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.

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.

When the major stock market averages declined by 10% from their 2007 highs on Monday, we were in official market correction. Sentiment is negative owing to the economic back drop of, at best, tepid growth according to the Fed, or a recession.

 

Consumers twenty-five year credit binge fueled by home equity loans, credit cards arriving in the mail, subprime and adjustable rate mortgages and automobile leases, appears to be over. Savings rates has plummeted from 14% to 0% (perhaps to a negative number if home values continue to decline). Pile on top of that the banks debt problems, high energy prices, the homebuilding industry’s woes, weak retail sales and declining consumer sentiment, it’s no wonder that many investors believe a recession is in the offing.

Investors face two challenges right now. If the economy is headed into a recession, where do I put my money? And, if the economy avoids a recession will I be in the right investments? The stock market anticipates the future. It will decline prior to the US entering a recession and it will start going up prior to the end of the recession. Investors who wait for certainty that a recession has begun will be selling stocks at the worst possible time. The same logic holds true if you wait to buy stocks until after the economic recovery, the market will have already moved higher in anticipation. Human psychology is a future complication. We’re most optimistic about the stock market when it’s roaring ahead and most inclined to buy; and most pessimistic and most inclined to sell, when it’s at its bottom. Of course, our investment strategy should be just the opposite.  The moral to this story is that you should invest for the long term and not try to time the market. 

 

If a recession is imminent, the stock market will decline by another 10%. How do you make money? To get technical, buy mutual funds, ETFs and stocks with negative betas or high alphas, such as gold, commodities, real estate and foreign stocks. Gold and commodities already have had good runs, the US commercial real estate market appears to be weakening and foreign economies are increasingly becoming intertwined with ours. Non-investment grade bonds have good yields but are not the place to be given the continuing bank credit problems. High grade bonds and Treasures have relatively unattractive yields, particularly as you go out in maturity.

 

The best performing stocks in a recession are likely to be industry leaders, companies with strong overseas sales, consumer staples and health care. The technology sector is solid and internationally focused, so we’ll add it to our list. Essentially we’re looking at companies whose sales will be strong during a recession. These stocks may not go up in price during a recession but they will perform relatively better than most other equities and are safe investments. The bottom line is it’s hard to make money during a recession.

 

If the Fed is right and we’ll see modest economic growth in 2008, the markets are at their lows and could move 20% higher over the next six months. How do you position your investments for this possibility? By staying in the market and buying the same mutual funds, ETFs and stocks as you did for your recession portfolio. The recession portfolio is a conservative portfolio. Although it will miss some of the dramatic gains made by small cap and more violate stocks, it also protects you from the downside of those stocks while enabling you to participate in any stock market rally.

 

What to do now? Review your long term goals and make sure you’ve got the right asset mix, take losses (up to $3,000 more than your gains, remembering to match short term gains and losses) to minimize your taxes, reposition your equity investments according to our recession scenario, move your bonds into cash and tighten your seatbelt. We’re in for a bumpy ride.

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.

 

Why could the U.S. be heading into a recession? The most likely reason is the housing market – a multi-faceted subject. There’s the new home building sector.  It’s important because it employs so many people, not just in construction but, by extension, in the industries that supply materials to the homebuilders – lumber, concrete, appliances, and even retailers like Home Depot. Think about all the “stuff’ that goes into a home and how much you buy when you move. A slowdown (or collapse) in new home building has a ripple effect throughout the economy and could drive up the unemployment rate. 

 

Housing market problems are not limited to new home sales. The value of your home and the market for sales of existing homes is falling. By how much and for how long is the big question. But the problem here is the equity we have in our homes is evaporating. Even worse, those of us who have recently purchased homes or have taken money out of our homes, through refinancing or home equity loans, may have no equity left. A reduction in home values reduces homeowners net worth, causing them to pull back on spending.

 

The mortgage market mess is the last, but the not least, of the housing market issues.   The big problem is not subprime mortgages, it’s adjustable rate mortgages. Bumps in mortgage payments due to contractual provisions or an increase due to a rising LIBOR rate – most mortgages are tied to this rate and it may rise even if interest rates fall in the U.S. – will force consumers to cut back spending in other areas.   Lastly, will more stringent lending standards exacerbate the new home construction and/or existing home value problems?

