Another piece of the puzzle fell into place last week as the economy slides into a recession. The manufacturing index fell to 48%, anything below 50 signals an economic contraction. The December jobs report was mixed. 18,000 new jobs were created but the unemployment index rose to 5.0%. Don’t be surprised to see the January or February jobs report turn negative, at which time the last remaining significant economic indicator will have slipped into the red.

 

The likelihood of further declines in existing home values was reemphasized last week. Housing prices will have to fall 15% to return to their historical relationship with rents – the point at which renters will consider/be able to afford buying a house. Commercial real estate does not suffer from the same speculative excesses of the residential market but some cracks are appearing in commercial properties as well. Unsold houses being rented are impacting apartment owners, weak retail sales are effecting shopping centers and an economic downturn will effect office rents.

 

Companies are revising their 2008 earnings forecasts downward or issuing cautionary statements, except for the U.S. auto industry. That’s odd since the auto companies biggest sellers are pickup trucks, followed by SUVs, and the demand for trucks is weakening. Oil hitting $100 a barrel last week doesn’t help the auto industry. Although, the $100 mark is a noteworthy psychological level, the different between $92, $95, $98 a barrel oil is immaterial. Rising food prices, driven by crops being planted for biofuel, is a more significant inflationary worry.

 

It’s no wonder that the Dow and S&P are down 4% for 2008 and the NASDAQ is down 6%. Hopes of a Fed rate cute may temporarily buoy the stock market but a rate cut, or cuts, won’t enable the U.S. to avoid a recession. Financial firms and banks have to loosen credit and the residential housing market has to return to equilibrium before the Fed’s actions will have a lasting effect. Look for the stock market to work its way 15% lower.

The economy faces serious challenges in 2008: 1. New home sales are at a 16 year low and may go lower;  2. Inflation will be high for the next few months as energy and food prices work their way through the economy;  3. Retail sales will be weak, as evidenced by the Christmas season;  4. Illiquidity in the credit markets will spread from mortgages to auto loans and credit cards due to financial companies tightening their lending standards;  5. Adjustable rate and subprime mortgage problems will continue; 6. Corporate profits will turn negative. These factors will contribute to, but not cause, the 2008 recession and they will be somewhat mitigated by strong export demand (thanks to the weak dollar) and, at least for the time being, good unemployment numbers.

 

The decline in the value of existing homes is what will cause the 2008 recession and cause it to be the most severe recession since the early 1980s (although not all that bad by historical standards).   The bulk of the average American’s savings is in their home and their net worth is decreasing. There will be far fewer mortgage refinancings and home equity loans to monetize housing values. Declining housing values will cause/force consumers to cut back spending.   

 

Existing home prices were down 3.3% for the twelve months ending in November.  Although sales were up slightly in November, they’re still down 20% from a year ago. Record levels of foreclosures and mortgages which rates adjust in 2008 make it unlikely the November up tick will be sustained.   There will no economic recovery until housing prices bottom. The Fed will cut rates to combat the economic downturn but financial institutions stricter lending standards will mitigate the impact of the Fed’s actions. Thus, we should expect up to four quarters of negative economic growth. 

 

Morgan Stanley, in their December 10 Strategy piece, looked at historical stock market declines and concluded that, on average, the S&P declines 9.5% from its peak to the start of a recession, 18% from there to its bottom, then rebounds by 25% through the end of the recession. The S&P (and the Dow and NASDAQ) is off about 5% from its 2007 high.  This suggests another 23% decline until it reaches its recessionary low. Forecasting is not an exact science (far from it) and the U.S. economy has proven to be remarkably resilient. Also, the S&P is trading at a reasonable level, based on its P/E ratio, so maybe the decline will be less this time, say 15% from current levels.

