Ignore the endless bottom calling in the press that is buzzing around with some financial pundits pointing to the Bear Stearns blow-up as a likely capitulation in the markets. One thing that should be abundantly clear is that Wall St. tends to err on the side of optimism. I recently watched a clip of Maria Bartiromo being interviewed while in the U.K. who said that the financial media was playing a role of talking ourselves into a recession. What struck me was nowhere in the interview did the other side of the coin come up, that we can talk ourselves into a euphoric bubble. I guess it's important to keep up consumer confidence, at least that's what Stephen Colbert from Comedy Central maintains in his segment, "The Audacity of Hopelessness." (Click the link for a little humor.)
From 2004 to early 2006 all we heard about was the booming economy led by housing and the record homeownership in the country, which was supposed to be a “good thing,” and never any mention of the “bubble” that was brewing in housing with risky mortgages being made and the garbage being securitized all over the world. Not only had the financial press failed to take a balanced view of the economy by presenting the risks of bubbles brewing, but they have also played down the bubbles bursting with endless bottom calling and “containment” nonsense.
Well, expect another round of this excessive bottom calling with the “capitulation” in the markets over Bear Stearns demise and the markets rally from yesterday’s Fed cut. Yes, the markets are deeply oversold and various technical positive divergences are pointing to some sort of rally, but the headwinds facing the economy and the stock market are far from over for two reasons.
No “Bottom” for Bank Losses
As bank losses mount the number of unprofitable institutions has surpassed the 2001 recession and is fast approaching the levels of the 1991 recession. The positively sloped yield curve is benefiting banks profitability, though the negative factors of an increase in loan loss provisions and non-interest expense are trumping the benefit of the positive yield curve engineered by Fed rate cuts. Moreover, the surge in negative factors is causing quarterly net income and return on assets (ROA) for the banks to quite literally fall off a cliff as bank losses surge.
Figure 1
Source: FDIC: Quarterly Banking Profile
Figure 2
Source: FDIC
Figure 3
Source: FDIC
Figure 4
Source: FDIC
What is important to understand and also why the bottom in the markets will remain elusive is that bank losses in the residential real estate are nowhere close to peaking and bank losses are now spilling over to other loan categories as the credit crisis infects the other areas of the baking sector. Many in the financial press are solely focusing on subprime losses while ignoring (denying) the losses in other areas. For example, bank loan exposure to residential mortgages is just under 28% of total loans outstanding and represents 32% of total bank net charge-offs. Non-residential mortgage’s make up 72% of bank loans outstanding and 68% of bank charge-offs. Credit cards represent only 5% of loans outstanding yet make up 26% of bank charge-offs with other consumer loans representing 8% of loans outstanding and 19% of charge-offs.
Figure 5 – FDIC Bank Loan Composition
Source: FDIC
Figure 6 – FDIC Bank Charge-Off Composition
Source: FDIC
As the above analysis shows, bank charge-offs go beyond residential real estate as the credit contraction has spread to every loan category. Additionally, these losses are also uniformly increasing which supports the notion that we can not call a bottom in the markets when no one knows when the top in losses will be.
Figure 7
Source: FDIC: Quarterly Banking Profile
Figure 8
Source: DismalScientist
Exports Likely to Support, Not Save the Economy
The other reason why the bottom in the markets will remain elusive is that the economic recovery will not likely take place in the second half of this year, as is the main consensus, but be pushed out into late 2009. The main reason cited for near-term economic strength is growth in exports (and the government’s stimulus package). Exports are indeed contributing positively to incremental economic growth but how big are exports as a share of GDP and how many people in this country work in export industries versus service industries? The lion’s share of GDP still belongs to the consumer (personal consumption expenditures) who makes up 70.5% of total GDP while net exports remain a drag on GDP as our imports continue to exceed our exports.
Figure 9
Source: BEA
Figure 10
Source: BEA
So the question remains if the export economy is set to improve in the future with a weaker dollar, how beneficial will that be to our aggregate economy? The answer to that question in terms of employment is not much. Our manufacturing base now makes up only 9.9% of total employment while our service economy represents 84.2% of total employment.
Figure 11
Source: BLS, BEA
Figure 12
Source: BLS, BEA
In actuality, a falling dollar is more likely to be a net negative on the aggregate economy than a positive as the manufacturing sector represents a small portion of the economy, and the ENTIRE economy is hurt by rising import prices as our purchasing power falls. As the saying goes, “No nation in history has ever devalued its way into prosperity.”
