Why This Recession Could Last Another Year
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Is the US Economy Turning Around?
2. The Housing Blues Getting Bluer
3. Adjustable Rate Mortgage “Resets” To Soar
4. Commercial Real Estate – The Next Shoe To Drop?
5. Conclusions – This Can’t Be Good For Stocks
It’s time that we had a talk about the “conventional wisdom” making the rounds in the financial media. We are constantly reminded that the US economy always comes back and that the frozen credit markets will return to normal. We are also assured that the stock markets always recover and go on to new highs. Yet there is little disagreement that we are in the worst economic downturn since the Great Depression and the worst global credit crisis in our lifetimes.
Despite that, dozens of well-known economists and forecasters now tell us that the US economy will be out of the recession and back into positive growth in GDP by the end of this year. They must assume that the serious housing slump is somehow going to go away this year. It won’t. In fact, the housing slump looks to get worse before it gets better and is likely to drag on for several more years.
Most troubling is the fact that the home mortgage foreclosure rate spiked 46% in March from a year ago, hitting a record high. A record 5.4 million Americans are delinquent on their mortgage loans, or are already in foreclosure. A record 20 million Americans now owe more on their mortgage loans than their homes are worth. Home prices plunged a record 19% in the 1Q.
These foreclosure numbers are almost certain to get even higher over the next year or two at least as millions of adjustable rate mortgages (“ARMs”) are scheduled to “reset” to higher monthly payments, as I will discuss in detail below. Then there is the question of whether the commercial real estate market will follow suit as developers try to refinance their loans over the next year or two. Defaults and foreclosures are already rising rapidly in commercial real estate.
It is for these reasons that I believe the housing slump will get worse before it gets better. If correct, that is not good news for the credit markets or the stock markets. Therefore, it is quite possible that this recession could drag on for at least another year. Let’s talk about it.
Is the US Economy Turning Around?
As the stock markets have continued to move higher, more and more economists and analysts have been revising their forecasts upward. Some polls show that a majority of forecasters now believe that we will be out of this recession by the end of the year. Fortunately, there has been some encouraging news over the last couple of months. The major stock market indexes have rebounded by 35-40% since early March, and many analysts conclude that this is a sure sign the recession will end later this year.
This rosy outlook is helped along by what Fed Chairman Bernanke called “green shoots” (good news on the economy) suggesting that the worst of the recession is behind us, and that the economy should be back in mildly positive territory by the end of the 4Q.
Barring any further major shocks in the credit markets, I would agree that we have probably seen the worst of the recession. GDP plunged 6.3% annual rate in the 4Q and -6.1% in the 1Q based on the latest Commerce Department estimate. A growing number of analysts seem to believe that the economy (GDP) will only dip by 2-3% in the 2Q, improve more in the 3Q and then be flat to slightly higher in the 4Q. Obviously, I think such forecasts are too optimistic as I will discuss as we go along.
But we have seen a few encouraging signs of late. The Index of Leading Economic Indicators rose 1.0% in April, the first monthly increase in seven months. The Consumer Confidence Index rose from 29.7 in March to 39.2 in April. The government announced today that the confidence index jumped to 54.9 in May, the highest level in eight months, and stocks are up sharply as this is written. We have also seen a rise in business confidence over the last month or so.
Unfortunately, the rise in consumer confidence has not led to an increase in consumer spending. Retail sales fell .4% in April after falling 1.3% in March. This is another reason I do not believe the economy will be out of the recession this year. Consumer spending accounts for 65-70% of GDP. Yet consumers are still reducing debt and increasing savings in the wake of the credit crisis, and this trend is likely to continue for at least the rest of this year.
The ISM services index (non-manufacturing sectors) edged slightly higher in April from 40.8 to 43.7, but keep in mind that any reading below 50 is an indicator that the economy is still contracting. That’s about it for the good news of late.
On the manufacturing front, the news continues to disappoint. The ISM manufacturing index stood at 40.1 in April, thus marking the 15th consecutive month of manufacturing contraction. Factory orders declined .9% in March (latest data available), and durable goods orders fell almost as bad at -.8% during the same period.