 

How do you invest for a recession? For stocks and mutual funds look for companies which sell consumer necessities, heath care companies, companies with large foreign sales, high dividend (make sure its secure) stocks and invest internationally. Bonds typically perform well during recessions because of falling interest rates. But with Treasury yields already low and the uncertainties surrounding corporate bonds, you would be wise to keep your fixed income investments short-term until the credit situation resolves itself. What you shouldn’t do, though, is get out of the stock market. The U.S. will come through this recession as it has every other and economic growth will drive the stock market to new highs. As the Morgan Stanley report points out, the stock market rises sharply prior to the end of a recession and nobody can pick the turning point.   Lastly, although I don’t advocate market timing, I’d put new 401-K and IRA contributions into cash for the time being. Cash is king in times like these. 

For the week, the Dow was down 2.1%; the S&P and NASDAQ were off about 2.5%. The new news was inflation. The Producer Price Index increased by 3.2%, in November and 7.2% for past twelve months. The Consumer Price Index was up 4.2% for the same twelve month period. The primary culprit was energy. Gasoline prices increased 35% last month. The only reason the CPI wasn’t up as much as the PPI is that energy companies have been reluctant to pass along price increases for fear of government backlash. Energy prices have been rising, in part, due to a declining dollar. With a $60 billion monthly trade deficit, the world is awash in dollars. This puts further pressure on the dollar, driving up the cost of imports, particularly energy. This is a vicious circle.

 

The old news last week was the housing and financial issues. The financial crisis has tightened credit standards for all potential mortgagees. (These tough new lending standards are spreading to auto loans and card cards.) Tight credit slows down the demand for homes, both new and used. The result is more homes on the market and for a longer time. This puts pressure on housing prices which reduces, or wipes out the homeowners equity, making refinancing or moving more difficult. This is another vicious circle.

 

The international central bank coordination announced by the Fed last week doesn’t address any of the above problems nor does the cut in the Fed Funds rate. The Fed can’t force financial institutions to lend and lending won’t return to normal levels until banks balance sheet problems are cleaned up. And, in view of the recent inflation numbers, the Fed finds itself in a difficult situation because further lowering interest rates to stimulate the economy will also stimulate inflation.

Investors were talking about subprime mortgage problems back in April, yet it took until August for the market to react. The same may be true for energy prices and inflation. We’ve been watching $90 per barrel oil for months but it appeared to have no effect on the economy. Now we may be in for a six to twelve month period of high inflation as we experience the downside of a weak dollar and our dependence upon foreign oil.

 

The economy is operating at close to stall speed but the outlook isn’t entirely bleak. Retail sales were up 1.2% in November and the employment market is strong. The U.S. economy is resilient, witness its ability to absorb the financial meltdown of the late 1980s. Remember the RTC? However, the odds of a recession are somewhere between likely and probable. The prudent investor should prepare for a recession and a period of higher inflation (bad news for bonds). Conservative stocks, mutual funds and ETFs are in order, along with short term bonds.

A front page article in Saturday’s Wall Street Journal, Evidence Grows That Consumers are Pulling Back, discussed the slowdown in spending on cosmetic surgery as a harbinger of a recession.  (I’d like to link to the article but The Wall Street Journal doesn’t allow it. Hopefully, Mr. Murdoch will change this now that he owns the paper.)  It seems as if spending on such surgery had previously been recession-proof. Perhaps it fell under the heading of consumer necessities. Now cosmetic surgeons are feeling the economic pain. The article specifically mentions a drop off in corrective eye surgery and breast implants. There used to be a hemline indicator for the stock market. For every decade starting with 1900, the stock market rose and fell following the length of women’s skirts. It would be politically incorrect for me to suggest an implant indicator, so I won’t. 

 

Are we heading for a recession, and a 15% decline in the stock market from its present levels? Plastic surgeons might say yes. Last week, though, the stock market said no. The popular indexes were up close to 2%. The past two weeks rally has moved the S&P and the NASDAQ close to their 2007 highs. The Dow has lagged somewhat, positioned approximately halfway between its 2007 high and low.  The market responded positively to an anticipated Fed rate cut. We’ll find out on December 11^th what the Fed intends to do, but a ¼ point cut seems baked into the market and some expect a ½ cut. After that’s out of the way, the market will again be left to ponder the likelihood of a recession. On the plus side, the Q3 productivity number was excellent and Friday’s report of 94,000 new jobs created, although slightly below the magic 100,000 number, was encouraging. 