 

There are other economic concerns as well – consumer spending (beyond the impact of the housing market), rising energy prices, the U.S. balance of trade deficit (are jobs being exported as a result?) So, if you’re concerned about the possibility of a recession, and who shouldn’t be, how do you invest?

 

The stock market, according to classical wisdom (or folklore) anticipates a recession by six to nine months. Since it’s currently at record highs (at least the Dow and S&P) this suggests a recession is not in the offing. But the market could change direction at any time. There’s a saying that the stock market has predicted ten of the last five recessions.   So maybe it’s not such a perfect predictor after all. The stock market also anticipates economic recoveries.  Add to the mix the psychological difficulty of investing in stocks when things are the bleakest (the best time to buy) and it demonstrates the difficulty (impossibility, for most of us) of trying to time the market. 

 

Most investors should be in the stock market to take advantage of growth in principal value and income which comes through the long term ownership of equities. Stocks which do best in recessions are those of the strongest companies and companies whose products consumers must keeping buying (think toilet paper not cars). The stocks to focus on are big cap companies, consumer staple products and health care. There’s an overlap between many big cap stocks and consumer staples and health care companies. I’d also add to this list companies with significant international sales. (Did you know that a majority of McDonald’s, and many other U.S. companies, sales are overseas?) There’s also a substantial overlap between big cap and international sales. You can find many good mutual funds which focus on these areas.

 

Will this investment strategy provide a positive return during a recession? Not necessarily but it will keep you in the stock market with a minimum amount of risk and the long term investor will be well positioned if there is no recession or for the upturn in stocks after the recession occurs.

 

What about bonds, you ask.  Don’t they do well during a recession? Yes, if interest rates decline as a result, but that may be occurring just when stocks are beginning to rally again. With long term U.S. Treasuries yielding below 5% (some good money market accounts have higher yields) how much lower can interest rates go, so how much higher could bond prices go? Focus your risk-taking investments on the stock market and keep the rest of your capital in cash.

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.

So, what’s the Fed going to do tomorrow? I continue to believe it’s possible there won’t be a cut in the Fed Funds rate. I also believe the stock market will respond negatively, whether or not the Fed cuts rates.

 

The Fed might not cut rates for four reasons:   The self-correcting mechanisms containing the subprime mortgage/debt securitizations problems are working smoothly.  Pimco, and few organizations know more about debt than Pimco, announced the launch of a distressed debt fund last week. Pimco is the second major financial firm to make such an announcement.  The debt market is correcting itself.  A second reason why the Fed won’t cut rates is fear of inflation as evidenced by rising energy prices. Oil was back at $80 per barrel last week. The economy is still growing. Granted, the last jobs report was weak but one report doesn’t make for a sea change.  Solid retail sales offset the jobs numbers (at least for now). Lastly, US exports are strong because of strong global demand and that buoys our growth. 

 

Whether or not the Fed cuts rates, I expect the market to react in the same way – it will go down. This will be a short term reaction but it’s based upon the assumption that if the Fed cuts rates, it will be fulfilling the market’s expectation and the old adage of buy on rumor, sell on fact will hold true. If the Fed doesn’t cut rates, (some) investors will be disappointed and the stock market will decline. It will only be a brief sell off, then the market will resume trying to figure out the fundamentals, so let’s take a look at them.

 

The big question is whether there’s a recession in the offing. The answer to that will become clear over the next 30 - 45 days as we get additional information on employment, retail sales and, in October, third quarter earnings reports. Stay tuned. Right now, it is anyone’s guess as to whether we’ve in a mid-cycle slow down or on the cusp of a recession.  If a recession is coming, expect the stock market to decline by 15% from present levels.

 

The mortgage debacle has been picked over but one aspect of it which hasn’t received enough attention is that most adjustable mortgages are re-set based upon LIBOR (London Interbank Offered Rate), not a US interest rate index (and certainly not the Fed Funds rate). LIBOR is a global index, impacted only in part by what’s going on in the US. Because of stronger economies, central banks around the world are tightening rates. Thus, there’s upward pressure on LIBOR. The result may be an unpleasant surprise for US home owners who discover that their mortgages rate has been re-set higher, rather than lower, even if US interest rates decline. This could be the ticking time bomb that pushes the US economy into a recession.

 

For now, let’s use any market correction as a buying opportunity, all the while having identified our sale candidates if future economic news is not good.