely available, but I have read estimates that losses on sub-prime defaults and CDOs could easily run in the $150-$250 billion range.  Again, these are estimates, so the losses could higher or lower.

In the case of the Bear Stearns blow-ups, it was the investors in the funds that ate the losses.  Bear Stearns can probably withstand the financial loss of its loan of $1.5 billion (assuming they really lose that much).  But the question remains – will the sub-prime and CDO debacle spill over into the major investment banks?  Most analysts seem to think not, but you wouldn’t know that in watching the big banks’ stocks plunge in recent days.

This sub-prime and CDO fiasco deserves watching closely.

Stocks – A Correction, Or Something Worse?

After setting new record highs earlier in the month, the broad equity markets have been hammered over the last week or so.  The Dow Jones plunged over 1,000 points just last week alone.  The S&P 500, which finally managed to close at a new all-time record above 1,550 on July 13, has since plunged almost 100 points. 

Over the last week or so, stocks have been plagued by a variety of worries including soaring oil prices, Exxon/Mobile missing its earnings estimate and certainly by fears that we may be entering a credit crunch.  As noted above, there are growing fears that the sub-prime mortgage debacle may actually be spreading to the prime mortgage players and large banks.  As a result, so-called “capital market” stocks such as JP Morgan, Bank of America, Citigroup and others have been hit hard.  The latest weak home sales data discussed above only made matters worse, despite the fact that there was some good news in the latest housing reports. 

Credit-market woes are partially rooted in the sub-prime-mortgage sector, which has been a source of market angst for months.  But as noted above, these problems have become more acute, as hedge funds invested in mortgage-backed securities have struggled, and as default rates have risen, even among prime borrowers.  Banks have been hurt by having to take loans onto their balance sheets instead of passing them on to outside investors. And major private-equity acquisitions have struggled to find financing, possibly removing one long-standing support for the market.

The question, of course, is whether this is merely a downward correction which will end soon, or are we really facing a true credit crunch which could spell the end of the bull market?  BCA, for one, believes it is the former and not the latter.  In a bulletin to subscribers on Friday, BCA made it clear that they continue to believe the equity bull market is not over.  While it remains to be seen if last week’s correction will continue, BCA feels that the severe sell-off in capital market stocks is overdone.  They recommend that clients stay fully invested.

As always, it is impossible to know how far these downward corrections will run. A 10% correction (not that 10% means anything) in the Dow Jones would put it down to the 12,600 level, with good technical support should it fall a bit further.  A 10% correction in the S&P 500 would put it down to the 1,400 area, with good technical support should it fall below that level.  Of course, it is also possible that last week’s correction is already over.  The Dow Jones rebounded 93 points on Monday, and is up sharply again today (so far).

The one thing I think we can be sure of is this: the higher these equity markets go, the higher the volatility will be, on the upside and the downside.  Big, big swings like we’ve seen in the last few weeks should not come as a surprise.  Many investors will be scared out of the market, usually at the worst time, and never get back in.

This is why I believe so strongly in having a significant amount of your equity portfolio in the hands of professionals with sophisticated and disciplined systems for entering and exiting the market, especially when this bull market ends.  I don’t expect it will end pretty!

Ignore The Shocking Financial Media Headlines

With the kind of year we’ve seen in the equity markets – complete with nosebleed rallies on the upside to new record highs and gut-wrenching plunges on the downside - the financial media has had a field day.  The following are just a few examples of the headlines we’ve seen in the papers, on the talking heads TV shows, and on the Internet over the last couple of years:

“Dow suffers biggest one-day loss in 3 years” – CNNMoney.com, 5/17/2006

“Stock Market Suffers Biggest One Day Loss in 30 Years Today!!” – Internet financial blog entry, 2/27/2007 (not only is this sensational, but it’s wrong – see next entry)

“Dow Ends Down 416, Biggest One-Day Loss in 3 Years” – MoneyNews.com, 2/28/2007 (also not quite accurate – the 2/27/2007 drop was the biggest since 9/17/2001, the first trading day after the 9/11 terrorist attacks, a period of over 5 years)

“Dow Has Biggest Gain in 2 Months…” – Washingtonpost.com, 6/9/2007

“Dow’s gain biggest in nearly 4 years” – Denver Post, 7/13/2007

“Dow suffers 2nd worst day of 2007” – CNNMoney.com, 7/26/2007

I would be remiss not to include a couple of the latest headlines on Monday, following the big sell-off last week:

            “Dow, S&P Have Worst Week in 5 Years” – Yahoo.com

            “Wall Street has Worst Week in Nearly 5 Years” – New York Times

Would someone please tell me what possible value these purposely shocking headlines have for sophisticated investors (or any investors for that matter)?  I have been in the investment business for over 30 years, and I have yet to hear a qualified financial analyst tell me the relevance of such scare tactics.