 

The not so good news for the week was delinquent mortgage payments hitting their highest level in 20 years and foreclosures reaching record levels since they’ve been tracked, beginning 35 years ago. The value of existing homes is expected to continue falling into 2009 and level off 15% below 2006 values. Neither the administration’s subprime mortgage freeze nor a cut in the Fed Funds rate will solve these problems. As for the Fed, a ½ point cut would be an admission of just how worried it is about the economy.

 

The stock market is over bought right now. Wait until after December 11 and see what issues the market is focusing on before you commit any new money to equities. If you’re overweighed or nervous, reduce your equity exposure today.

The stock market rebounded this week like a cork popping up after a fish wiggles off the hook. The Dow opened the week below 13,000, declined to 12,725, then railed 647 points to close on Friday at 13,372. The S&P and NASDAQ turned in similar performances. From a 10% correction, fears of a meltdown in the financial sector and recession the preceding week, the market rallied for four consecutive days and closed at its high for the week. What caused this swing? Equity investments in Citicorp and e*Trade demonstrated that capital was available for the financial sector and the financial stocks rallied on the news.  Treasury Secretary Paulson proposed a moratorium on rate adjustments for certain subprime mortgages and Fed spokespersons, including Chairman Bernanke, hinted at the possibility of another rate cut in December. And, overshadowed by all the good news in the financial sector, oil closed at $88.70 a barrel, below $90 for the first time in weeks.

 

Has the economic outlook improved that much to justify an almost 5% move in the stock market? No. The only change was the infusion of capital into the financial sector. That’s good and the financials responded, although I think their lows will be re-tested, but it doesn’t solve their problems. Neither does the government program. The proposed rate freeze for selected mortgages is a band aid which will benefit some homeowners but does not address the underlying problems facing mortgage lenders. The mortgage industry is in for a period of contraction due to the economic slowdown, slowing new home construction, a slowing re-sale market for existing homes and the ability of homeowners to meet their payment obligations, particularly if the employment picture weakens. Interrelated are the tighter lending standards which the major mortgage originators have implemented.  Reality will set in when the initial euphoria wears off.

 

As for oil, who knows how much of the recent movement, in both directions, was due to speculators adding to, or closing out, their positions. Demand for energy is increasing worldwide, even the US is consuming more gasoline this year than last, so don’t expect prices to fall for long. Even if crude prices do fall, consumers are in for a disappointment. Retail prices for gasoline and home heating oil did not rise as much as crude oil, the refiner’s margins took the hit, so don’t expect prices at the pump to fall by much.

 

The economy is still the big fish (a feeble attempt to tie to my opening sentence).   The economic outlook and the problems facing the economy haven’t changed.   Thus, the swing in investment sentiment we saw last week is not justified. Don’t get caught up in the moment. This is not a time to become aggressive. Stick with your long term investment strategy and don’t get hooked.

 

The Dow hit a low for the year on the day before Thanksgiving, down 9% from its 2007 high. The S&P 500 and the NASDAQ are fairing a little better, down 8% from their 2007 highs. (Significantly, all three averages are up for the year, albeit slightly.) The definition of a market correction is a 10% decline. A 20% decline is to be expected if there is a moderate recession or the expectation of one. Are we headed for a recession? Let’s review the economic facts.

