Market Mayhem & Credit Fears

FORECASTS & TRENDS E-LETTER
Gary D. Halbert
September 11, 2007

IN THIS ISSUE:

1. The Economy – The News Is Not All Bad

2. Consumer Spending Remains Firm For Now

3. Housing & Subprime – More Bad News

4. Should The Government Come To The Rescue?

5. The Fed Needs To Act On September 18

6. BCA’s Latest Analysis & Forecasts

Editor’s Note: 6th Anniversary of 9/11

As I am sure all of you are aware, today is the 6th anniversary of the terrorist attacks that saw the WorldTradeCenter’s twin towers crumble to the ground and the Pentagon building attacked. In all, almost 3,000 people lost their lives in the terror attacks that day. As I have watched the news coverage leading up to this anniversary, the archive news footage brings me back to that day six years ago when my whole office staff watched in horror as the towers disappeared before our eyes.

Since that fateful day, we’ve seen a lot of new legislation, a lot of political maneuvering and the loss of even more American lives in the name of taking the fight to the terrorists. I wish I could say that the world is now safer than it was back in 2001, but what I am sure of is that the world is a more dangerous place, and will likely continue to be that way far into the future.

On this 6th 9/11 anniversary, however, my thoughts and prayers continue to be with the families of those killed and injured in the attacks, as well as the families of military personnel killed in action since then. It has been relatively easy for the rest of us to get on with our lives and assume those affected by the loss of loved ones are doing the same. However, I think it’s appropriate for all of us to take a moment and say a heartfelt prayer for all of those who are still coping with the loss of husbands, wives, parents, children and friends since 9/11. May none of them have died in vain.

Introduction

Whenever a credit crunch rears its ugly head, and there have been several over the last 20-30 years, the tendency is to expect the worst. Investors get nervous, stock markets fall and fears of a recession escalate. As I discussed in my August 28 E-Letter, the odds of a recession over the next year have clearly increased as a result of the housing slump and the subprime meltdown. But as I also discussed on August 28, we’ve been through three similar credit crunches since 1987, and in each case the US economy surprised on the upside and stocks rebounded to new record highs.

As always, the gloom-and-doom crowd promises this time is different: consumers have borrowed heavily from their home equity; now home prices are falling, so consumer spending is going to go in the tank; and a recession or worse is a slam-dunk. For these perma-bears, the subprime mortgage crisis is just icing on the cake. Sell, sell, sell.

Never mind that this crowd has been telling you to sell for decades and completely missed the greatest equity bull market in history. But there’s the old saying: Even a stopped clock is right twice a day. So could it be that the gloom-and-doomers finally get it right after so many years of being dead wrong? That remains to be seen, and we may not know for certain until sometime next year.

My best source for economic and market forecasts, The Bank Credit Analyst, continues to believe that a recession is not the most likely scenario just ahead. They believe the Fed will cut interest rates, several times if necessary, and that the government will come to the rescue just as it’s done in the past, if need be. I will summarize BCA’s latest thinking for you in the pages that follow. You may be surprised.

We’ll also look at the latest economic news, both the good and the bad. What, you didn’t know we’ve had some good economic news recently? You can thank the media for that, as they have only focused on the negatives. While consumer confidence took a hit in August, consumer spending remains solid and personal income reached a new high this summer. There has even been a bit of encouraging news on the housing front, which you probably didn’t see reported in the media.

There’s way too much to cover this week, but we’ll start with the economy and some key statistics on US consumers; we’ll then move on to the housing sector and subprime and what the Fed is likely to do, and whether or not the government should come to the rescue; and finally, I summarize BCA’s latest thinking and forecasts.

The Economy – The News Is Not All Bad

Media coverage of the latest economic news has focused almost entirely on the bad news, and there has been plenty. Record high home foreclosures, a plunge in pending home sales (more details below), and the first monthly drop in non-farm payrolls in four years – just to name a few. The question, of course, is whether housing woes and the subprime crisis are enough to bring down the otherwise very strong US economy?

Let’s start with the latest unemployment numbers. Last Friday, the Labor Department announced that non-farm payrolls decreased by 4,000 in August, the first monthly payroll decline since August 2003. Analysts had expected an increase of 100,000 non-farm jobs, so the report was a big surprise. Not only that, the government revised the employment numbers for June and July downward, which was also not expected.

The actual unemployment rate for August was left unchanged at 4.6%, which was heartening until you dug a little deeper into the figures. The Labor Dept. estimates that some 592,000 people left the workforce in August, so they are not counted in the unemployment numbers anymore. We should not be surprised if the overall employment numbers weaken a bit more over the next 2-3 months as the economy slows down.

