The House of Morgan is following along with others on Wall Street by writing down a few billion dollars in debt. As with the various reports, each has wiped out much, if not all the earnings of the prior year with a wave of a sharp pencil. Oil and gold prices are rising, the dollar is falling, sub-prime “blowups” are a weekly occurrence and housing remains on its back – little wonder that the stock market (as measured by the SP500) has taken it on the chin by falling just over 5% from its early October peak. As always, the big question is – what happens next? While the clamor for significantly lower stock prices has increased, so too have those calling the recent decline a buying opportunity, especially in some of the more hammered issues (financials come to mind). So which makes the most sense – and is there enough blood in the streets to begin tip toeing into those portions of the markets that could provide investors significant gains in the years ahead. Let’s review the economic situation and then view some of the industry groups. The economy is slowing – even Alan Greenspan gives the risks of a recession at 50/50 in a recent speech. It can be argued that we are actually in a recession as we speak – but it won’t be official until late next year when the government makes their pronouncement. If employment is the driver of the consumer, how is the labor situation holding up? Based on the recent non-farm payroll data, a surprisingly good number was reported and revisions to the prior months provided a much better view of employment than had been the case for much of the year. However, this series is becoming more volatile and subject to large monthly revisions, making this series less reliable. We get weekly readings on initial unemployment claims, which have historically done a reasonably good job of confirming a poor labor environment – it last broke a long-term downtrend late in 2000, well ahead of the worst economic carnage. Save for a bump in claims related to Katrina in ’05, this series has been remarkably stable within a fairly wide range between 300,000 and 370,000 since early 2004 – an indication of a relatively stable labor environment. But, the jobs workers are getting are low paying jobs – but if you look at the average hourly earnings, those figures are running at a 4% annual rate and have been doing so since the first quarter of 2006. So far, the employment picture remains decent – not great, but not falling off a cliff, however these series bear watching for the signs of deterioration in employment. The housing sector has been the flash point for those looking for economic collapse, and certainly the reports from the housing markets have been poor (to be generous). But unlike stocks, not every piece of property is created equal. A couple of examples: my folks have been in their house for over 15 years, making their monthly payments religiously from the start, never taking out equity (the idea is not to have debt!) and while their house has appreciated, they are living roughly the same lifestyle that they have for that 15 year period of time. To them, this housing “thing” is much ado about nothing, as they will continue to make their payments and little will change in their lives. My neighbor of 10 years has pulled out every ounce of equity, as his house had more than doubled in value – did a remodel on the house, bought a second home down in Florida and has a couple of new cars. Then the floating rates begin to float and he is finding out that he can’t get out from under the place in Florida and is struggling to make his monthly payments, now that they have increased by more than 25%. For him, this real estate and sub-prime “thing” is very real and very costly to his net worth. Finally, we have a couple of houses up for sale on our block – one sold a week ago, while the other still sits. Why was one sold and the other remains on the market? There are a variety of reasons too numerous to go into in a short market update letter. Suffice it to say that real estate is not like buying 100 shares of Cisco in early 2000 and watching it drop 80% - everyone loses the same amount, very unlike the real estate market. The point – the real estate market is not like the stock market bubble and will take a much longer time to work out – our best guess is an initial bottom is likely in 2009 and we won’t see a meaningful turn higher in overall real estate prices until sometime 2011-2012. Energy prices continue to approach $100/bbl – and it is, at least over the past couple of weeks, worrying investors. Should it? Unless your investment portfolio is all in the energy sector – yes, but not right away. We are likely to see $3.50 or higher at the pump by year-end, however consumers have been only looking at the marginal costs of filling their tank and not that it cost so much less last year. Same is likely to be the case when the heating bills come in – the philosophy seems to be that “I have to drive to get to work, so I’ll pay the fare” or “I have to keep the house warm (maybe not AS warm!), so I’ll pay the bill.” The real issue is when it begins to affect HOW consumers handle their driving or usage of energy – so far, miles driven has not declined by much nor are the sales of “green” vehicles increased substantially. When we begin to see consumers trading in their Hummers or monster vehicles for a fuel efficient vehicle, we will know we have reached the breaking point.
The markets are in the process of a correction that may blow up into a significant decline. (See chart above) From 2003 to late 2006, the markets traded in a nice channel, hitting both the top and bottom channels multiple times over that three year period. However, once it broke above the top trend line, the rate of growth has slowed noticeable, rising by just over 5% on an annualized rate (based on today’s close) – which was roughly the rate on Treasuries available at the time of the breakout. So, buy the breakout in stocks or buy bonds, your return to date would essentially be the same – bonds without the now three gut wrenching declines of May, August and today. While we won’t necessarily dismiss the moves in the energy and metals markets out of hand, any technician looking at the parabolic move in these markets would be looking for a correction at some point of some significant size. We still like the bond market vs. stocks, even though we may get a short-term bounce from the now very oversold levels in the markets. Today, Bernanke talked, few listened and fewer actually believed what he said. Based upon the trading pattern after he gave his statements, the focus was on the inflation risks of higher commodity prices and discounted his views of an economy that is slowing – but not yet recessionary. Still hewing to the “data dependent” comments, the Fed would be watching the economic data to determine whether to move again in their current rate cutting cycle. The bond market has already leapfrogged the Fed and is expecting another rate cut at their next meeting and is already beginning to price in a Fed Funds rate below 4% by mid-year. Given that the bond market seems to be seeing the economy better than stocks at this time, it may be time to watch what the bond market is saying. Markets were mixed for the day, with the Dow ending lower by 33.73 points to close at 13266.29, and the S&P 500 losing almost a point to close at 1474.77. Crude dropped slightly today, 0.91 points closing at 95.46 while gold gained 1.75 to close at 832.85. Paul Nolte © 2007 Paul J. Nolte, CFA
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