Housing, and related, jobs account for 10% of our total employment.  Single family housing starts fell 7.3% in October and permits dropped 6.6%, to the lowest levels in 15 years. (You can see the ripple effect on the earnings of Home Depot and Lowes.) New housing starts have fallen for almost two years. Every time in post-war history housing has declined for two years, it has been accompanied by a recession. On top of this, the value of existing homes is declining, creating a (true) feeling of less wealth and limiting the use of home equity loans to monetize residential real estate. Even if the equity is there, home-related lending standards are tightening, making it harder to get home-equity and new home loans. Tight credit keeps buyers out of the market further slowing new home building and existing home sales.  Is this a vicious circle? Add to this some $350 billion of adjustable rate mortgages which are due to adjust in 2008. Most (all?) of these mortgages will adjust upward.  Many are two year adjustable mortgages which are arriving at their first adjustment – from that attractive low rate to a healthy premium over LIBOR. Under the best case scenario, this will take money out of consumer’s pockets. The worse case is much worse.  Thus far, tightening credit has been limited to the residential market but we now see signs of it spreading to auto loans and credit cards. There’s an excellent article in the November 26 BusinessWeek, The Consumer Crunch, which outlines all the reasons why there will be credit retrenchment in the US. But wait, you say, the Fed can solve this problem by lowering interest rates. It’s true, the Fed Funds rate can be reduced and interest rates should follow (although not necessarily LIBOR-based loans) but a rate cut will not impact lending standards. If financial institutions keep tight lending standards, it’s the same as a tight money policy regardless of what the Fed does. 

 

The Fed is predicting modest growth for 2008, in the 1.8% - 2.5% range (the low end suggests the economy is operating at dangerously close to stall speed), and continued growth beyond.  There are economic bright spots: exports, technology and farming. (Although, let’s also not forget the potential for high energy prices to disrupt the economy.)  Black’s Friday’s retail sales were encouraging and inflation is in check.   However, the consumer accounts for about 70% of the economy. Strong exports and technology sector sales cannot overcome a slowdown in consumer spending. Economists like to point out the resiliency of the U.S. economy and they’re right. But, in this instance, it doesn’t mean we will avoid a recession, it means we’ll come out of it and keep growing afterwards. The problem with recessions is that they’re hard to predict. The old saying is that the stock market has successfully predicted ten of the past five recessions. We won’t know we’re in a recession until we can see it in the rearview mirror. By then we’ll be in it or, hopefully, coming out of it.

 

The stock market is in its second major correction of the year and sentiment is decidedly negative. Is this the capitulation which signals a market bottom or will there be another 10% downward movement to reach the 20% decline typical of recessions?  The honest answer is - who knows? But, that’s not an acceptable answer for an investor who needs to know what to do with his or her money. So, let’s look at the risk/reward for stocks and bonds and make some decisions.

 

The S&P is currently selling at about 13.5x estimated 2008 earnings. This is a reasonable valuation. A market selling at under a 15 price/earnings ratio is attractive. Even if 2008 earnings estimates are 10% too high, the market moves from being undervalued to fairly valued.   If we avoid a recession, earnings and multiples suggest a 20% market rise. So the risk/reward is 10% downside; 20% upside. This is why long term investors should stay in the market. Focus on the companies doing the best – large caps with foreign sales.

 

As for fixed income investments, let’s use US Treasuries as our proxy. You certainly want to stay away from riskier bonds until the credit mess sorts itself out. Five year Treasuries currently yield 3.5%; 10 year yield 4.0%. Why subject yourself to the uncertainly of inflation and other risks over the next decade for such a low return? These aren’t attractive yields given money market fund and bank deposit rates in the 4%-plus range. You’re better off in cash than bonds.

 

The stock market took the long way around last week, with a 300 point up and a 200 point down day, to end basically flat. The Dow and S&P were slightly up; some broader averages such as the Russell were slightly down. Volatility is exhausting.  

 

Financials had another rough week and the Transportation Index was down, at least in part, due to FedEx’s tepid forecast. The financials continued to take a pounding, reaching lows not seen since August. The Transportation Index is often thought of as a bellwether for the economy. Fewer goods shipped implies an economic slowdown.  The index’s performance was consistent with another warning from retailers of a weak Christmas selling season. The high price of oil is taking its toll.  Airline ticket prices are rising as are gasoline prices and worries about the price of winter heating bills is setting in. One pundit put the chance of recession at 40%.