Let us not forget, however, that unemployment below 5% is still very strong. Further, only those living under a rock should be surprised that unemployment is rising. For example, Countrywide Financial Corp., reportedly the nation’s largest mortgage lender, just announced it is cutting its 60,000 workforce by 20%. Others in the mortgage industry will be following suit, while large numbers of mortgage lenders have already closed their doors. This should not be big news, but stocks plunged 250 points on Friday following the unemployment report.

But as has been the case for the last couple of months, the markets tended to ignore a considerable amount of good news in the last week or two. At the end of August, the Commerce Department revised its estimate of 2Q GDP upward from 3.4% to 4.0% (annual rate). The Index of Leading Economic Indicators rose a solid 0.4% in July (revised, latest data available). Durable goods orders rose a surprising 5.9% in July. Factory orders were up 3.7% in July.

Despite the media’s intense focus on the negative reports over the last few weeks, the economy appears to remain in solid shape overall, even in the face of the many problems in the credit markets and the housing sector. While I think it’s a given that 3Q GDP growth will slow to well below the 4% rate in the 2Q, there is no indication it will fall into negative territory this year.

Consumer Spending Remains Firm For Now

There is a broad consensus that the key to the economy is consumer spending which accounts for apprx. 70% of GDP. On August 28, I reported that consumer confidence hit a six-year high in July but then plunged in August to the lowest level in a year. This led many analysts to predict a collapse in consumer spending. However, the Commerce Dept. reported that consumer spending in July increased 0.4%, even better than in June. Retail Metrics also reported last Thursday that consumer spending increased in July and even more in August. The retail tracking group reported that sales at stores open at least one year rose 3.1% last month, well above expectations. High-end retail chains enjoyed the largest gains, but even Wal-Mart had a 3.1% bump in August.

As noted above, the perma-bears believe US consumers are tapped-out (never mind they’ve said this for years). Consumer debt is at record levels, and even most mainstream economists are wondering when consumers will significantly cut back on spending. Yet I have maintained for over a year now that consumer spending will remain relatively firm so long as the job market remains strong.

Personal Spending Personal Income

There is a powerful link between consumer spending and personal income. As long as personal income continues to rise, consumers will continue to spend. Having said that, I do look for consumer spending to slow down later this year as fears over the housing slump take a continued toll on consumer confidence. But I do not expect spending to fall off a cliff as the gloom-and-doomers assure us it will.

Housing & Subprime – More Bad News

On Wednesday of last week, the National Association of Realtors (NAR) said its Pending Home Sales Index plunged 12.2% in July to its lowest level since just after the 9/11 attacks. The index was 16.1% below a year ago. A home sale is listed as “pending” when the contract has been signed but the transaction has not closed.

Many home purchases aren’t closing because mortgage loans have been increasingly falling through at the last moment. Lawrence Yun, a senior economist with the NAR, explained the large drop in July as follows: “These temporary problems are primarily with jumbo loans, and there are continuing issues for subprime borrowers, but there are no serious problems for the majority of buyers who qualify for conventional financing or FHA-insured loans. Some consumer concerns remain, but since mid-August the market has been stabilizing somewhat.” That remains to be seen, of course.

Then on Thursday of last week, the Mortgage Bankers Association (MBA) reported that the number of mortgage loans entering the foreclosure process set another record high in the 2Q. A seasonally adjusted 0.65% of mortgages on one-to-four family residential properties (including duplexes, triplexes, etc.) were in foreclosure in the 2Q, the highest level in the survey’s 55-year history. Analysts speculated that it could be another year before the foreclosure rate peaks. The media would have us believe this is a nationwide dilemma.

However, a closer look at the MBA survey numbers reveals some interesting details. The worst foreclosure problems are concentrated in four states – California, Florida, Nevada and Arizona. Doug Duncan, the chief economist for the MBA, noted in a news release: “Were it not for the increase in foreclosure starts in those four states, we would have seen a nationwide drop in the rate of foreclosure filings. Thirty-four states had decreases in their rates of new foreclosure and the increases were very modest in the states with increases, other than those four.” [Emphasis added.]

Should The Government Come To The Rescue?

There is no question that the combination of the subprime fiasco and the slump in the housing sector has led to a seizing up in the credit markets and a crisis in confidence. The question is what to do about it, and should the federal government step in with some sort of rescue plan? There seems to be a general agreement that the government should not bail out investors, hedge funds and other players that own subprime debt that is now worth a fraction of what they paid for it.