Granted, there are those who practice technical analysis that do look at trends and various technical indicators, including new highs and lows over given periods of time.  However, such professionals are generally quite sophisticated and are not the target audience of these articles and shows.  Plus, it’s doubtful that even these technical analysts would have much use for a statistic regarding performance events that are years apart. 

Just chalk this up to yet another example of the financial media’s frequent references to useless statistics.  They can use such headlines and catch phrases to sensationalize a larger than usual gain or loss in the market, even though the move may not be significant in relation to the value of the overall market index, or any particular stock. 

What irritates me even more is to see the financial press, especially the talking-head TV shows, trotting out “experts” to comment about how they think a single day’s or week’s performance is indicative of a major shift in the market.  Just take note next time you see a big drop in the market.  The next day, you’ll see all manner of experts declaring how a bear market is upon us.  Just the opposite happens when the market has a strong up day.

We’re seeing exactly these kinds of senseless discussions going on as you read this, in light of the big drop in the equity markets last week.

What Really Matters

As I hope my readers know, the more important statistic related to market movement is the percentage of the move based on its prior position, and the trend in those moves, not how many points were gained or lost.  The Dow Jones Industrial Average provides a wonderful example.  An analysis of historical DJIA statistics, available from the Dow Jones website (www.djindexes.com), shows the following:

1.  When evaluating the 20 most significant percentage losses in the DJIA, the data show that 15 (75%) occurred prior to 1938.  Only five of the largest percentage losses have occurred since then, and only one has happened in the new millennium (and it was due to the 9/11 terrorist attacks).  To put last Thursday’s percentage loss of 2.3% into perspective, it would not even show up on a list of the 20 worst percentage drops.

2.  In contrast, the 20 most significant point losses have all occurred in or after 1987. This makes sense because the market level is so much higher than in earlier years.  However, this higher level makes large point increases and decreases less relevant.  For example, last Thursday’s point loss of 311 points on the DJIA would rank 16th on the list of worst point losses.

The moral to this story is that absolute numbers are virtually meaningless except for the purpose of producing a headline that will have an impact with the audience.  Percentage gains and losses, coupled with the direction of the overall trend in the market, are far more important factors, but I guess they just don’t have the same pizzazz as a big point movement.  Unfortunately, this pizzazz can evoke emotional reactions from investors.

And therein lies the problem.  Since learning of the Dalbar studies back in the mid-1990s, I have been on a campaign to inform my clients and readers that their emotions can be their worst investment enemy.  I have written about Dalbar’s studies a number of times in the past, but to summarize: Dalbar has shown that investors’ emotions many times cause them to hop into and out of the market at exactly the wrong times.  The result is that the average investor does not fare nearly as well as the population of mutual funds in which they invest.

Thus, my advice has always been to largely ignore the financial media, especially in relation to detailed financial advice.  While my staff and I take in a lot of information from these sources, we know what to keep and what to disregard, but this is not true for all investors.

Conclusions – Are There Any?

As it is time to hit the “send” button, it is not at all clear if the big sell-off in stocks last week was just a typical correction in the bull market, or if it will prove to be something more serious.  As noted above, the US equity markets have rebounded so far this week.  For now, the jury is out, but let us not forget that US stocks have regularly surprised on the upside over the last several years.

Likewise, it is unclear how many more hedge fund blow-ups lie ahead as a result of the sub-prime and CDO debacle.  And it remains to be seen whether or not any of the largest banks will have serious problems, with the potential to spark a credit crunch.  BCA continues to believe the sub-prime/CDO debacle will not result in a major credit crunch.  Time will tell.

What we do know is that the economy rebounded nicely in the 2Q, and that the latest inflation numbers show some significant improvement.  Both of these factors, not to mention the sub-prime dilemma, virtually assure that the Fed will not raise interest rates this year.  Continued low interest rates and inflation should be good for the economy and ultimately for the equity markets over the next year or so.

In the near-term, it remains to be seen if the stock markets have further to fall, or if we’ll see new highs in another few weeks.  What I can tell you is that the higher these markets go, the bigger the swings will be in both directions from time to time. 

It is in times like these that I appreciate the fact that I don’t trade the markets myself anymore!  I leave that up to the carefully selected professional money managers I recommend.  Maybe you should too.

Wishing you profits,

Gary D. Halbert

SPECIAL ARTICLES

Analysts debate if bull market has peaked
http://online.wsj.com/article/SB118575324077581751.html?mod=hpp_us_pageone

Is it really noble to be a “public servant”? – good read from Thomas Sowell
http://www.realclearpolitics.com/articles/2007/07/prince_of_darkness.html

Here Come the Democratic Tax Hikes
http://article.nationalreview.com/?q=N2FkMTdkMzRmMWE3YjU0ZGNlNGI1NmU2OGY3ZjQ1MzY=

As Clinton and Obama trade shots, rivals benefit
http://desmoinesregister.com/apps/pbcs.dll/article?AID=/20070731/OPINION01/707310354/1035/OPINION


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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