 

There was some good economic news. The core CPI, ex-food and energy, was up 2.4%. Including food and energy, the CPI was up 3.6%, not great but not bad considering the increase in oil prices. The Fed came out with a forecast of slow growth into 2008, also not great but projecting continued economic expansion nonetheless.

 

The key economic report this week will be new housing permits and starts. They’re projected to be down but the question is, as it always is, whether they’ll come in above or below expectations.

 

Where does all this leave us? The economy is operating at just above stall speed and housing or energy could drag it into a recession but, thus far, it is continuing to move forward despite the significant headwinds. Recessions are notoriously hard to predict and the stock market appears to have discounted a 50% probability of one occurring. Bond yields, particularly US Treasuries, remain unappealingly low. Thus, the stock market remains the place to be, although a cautious investment approach is in order.

 

The stock market has drifted down to near its lows for 2007 as it tries to sort out the economic picture. This is an excellent base for an upward move, assuming the more likely scenario of continued economic growth. The market needs a catalyst and it will be the financials. Once the third quarter write-offs are out of the way and the banks provide some comfort that the financial crisis is behind them, even with continuing weakness in the mortgage market, the financial stocks will stabilize and the stock market will move higher. Watch the financials.

Ugly describes the stock market last week. The Dow and S&P were down approximately 4% and the NASDAQ was down 6.5%. The Dow and S&P are approaching their lows for the year, reached during the August credit crisis. It’s hard to believe that just a month ago the Dow and S&P were at record highs and the NASDAQ was at its highest level since 2000. Market sentiment is decidedly negative or, to reuse my opening word, it’s just plain ugly out there. It wouldn’t surprise anyone if the market hit a new low for the year this week.

 

                        October High      August Low      Nov. 9 Close       

Dow                      14,164                12,861             13,043

S&P                        1,562                 1,406               1,454

NASDAQ                  2,859                 2,451               2,628

 

 

What’s happened over the last 30 days to turn the market around?  More bad news came out of the financial industry with Morgan Stanley and Wachovia reporting big write-downs. Worry over the financial institutions has morphed from subprime mortgages to securitized mortgage pools, to collateralized debt obligations (CDOs), to structured investment vehicles (SIVs), and, most recently, to credit default swaps and the insurers of all these derivative instruments. None of this is surprising, or new, news and we have to keep the derivatives issue in perspective. Banks are sound, the problem is contained to the financial industry, and it’s not the first time the banking industry has experienced problems, i.e., the Mexican and Russian debt crises, Long Term Capital Management. Oil is trying its best to hit $100 a barrel, with dire consequences for home heating bills if we experience a severe winter, and the dollar continues to hit new lows (one of the reasons why oil prices continue to rise). The homebuilding industry struggles persist. It was sad to see the pioneer homebuilder, Levitt, file for bankruptcy protection this week. Lastly, retail sales were mixed and retailers are forecasting a poor Christmas season. What puzzles me, though, is that all of the above is old news. It’s been around for months. 

 

The market ignored much good news last week. Exports continued to drive our economy (and are helped by the weak dollar), productivity growth was a remarkably strong 4.9% for the third quarter, wage increases were modest (both suggesting inflation is not a worry) and Mr. Bernanke spoke about continued economic growth (albeit weak in the near term) through 2008. 

 

So why was the stock market at record highs last month and testing its lows for the year this month? Psychology. The glass has gone from being half full to half empty. Which view is right? October’s or November’s? Obviously, only time will tell. We’ll get an important piece of data, though, this week when the CPI is released. That will tell us the impact high energy prices and a weak dollar are having on inflation. My forecast is the CPI, particularly ex-energy, will come in better than expected. And, although, the market may go lower, the issues it’s concerned about have been around long enough for the consumer and business to adjust to them. I stick by my forecast that the market will show a 20% return over the next six to nine months.

