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 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.

Last week we received further evidence that the August credit crisis is resolving itself in orderly fashion. The First Data buyout went through and investors eagerly snapped up the debt to finance it.  The buyers of Harman and Sallie Mae reneged on their purchases. The prices were just too high in today’s rational debt world. Credit market problems and subprime mortgages are old news. As I’ve written about before, adjustable rate mortgages that re-set based on LIBOR will be a problem (see The Economic Crises of 2008 and On the Rebound), so the housing/mortgage market isn’t out of the woods yet.

 

New homes sales dropped to their lowest level in seven years (still, not bad compared to the long term average for annual new homes sales) and the sales prices dropped by 8%. This is a cyclical slowdown in the new homes market and is separate from any mortgage problems, but if it is coupled with a decline in value of existing homes it likely will plunge us into a recession. Further Fed cuts won’t prop up home values, what will mitigate it is a growing economy and that brings us to our final point. 

 

This Friday, the September jobs report will come out. (Remember, August’s was a disappointing 4,000 new jobs created.) The preliminary indication is 100,000 new jobs created in September, a number sufficient to suggest that the economy will keep growing, albeit slowly.

 

The market is craving economic news so it can determine if we’re heading for a recession or continued economic expansion. Housing values and mortgage rate adjustments will play out slowly over the remainder of the year. This week, the market will focus on Friday’s jobs report and will market time until then.

The question on every investor’s mind is: are we experiencing a mid-expansion slowdown or are we on the cusp of a recession?   But even a recession would be just a bump in the road when compared to the damage to the economy, and the value of our investments, which would be brought about by a decline in the value of our homes or the huge US trade deficit.  

 

Housing prices nationwide have increase by 50% over the past five years, although some speculative markets, think parts of Florida and California, have shown prices decreases this year. Given the run up in housing prices, a 10% correction is not out of the question but it could put the economy into a tailspin. Why?  Homeowners have been taking out the increase in the value of their homes through home equity loans and/or refinancing with higher principal balances.   If, for example, a homeowner had 20% equity in her home, but the value of the house fell by 10%, 50% of her equity would be wiped out. (Don’t believe it? Run the numbers. This is the downside of leverage.) 

 

A downturn in the housing market could exacerbate a decline in home prices. New homes construction has slowed, there’s a backlog of houses and condos purchased by speculators to be worked off, mortgage rates could go higher, and mortgage terms are getting tighter as a result of the subprime debacle. Why would mortgage rates go higher since the Fed is cutting rates, you ask? The answer is that many mortgages, including adjustable rate mortgages, are priced off of LIBOR, a London-based rate.   Interest rates in Europe and elsewhere outside of the US are going up (and US interest rates could go higher, as discussed below). The result of a decline in housing prices and/or increasing mortgage rates will be a reduction in consumer spending that could plunge the US economy into a recession.

 

The annual US trade deficit has ballooned from approximately $100 billion in 1997 to an estimated $800 billion in 2007.  What does the world do with all those excess dollars? It invests some back in the US stock market, buys American companies, real estate, and US Treasury securities. Foreigners buying US Treasuries is good for us because it helps us finance our domestic budget deficits. The 2007 deficit is estimated to be in the $200 billion range.

 

Along with trade and fiscal deficits, the value of the dollar vis a vis other major currencies has been declining. Compared to the Euro (and a market basket of Western European currencies prior to the Euro), the dollar has depreciated in value by 38% over the past ten years. You’ll only hold a depreciating currency if the return on your investment exceeds its decline in value. In other words, the yield on US Treasuries has to compensate a European, for example, for holding a security whose principal value declines each year as the dollar declines, and provides a net return equal or greater than the return on Euro dominated government bonds. 

 

The bigger our trade deficit, the bigger becomes the problem of recycling dollars.  By the way, our single biggest import is oil and oil is priced in dollars. Thus, as the dollar declines in value, the price of oil will increase, adding to our trade deficit (and inflation). A vicious circle if there ever was one. Will the world keep accepting US dollars? Probably, but at a price. Foreigners will demand higher interest rates on US Treasuries to compensate them for the dollar risk. This will have a ripple effect through our economy, driving up the cost of corporate borrowing, home mortgages, and causing a decline in stock prices as returns adjust to higher interest rates.

 

The government lacks the tools to quickly address either a housing value or trade deficit problem. Lowering interest rates further to ease the homeowners/mortgage holders plight would increase the fiscal deficit and create inflationary pressures. Let’s hope for a soft landing here. The only cure for a trade deficit is further depreciation of the dollar, a likely scenario, and a solution to our dependence upon foreign energy, an unlikely scenario in the near term. Let’s hope foreigners will be happy to hold more dollars at the current interest rates. But, it’s just that – a hope.

 

A decline in housing values or a trade deficit-induced crisis could throw the US economy into a recession of the depth not seen since the 1970s. Interest rates would go higher, unusual in a recession, and the stock market could correct by 40%. Invest cautiously.

Last week was a week of records. The Dow and S&P closed at new highs. The NASDAQ closed at its highest level in six years. Oil closed at $74 a barrel, an 11 month high. The Euro hit an all-time high against the dollar. It now takes over $1.38 to buy one Euro. (My sympathy to all of you vacationing in Europe this summer.) 

 

Twice last week I read/heard commentators saying that rising oil prices are good – they’re a sign of a strong economy. The talking heads glass is half full (and I think it’s filled with something stronger than water). Rising energy prices worry me. They take money out of the consumers pocket, add to inflation and increase our balance of payments deficit, leading to higher interest rates. Sorry, my glass is half empty on this one, but maybe I’m just old school.

 

Something else happened last week, which received almost no press. Credit spreads widened. This means the yield on junk bonds rose, even though the Treasury market was flat. Why did junk bond yields (and the cost of financing with junk bonds) go up? It could be due to ongoing problems in the subprime market and/or the amount of private equity transactions which need financing. Or it could be something more ominous.

 

The bond market has been better at calling turns in the economy than the stock market. The players in the junk bond market are really smart guys (and women). If their glass has gone from half full to half empty we better beware.

 

Here’s how events could play out. Rising interest rates in the junk bond market ripple through all classes of debt. The continuing record trade deficit and the declining value of the dollar cause foreigners to demand higher returns to hold US Treasuries. The result is both rising interest rates and rising credit spreads (making junk debt financing more expensive/driving the price of existing bonds lower).   The tipping point from rising interest rates to a full blown credit crisis is a debacle in the subprime market or the inability for a private equity firm to finance a big transaction (think Chrysler, Hilton, Sallie Mae). 

 

Interest rates will rise and, at some point, the stock market will switch from viewing the glass as half full to half empty. Soon, I think.

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.