While an investor bailout is not in the offing, at least as this is written, there are two ways the government can get involved. The most obvious way is via the Federal Reserve which can, and has been, adding liquidity to the financial system, as well as lowering interest rates (more on this below). The other way the government can get involved is through fiscal policy. In general, easing fiscal policy means increasing government spending to inject more money into the economy. You and I know it by a different name - deficit spending.

The problem is, there’s not a liquid market for these distressed securities at present. There is growing talk about establishing an interim government-backed clearinghouse (something along the lines of the Resolution Trust Company) to make a market in this distressed mortgage paper. However, this would not be a bailout of those who hold bad subprime debt; those who own this debt are going to eat their losses. It would simply provide a means for holders of subprime debt and related instruments to sell what are now essentially illiquid assets.

While I am not recommending it, I might speculate as to the rationale that politicians may well use in the coming weeks. In 2006, the federal budget deficit for 2007 was estimated to be $270 billion, and that it would be apprx. $250 billion in 2008 and 2009. Due to much higher than expected federal tax receipts, the deficit for 2007 is now expected to be only around $160 billion and around $185 billion in the next two years.

I can just see politicians rationalizing how they could spend the difference between what they thought the deficits would be and the now much lower numbers and projections. Can’t you? Only the twisted politicians in Washington could envision how to spend money we don’t have just because the deficits are not as large as originally projected. What else is new?

I could see an action whereby the government compels lenders to put a moratorium on mortgage rate “resets,” while at the same time working with lenders and homeowners to refinance predatory loans with outrageous resets that will only guarantee a flood of homes coming onto the market later this year and especially next year.

President Bush is already talking about a program to expand the FHA to assist homeowners who are facing mortgage rate hikes, so do not be surprised to hear of new federal programs to help ease the housing slump, and in the process, the credit crunch.

The Fed Needs To Act On September 18

The Fed Open Market Committee is not known to act on impulse. Nor is it known to act as a result of pressure from lawmakers or industry groups, unless of course that industry group is the banking industry – which in this case, it is. Fed Chairman Bernanke is said to be a serious student of the Great Depression and the actions and inactions that triggered it. I don’t think he wants an escalated credit crunch and a possibly severe, deflationary recession on his watch.

The statement following the August 7 FOMC meeting indicated, in “Fed-speak” of course, that the FOMC is very much aware of what is happening in the credit markets and included the following language: “…the downside risks to growth have increased somewhat…”. This was the Fed’s way of hinting that its concerns may be shifting from inflation to the economy and the credit crunch – as well they should.

The 2Q GDP revision at the end of August, which hiked growth from 3.4% to 4%, also had some good news on the inflation front. The Commerce Dept. revised the “core” price index for domestic purchases down to 1.6% in the 2Q. 1.6% should be well within the Fed’s supposed target range for inflation.

Finally, the Fed has plenty of room to lower the key Fed Funds rate. At 5.25% for well over a year, the Fed could easily cut the rate several times over coming months without risking another “easy money” policy. In fact, the markets are currently priced for a 100 basis point lowering of the Fed Funds rate over the next year.

I think the Fed needs to lower the rate by 50 basis points next Tuesday. If they leave the rate unchanged again, I would expect all hell to break loose in the markets! I would expect another nasty plunge in the stock markets like we saw in late July/early August. But Bernanke & Company know this. I think we’ll get a cut.

Just to be clear, a rate cut by the Fed does not directly affect the problems in the credit markets or the subprime mess. As I have emphasized, what has happened over the last two months is not only the implosion of the subprime space, but more importantly a crisis in confidence has developed. A rate cut by the Fed, more than anything, is simply a signal: Hey guys, we’re not asleep at the switch.

[Editor’s Note: I will write next week’s E-Letter on Monday and Tuesday morning, as usual, knowing full-well that the Fed’s decision to cut, or not cut, will be released Tuesday afternoon after I have had to hit the “send” button – and could render whatever I say useless. Maybe I’ll pick another topic next week!]

BCA’s Latest Analysis & Forecasts

Long-time clients and readers know that I am a huge fan of The Bank Credit Analyst. I have been a continuous subscriber since 1977. In late 1981/early 1982, when the US economy was in a recession caused by the runaway inflation in the late 1970s, BCA made a shocking long-term forecast. Martin Barnes and his fellow editors at BCA predicted that the US would embark on what they called a multi-year (perhaps multi-decade) “Longwave Upturn” which would be highlighted by powerful economic growth, with infrequent, minimal recessions along the way.

The BCA editors based their long-term bullish views on the US on what they called the coming “technological revolution.” It seems so logical now, but the BCA editors were roundly criticized for their foresight back in the early ‘80s. While I never criticized them, I was highly skeptical at least at first. Who could have known the magnitude of the US-led technology boom back then?