The S&P and the NASDAQ were flat last week. The Dow was down about 200 points, the result of its 300 + point sell-off on Thursday.  Citigroup was the culprit.  Its bigger than expected write-downs cost the Dow and cost its CEO his job. With the CEO of Merrill losing his job at the beginning of the week, it turned out to be a very bad week for financial company CEOs. (Is the CEO of Bear Stearns next?) All the financial stocks suffered as a result of Citi’s and Merrill’s woes but the cause of their woes is old news. We already knew about the subprime and collateralized debt problems and we knew the third quarter was going to be bad for banks and their brethren. 

 

The Fed cut rates by ¼ point. Cuts in Fed Funds rates usually boost financial stocks. Not last week. The jobs report on Friday was tremendous. 166,000 new jobs were created, twice the estimate, and well above the 100,000 mark, a broad-brush delineator between strong and weak job growth. 

 

What didn’t the stock market like last week? Oil approaching $100 a barrel? Maybe we’re finally reaching the tipping point where energy prices put a brake on the economy. But, it doesn’t feel like it. That leaves us with the housing market as the guilty party. But wait, the new home building market bottomed a few months ago and isn’t getting any worse (it’s not getting any better, either, and probably won’t for at least another year). What’s left is the value of existing homes (and slow sales/declining prices in the existing homes market).  If the value of existing homes continues to decline, the consumer will feel the reduction in his/her net worth and will cut back on spending.  (And, no more home equity loans and refinancing to take money out). If homes values continue to decline, a recession will certainly follow. Throw on top of this rising energy prices and we have the makings of a category three economic storm.  This is the wall of worry which the stock market must climb. (If the market had no worries, the averages would be significantly higher and the potential reward wouldn’t be there.)

 

Assume for the moment that housing values, and energy prices, level off – don’t improve but don’t get worse. Then, we’re left with a low-inflation, export and technology-led economy with new jobs being created each month. If this is the case, then as I’ve said for the past few weeks, the stock market is reasonably valued, 2008 corporate earnings estimates are in tact, and the stock market could rise by 20% over the next six - nine months.  

 

Oh, by the way, the decline on the Dow as compared to the S&P shows the value of diversification. I’m not suggesting you buy 500 stocks, 30 stocks really are enough but the comparison of the performance of the two indices last weeks illustrates why you diversify.

The market enjoyed a good week last week with the popular averages increasing by more than 2%. The market focused on good earnings growth from technology companies, continued strong international demand, and reassuring news about the mortgage morass. The market shrugged off $90 oil and forgot about its principal worry of the preceding week – Structured Investment Vehicles (SIVs). Energy and SIVs are serious concerns. Squeezed refiners margins, and fear of government action, have limited the increases in the price of gasoline but how long can that continue? Further increases in the price of oil will have to be passed along, if not now, next spring when gasoline demand begins its seasonal increase. Even more worrisome is the impact of cold weather on home heating costs. SIVs are off balance sheet investments (remember Enron), so nobody really knows what going on with them but its safe to say that the question of the quality of their investments hasn’t disappeared in one week. 

 

Two key events take place this week: the Fed meets on Tuesday and the employment report is released on Friday. A cut in the Fed Funds rate would be greeted as a positive by the market but what would it really accomplish? It won’t help the mortgage market because most mortgages are priced against LIBOR (which the Fed can’t control). It won’t help the homebuilders or homes for sale because price is far more important than a small change in mortgage rates in build and buy decisions. Friday’s report will be the more important of the two. Employment figures will give us a further clue as to whether the economy will continue growing, albeit slowly, or if we’re moving closer to a recession.

 

Economists have a poor record of predicting big swings, such as oil going from $30 to $90 a barrel, and major shifts such as a recession. They can’t hit the curveball, but neither can most of us. We’ll only strikeout if we try to chase every pitch, every economic signal. We need to be long term investors. If there is no recession, the market will be significantly higher by next spring, as I’ve written about over the last few weeks. If there is a recession, the market will retract by some 20% but then it will start up again before the recession is over and, probably, when the outlook is bleakest.   This isn’t the time to take risks but to stay in the stock market and stick to your long term investment strategy.