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 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.

The stock market was flat last week. Not a bad performance given that the popular averages are up between 10% - 14% (S&P 10%, Dow 13%, NASDAQ 14%) thus far this year and the market is wrestling with the question of continued economic growth (and, if so, how much) or recession. Last week, the market digested mixed reports on corporate earnings, more bad news about the housing market, a benign PPI number, a continued low level of business inventories, and record oil prices.

Retail sales were up a surprising 0.6% in September. This increase was posted in spite of unseasonably warm weather (ask Al Gore) which reduced demand for winter apparel. Retailers are already bemoaning anticipated weak Christmas sales. Christmas before Halloween?   What happened to the Christmas selling season starting after Thanksgiving? (The good news is that retailers are setting a low bar for investor expectations.) Retail sales are important, consumer spending comprises two-thirds of our economy. The key to continued consumer spending will be what happens to home and energy prices. If home prices continue to decline, consumers will retrench in response to their declining net worth.

 

Oil hit a record high of $83.60 last week. Anyone who doesn’t think there’s a global energy shortage should read South American Nations Face Energy Crunch in the New York Times, October 13th. Our economy has been remarkably resilient to rising (soaring) energy prices, unlike our experience in the 1970’s. At some point rising energy costs will force the consumer to cut back spending in other areas. In the meantime, rising energy prices worsen our balance of trade deficit and force us to keep looking over our shoulder for signs of inflation. 

 

The stock market is priced at a reasonable forward P/E of 14. As I talked about last week (See The Government was the Last to Know), assuming the consensus corporate earnings growth for 2008 and no recession, the stock market should work its way some 8% higher over the next few months.  A very handsome return.  Suppose thought that you want to be in the market but are worried about a recession. How should you invest? Come back on Wednesday and I’ll tell you.

There were 110,000 new jobs filled in September, slightly above forecast and a good showing. The July and August numbers were revised upwards. The August revision was startling, going from a net loss of 4,000 jobs to 89,000 new jobs created. The discrepancy was due to the underreporting of jobs filled in the government sector. Gives you a lot of confidence in the government and their reports, doesn’t it? It also shows the danger of reacting to one month’s data, i.e., August’s initial report. The three months taken together suggest continued, albeit slow, economic growth.

 

The stock market, as usual, anticipated the stronger than thought economy. It had recovered almost all of its losses since its July high and, on Friday, the S&P 500 and Dow both had record high closes. Goes to show, you shouldn’t try to out guess the market and the wisdom of investing for the long term.

 

With new jobs creation receding into the background, at least until next month, the primary driver of the market becomes third quarter corporate earnings reports. Analysts are looking for a down quarter overall, due to the August credit market problems. If the aggregate results exceed expectations it will be a positive for the market.  Given current earnings projections for 2008, and assuming no recession looming, the Dow and S&P should work their way higher by about 8% between now and late-spring of next year. Add in the dividends you receive on your stocks, and your return will be greater. If this market movement  occurs over the next six months, with dividends, it could approximate a 20% annualized return, very respectable when compared to a sub-5% annualized yield on Treasuries and a 2 – 3% annual inflation rate.  So, the stock market is the place to be.

 

We’ll still watch retail sales, the price of oil and the monthly trade numbers but, for now, our primary focus will be on earnings reports and whether analysts adjust their 2008 projections up or down as a result. Assuming the status quo, the stock market will gradually work its way higher in a saw tooth pattern.

On the surface, the latest jobless report was good news. The unemployment rate fell to 4.4%, a great number by anyone’s standards. More jobs means more people setting up new households, buying cars, buying burgers, etc. This increased demand keeps the economy growing and ultimately pushes the value of your equity mutual funds higher. So far, so good.

 

Now, let’s look behind the numbers. 56,000 new jobs in construction. Wow!  That’s great. Homebuilding is rebounding (and everyone trying to sell their home can rejoice because the housing market has turned around). But, wait, that’s not quite true. Construction lost as many jobs the month before, so it’s just back to even. Not so good.

 

Where did the economy shed jobs? The manufacturing sector. Why is this important? Because that’s where the high wages (and benefits) are paid.  Where did the economy gain jobs? Retailing, leisure and hospitality, among others. These are mostly low paying jobs. The sales associate at your local discount store or front desk check-in person does not make as much money as the person building automobiles or airplanes. Not good.

 

The recent employment report suggests the economy will chug along for a while longer but it does not suggest any acceleration in growth and has an ominous undertone for the intermediate and long term. Investment caution is advised.