Figure 13
Source: Federal Reserve Bank of Atlanta/BLS
What is likely to trump export growth is a consumer retrenchment led by falling employment and falling household net wealth. The three-month employment diffusion index fell below 50 in November, indicating that more industries were letting workers go than hiring. The diffusion index continues to head south as employment conditions worsen which will reduce incomes, and thus consumer spending going forward. Adding insult to injury, all three major household assets are declining which is likely to weigh on both consumer sentiment and spending. Real estate, mutual fund shares, and corporate equities all turned south in the fourth quarter and are likely to remain in negative territory in the first quarter of this year as home price deflation accelerates and the stock market heads towards new lows.
Figure 14
Source: BLS
Figure 15
Source: FRB – Flow of Funds
There is very little doubt that we are in recession presently as Goldilocks remains aloof. What is troubling about being in a recession is that our economy is in far worse shape than it was entering the recessions over the last quarter century as was shown in a previous WrapUp (Proceed with Caution, 08.22.07). The figures below show various economic indicators just prior to the first quarter of negative growth in GDP, and “current” represents data from August of last year. What the figures show is that the economy in August was on the worse footing than in any of the previous periods just prior to a recession, with the state of the consumer also at the worst position relative to the last several recessions.
Figure 16
Source: BLS, BEA
Figure 17
Source: FRB, BLS, BEA
The CFO Survey conducted by Duke University released last week confirms the notion that the economy will not likely stage a recovery until next year. Key points from the survey are listed below (click here for the link, bold emphasis mine):
Optimism among chief financial officers in the United States has plummeted, with most CFOs saying the economy is currently in recession or will be in recession at some point during 2008. Nearly 90 percent of CFOs say the economy will not rebound until 2009. They expect inflation will increase to 3 percent this year.
Weak consumer demand and turmoil in the credit and housing markets are the top macro-concerns of CFOs. The high cost of labor ranked as the top internal concern.
Credit conditions have directly hurt 35 percent of companies, through decreased availability of credit and higher interest rates (up 118 basis points on average). Sixty percent of firms have postponed expansion plans in response to credit market unrest.
“There are some very significant findings from the survey,” said Duke professor Campbell R. Harvey, founding director of the survey. “Seventy-four percent of CFOs say the Fed cuts have had no impact on their business. Clearly, the Fed needs to switch to Plan B. Yesterday’s money market intervention announcement by the Fed is consistent with their desire to try a new reaction function.”
“Second,” Harvey noted, “the last two recessions lasted only eight months. In contrast, 90 percent of the CFOs do not believe the economy will turn the corner in 2008. Indeed, many of them believe it will be late 2009 before a recovery takes hold.
“This could be the longest slowdown since the double dip recession of 1979-81.”
“We also asked CFOs to rate the economy on a scale of 0 to 100, with 64 being the average rating since 2001,” Graham said. “The current rating is 52, the lowest score in the seven-year history of the optimism index. This is dramatic because CFOs have a track record of accurately predicting future economic activity, and their predictions run one or two months ahead of other common economic indicators. With overwhelming CFO pessimism, we expect weak capital spending and employment in 2008.”
Figure 18
Source: Duke Global CFO Survey
As outlined above, do not be suckered into thinking that this thing is over with “capitulation” and “bottom” calls being thrown about. Though the stock market works like a discount mechanism in forecasting future developments, the financial deleveraging and economic deceleration are far from over and thus, it is way too soon for the markets to be bottoming in anticipation of an economic and financial recovery. The CFOs are far better at forecasting the future than the financial press and economists. One is likely to be on the wrong side of the trade when betting against the CFO crowd based on their track record and with CFOs not expecting an economic recovery until late next year. Anyone calling for a bottom in the here and now will likely fail to find their footing as the “bottom” keeps falling to lower levels.
Today’s Market
Despite the markets initial rally in early morning trading driven by a positive earnings surprise from Morgan Stanley, and from the news that OFHEO will relax its excess capital restrictions on Fannie Mae and Freddie Mac, stocks gave back more than half of yesterday’s gains as a sell-off in commodities led the markets lower. There was a serious flight-to-quality into Treasuries as the yield on the 3-month T-bill fell 25 basis points to 0.65%, the lowest yield on the 3-month T-Bill in nearly 50 years.
Gold fell more than $50/oz to $943.30 per ounce while crude oil fell almost $5/barrel to $104.48/barrel after the inventory release which showed an increase in crude oil stockpiles.
The Dow Jones Industrial Average fell 293.00 points to close at 12099.66 (-2.36%), the S&P 500 lost 32.32 points to close at 1298.42 (-2.43%), and the NASDAQ shed 58.30 points to close at 2209.96 (-2.57%). Declining issues represented 70% and 68% for the NYSE and NASDAQ respectively, reflecting a mostly down market.