As everyone knows, the rate of unemployment continues to spiral upward, rising from 8.5% in March to 8.9% in April. Initial claims for unemployment insurance have been well over 600,000 in each of the last two reporting weeks. I continue to believe the official unemployment rate will hit 10% sometime this year.
Despite this, some forecasters still seem to believe we will be out of this recession by the end of the year. Some point to the recent improvement in several foreign economies and conclude that the US can’t be far behind. But as I will discuss in the next section, the US could be well behind these foreign economies in recovering.
Therefore, while there have been a few positive economic reports over the last several weeks, the news is still quite negative on balance. As a result, I am still doubtful, and you should be as well. As I will discuss below, the housing slump – which sparked this recession and credit crisis – is not over, and in fact is getting worse. Home foreclosures skyrocketed 46% from a year ago in March. And most of the other economic indicators and reports continue to point downward.
I continue to believe that this recession will be with us all year. If I am correct, it suggests that the rally in the stock markets will roll over to the downside soon. I continue to recommend that you move some money to the sidelines, put on hedges or at least use stop-loss orders.
The Housing Blues Getting Bluer
Even though some of the economic reports coming out show signs of hope for a recovery, I think it is important to revisit what got us to where we are in the first place – housing. After all, it was escalating foreclosure rates on subprime loans that started this recession and credit crisis, and a number of forecasters (myself included) are still convinced that we will not see the end of this recession until housing begins to recover.
The US housing market has two fundamental problems that look to get worse before they get better. As noted in the Introduction, the home mortgage foreclosure rate spiked 46% in March from a year ago, hitting a record high, as reported by RealtyTrac on April 16.
A temporary freeze on foreclosures by major banks and government-controlled home finance companies Fannie Mae and Freddie Mac ended in February. Filings, which include notices of default, auction sale or bank repossession, jumped 17% in March from February. Foreclosure filings for the 1Q also marked a record high, jumping 24% from the same period a year ago.
RealtyTrac also reported that one in every 159 US households with mortgages got a foreclosure filing in the first three months of this year. Filings were reported on more than 803,000 properties in the quarter. California, Florida, Arizona, Nevada and Illinois accounted for nearly 60% of US foreclosure activity in the first quarter, with a combined 479,516 properties receiving filings.
In the transition from industry freeze to new government rescues, the foreclosure filing floodgates reopened. RealtyTrac vice president Rick Sharga noted that after the foreclosure moratoriums ceased, “We saw an onslaught of notices of default, which is the first stage of foreclosure… The rise in filings suggests a backlog had built up due to the moratoriums.”
RealtyTrac predicts that home foreclosure rates will continue to rise and possibly not peak until near the end of the year. Mr. Sharga continued, “We still anticipate that we'll see upward of 3 million households receive a foreclosure notice this year, up from 2.4 million last year.”
One does not have to be a real estate expert to know that this is very bad news for home prices in general. Mr. Sharga added, “But unfortunately, these well-intentioned delays in [foreclosure] processing might have the unintended consequence of extending the housing downturn, and further dragging down home prices.”
Meanwhile, US home prices are still falling, down over 27% on average from their peak in 2006. In many areas, it is much worse. Even worse still, the Wall Street Journal reported earlier this month that a record 5.4 million Americans are delinquent on their mortgage loans, or are already in foreclosure. Making matters even worse, Bloomberg reported the following day that 20million Americans now owe more on their mortgage loans than their homes are worth.
The National Association of Realtors reported last month that the median existing home price across the nation fell to $169,000 in the 1Q, down from $196,000 a year earlier. Sales of new and existing homes were both down again in March, well below expectations. Housing starts and building permits were both worse than expected in March, with both coming in well below 500,000 units for the first time since such records have been kept going back to 1959.
While these declines will ultimately help to bring an end to the housing glut, it is clear that things will get worse before they get better. This is one of the main reasons I don’t see us coming out of this recession later this year.