In addition to their rosy long-term economic forecast, the BCA editors also predicted an unprecedented long-term bull market in financial assets such as stocks and bonds. And my, oh my, were they right-on! If you had bought the S&P 500 Index at the beginning of 1982, you would have enjoyed a spectacular average annual return of 13.2% (including dividends) since then.

The editors were also correct in predicting that recessions along the way would be few and mild. The US has experienced only two recessions since 1982, and both were mild by historical standards, including the recession of 2001 which resulted from the implosion of the “dot.com” tech bubble.

So what do Martin Barnes and his fellow BCA editors think now that we are in yet another credit crunch brought on by the housing slump and the subprime fiasco? Are we now at the beginning of the end of the Longwave Upturn?

In a Special Report sent to subscribers last Wednesday, the BCA editors make it clear that they do not believe we are now at the end of the Longwave Upturn. While they believe that the current housing slump and subprime woes are far from over, they do not believe these threats will tank the US economy, or send us into a nasty recession, or end the Longwave Upturn – just yet. Barring some major surprises, they believe there is at least one more leg up in the Longwave Upturn, and that the end-game – when things do finally fall apart - is still a few years away.

The BCA editors believe that the current housing/subprime/credit markets dilemma, while it will likely get worse before it gets better, will be solved without a full-blown financial crisis over the next 1-2 years. They expect a combination of monetary stimulus (multiple Fed rate cuts) and possibly fiscal stimulus (some new government housing/mortgage programs), which they believe will get us through the current credit crunch.

They continue to believe the US will avoid a recession over the next year, although they believe the next 2-3 quarters will see much slower economic growth, followed by some degree of a rebound in the last half of 2008. As for the US stock markets, the editors believe that the major indexes will be higher a year from now, but returns are likely to be disappointing due to the housing drag.

So where do the BCA editors think the juice might be in the next couple of years, assuming we avoid a recession and/or a housing meltdown in the US just ahead? For the last year, the editors have been saying that the next boom in the Longwave Upturn is likely to be in the global markets, and in emerging markets specifically. And, as usual, they have been correct; the global equity markets and especially the emerging markets in general have outperformed US equity market averages this year.

Conclusions

While the editors at BCA remain confident that a recession is not likely this year or next, and that the serious problems in the mortgage and credit markets can be ironed out without a financial crisis, we are certainly not out of the woods yet. As noted earlier, the problems in the housing and mortgage markets are likely to get worse before they get better.

This will not be good for the equity markets, although an argument can be made that the US equity markets have already discounted the continued bad news in the housing and credit markets. And there should be some comfort in the markets if the Fed lowers interest rates next week, as I expect it will.

The good news is that the US economy is still on solid ground, even though GDP growth rates are almost certain to slow in the coming months, following the surprisingly strong 4% rate in the 2Q. US consumers are still in pretty good shape as discussed above, but here, too, spending is likely to slow somewhat in the months ahead.

As strange as this may sound, we may want to be thinking about a buying opportunity just ahead in stocks and related mutual funds, especially for those who are on the sidelines. A lot of money has fled the equity markets to the safety of Treasuries recently, and that money will come back at some point, which will help stocks rebound.

But the extreme market volatility we’ve seen over the last two months is not likely to go away anytime soon. I hope I am wrong on this point, but I expect I am not. This argues even more for having professional money managers on your team. Interestingly, requests for information on the professional money managers I recommend have increased significantly in recent weeks.

As always, feel free to contact us if you are interested in getting “active management” strategies, with the ability to go to cash or hedge positions in the US markets, into your portfolio. Call us at 800-348-3601 or visit my website at www.halbertwealth.com. I hope the above analysis has been helpful.

Lastly, we know that many of you forward my weekly E-Letters to relatives, friends and/or associates. Please let them know that they can sign-up to get my weekly E-Letters free of charge directly at my website noted above.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

Reporting to Congress by General David Petraeus
http://www.realclearpolitics.com/articles/2007/09/reporting_to_congress.html

MoveOn.org’s disgusting “McCarthy Moment” – must read.
http://www.boston.com/news/globe/editorial_opinion/oped/articles/2007/09/11/moveons_mccarthy_moment/

Joe Lieberman on why we need to finish the job in Iraq.
http://article.nationalreview.com/?q=NzhmNTQwYWY1ZTY2Mzk5Njg3M2U3OWRmMjA0ODkxY2Y=

Never forget, 9/11 was an act of war.
http://www.nydailynews.com/opinions/2007/09/11/2007-09-11_we_must_always_remember.html