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. 

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.