Adjustable Rate Mortgage “Resets” To Soar
The other big negative facing the housing slump – and the credit crisis - is the flood of Adjustable Rate Mortgages (“ARMs”) that are due to have their interest rates and monthly payments “reset” to higher levels over the next several years. The riskiest of these loans include subprime mortgages, Alt-A loans, interest-only loans and so called “no documentation” loans. These are collectively called “Option Arms.” It is reported that 90% of all Option ARMs in 2006 were “no-doc” mortgages.
Option ARMs usually reset after five years, at which point the monthly payment typically increases 50% or more. About 38% of option ARMs originated in 2005 are still outstanding, 63% of the 2006 vintage are outstanding, and 82% of the 2007 loans remain outstanding, according to Barclays Capital. And about a third of the outstanding loans in these years are deeply delinquent.
All of these loans are scheduled to reset over the next few years if they are still outstanding (ie – have not defaulted). Unfortunately, most of these homeowners cannot qualify for traditional 15 or 30 year mortgages. That’s too bad since today’s mortgage rates are below 5% in some parts of the country. The bottom line is that many of these option ARMs are going to default, especially given that home prices continue to slump – down a record 19% in the 1Q alone.
The chart below is reprinted from a major study published recently by Credit Suisse which projects the dollar amounts and timing of upcoming option ARM resets. Note that the vertical axis is in billions of dollars. As you can see, the amount of option ARM resets will explode over the next several years, thereby dumping millions more foreclosed homes on the market.
Source: Credit Suisse
I should note that in February President Obama carved up to $75 billion out of his $787 billion stimulus package for what he called a new Federal Loan Modification Plan. This plan would make money available to banks and mortgage lenders so that they can modify loans to distressed homeowners. However, since most option ARM loans are paying no principal (and many not even 100% of the interest), this latest bailout is not likely to make a significant dent in the rising foreclosure rate. Ditto for the $2.2 billion rescue plan passed by Congress last week.
I should also mention President Obama’s $8,000 tax credit for first-time home buyers in 2009. Earlier this month, it was reported that first-time home buyers accounted for over 50% of home sales in March. Yet as reported above, new and existing home sales have declined each month so far this year. There are simply way too many homes on the market, and many more are coming in the next few years as implied by the chart above.
Commercial Real Estate – The Next Shoe To Drop?
The drumbeat of bad news in the commercial real estate sector continues to worsen, and many are worried that this could be the next big shoe to drop in the credit crisis. The US commercial property market is huge and is widely estimated at apprx. $5.3 trillion, of which apprx. $3.5 trillion is financed.
Foresight Analytics, a California-based consulting firm that serves institutional investors and lenders, estimates that close to $1trillion of the outstanding $3.5 trillion in commercial real estate loans is due to mature between now and the end of 2011. Not only is the default rate on commercial loans rising, the credit crunch has made such loans very hard to obtain when it comes time to renew them.
Widespread defaults in the commercial lending market would be devastating, as they were for Lehman Brothers, whose bankruptcy was precipitated by nearly $30 billion troubled commercial loans. In a May 19 report, the Wall Street Journal estimated that commercial loan losses for the 19 major banks that recently underwent the government’s stress tests could easily total $200 billion between now and the end of next year. In addition, the Journal estimated that smaller and mid-sized banks could suffer losses of another $100 billion over the same period.
Using the same scenario as in the government’s stress tests, the Journal examined 940 small and mid-sized banks around the country, and the results are troubling. Using the stress test criterion (which are not all that bad), the Journal found that more than 600 small and mid-sized banks would see their capital shrink to levels that would be “worrisome” for federal regulators.
The Journal concluded: “The findings are a stark reminder that the U.S. banking industry’s problems stretch far beyond the 19 giants scrutinized in the government stress tests. Regulators and investors have focused on too-big-to-fail banks such as Bank of America and Citigroup Inc. But more than 8,000 other lenders throughout the country are being squeezed by the recession and the real-estate crash.”
Making matters worse, for several years commercial mortgage loans have increasingly been packaged together and securitized into “Commercial Mortgage Backed Securities” (CMBS), much like with residential mortgages. Banks, investment banks, insurance companies and others could trade these loans on the CMBX (Commercial Mortgage Backed Index) market to offset some of the risk. We’ve heard this song before (read: subprime).
Not surprisingly, the issuance of CMBSs imploded in 2008. Earlier this year, JP Morgan Chase reported that issuance of CMBSs plunged 95% in 2008. The CMBX market is all but dead today, which virtually assures that commercial mortgage defaults will continue to increase. The Mortgage Bankers Association estimates that at least $171 billion in commercial mortgages will come due in 2009 alone.
It’s a vicious circle. The recession means lower consumer spending, which in turn causes problems for commercial businesses that rent space. In turn, rental income for commercial developers goes down. Then there is the fact that the value of commercial real estate is declining in general, and you have the perfect conditions for a spike in the default rate.
Then you throw in the credit crisis. Even developers that can prove their commercial properties are still profitable, despite the recession, are finding it next to impossible to find sources to renew their loans and maturing mortgages. We have just such an example right down the street from my office where a huge new “Galleria” mall recently filed Chapter 11 bankruptcy because it cannot find any lenders to renew its maturing construction debt. Yet the mall is teeming with customers, and most of the retailers, restaurants, etc. report that business is booming.
Conclusions – This Can’t Be Good For Stocks
While a growing number of economists are upgrading their forecasts, and more are predicting we will be out of this recession by the end of the year, I do not agree. While it is possible that we have seen the worst of the recession in the 4Q of last year and the 1Q of this year, I will be shocked if this economy is in positive GDP territory by the end of the year. There is simply too much bad news out there.
I do not believe that this economy will get back to positive growth until the housing crisis at least stops getting worse. Based on the discussion above, the housing crisis is set to get worse before it gets better. Maybe it starts to get better (ie – not getting worse) sometime in 2010. In any event, the housing slump will be with us for several more years as we work off a record large inventory of unsold homes, which will likely get even larger as option ARM resets lead to a continued spike in foreclosure rates.
Then there is the issue of commercial real estate defaults. As discussed above, most experts agree that the default rates on commercial real estate loans and mortgages will rise for at least the balance of this year, if not longer. We don’t hear much about this in the news, but I think it is safe to say we will in the months ahead. And it won’t be pretty.
I don’t believe most investors and the markets fully understand the ominous implications of what will almost certainly be a $2+ trillion federal budget deficit for fiscal 2009 and $1+ trillion deficits for years to come (especially if President Obama is re-elected). This mind-boggling explosion in our national debt is quite bearish for America’s economic and financial future.
For all these reasons, I believe the recession will last considerably longer than most forecasters have recently predicted. Likewise, for all these reasons and more, I do not believe that the recent strong rebound in the stock markets will last.
The S&P 500 Index has heavy overhead resistance at the point where is began to struggle two weeks ago. We may be witnessing the rollover to the downside again. For several weeks, I have recommended that you use this rally to move some money to the sidelines, put on hedges or at least use trailing stop-loss orders.
This may also be an ideal time to consider one or more of the professionally managed programs I recommend that have the flexibility to move out of the market and/or hedge long positions should the trend turn down once again. More aggressive investors may want to consider one or more of the professionally managed programs I recommend that will “short” the market.
Over the past year as the stock markets imploded, we have seen the fastest pace of new account openings in several years. More and more investors are finally coming to realize that “buy-and-hold” simply does not work in these unprecedented times, and are putting some of their investment money with the managers I recommend (and who manage my money).
If you would like to discover how active money management strategies might affect your portfolio, please feel free to call one of our Investment Consultants at 800-348-3601, send us an e-mail at firstname.lastname@example.org or complete our online information request form (your personal information is strictly confidential). As always, our consultations are available to you at no cost and there is never any obligation to invest.
Wishing you profits,
Gary D. Halbert
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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.