I’m not convinced the recession is over, but for arguments sake lets assume it is. Why didn’t the stock market bottom lower than it did? Given the S&P 500 at 666 and assuming, generously, $60 earnings equals a PE of 10. That’s a much higher bottom than it’s bottomed before.
I believe there just isn’t enough pain out there. Or maybe more appropriately the pain isn’t being distributed properly. The bottom 17% of the US that is un or underemployed is receiving the majority of the pain. Of that 17% many of them are collecting generous unemployment benefits. Another good portion of them may have sizable savings to fall back on. This whole situation needs to be given more time before some serious pain is felt.
What are we fighting for?
How much of this stimulus money is being spent on something worth sustaining? Sustaining the finance industry in its current state is a complete waste of resources (time, oil). It’s becoming more and more obvious that the finance industry is a giant leach on the rest of the economy by sucking money out of it while increasing, not decreasing, the costs of capital. Sustaining the majority of the auto industry is a disappointment. I could understand sustaining and auto industry where everyone could afford to drive an Acura TL, but most of the cars produced are garbage that merely get you from point A to point B. Is that really what a driving experience is about? What’s the point of sustaining a farming industry that pays farmers to not produce? What’s the point of sustaining an airline industry that, after the first 3 hours that includes driving to the airport and going through security, after delays, takes 6 hours for a 3 hour plane ride? What's the point of sustaining state and local governments where politicians and high ranking or tenured emergency workers make 5 times as much as an average government worker but don’t add anywhere near 5 times the value, if any value. I hate for this whole rant to be viewed as a healthcare rant, but I’ll end by saying with all those problems the worst problem of all is that the US can’t even take care of its own people, medically. I hate to imagine how many children or young adults will never become Doctors and Engineers because either they themselves became ill or because someone in their family became ill and the financial problems associated with it prevented them from moving forward.
How’s this going to play out, economically?
When you think about it it’s all very simple. Especially when you throw out what needs to be done or what should be done and just face the facts as to what will actually be done. The government is going to keep trying to stimulate the economy because that’s what the majority of voters want. The government won’t be able to afford to pay it’s debt when they come do so they’ll have to print the money to pay for them. Interest rates will go up as a result. Certain commodity prices will go up as a result. The quality of life for many Americans will decline.
Are prices YOU pay increasing or decreasing?
I’m talking about prices you actually pay. Not some government estimate. One example is not enough to make a conclusion about, so here are few examples.
Price decrease wise (aka Deflation, but a decline in the money supply really Deflation), here is what I see:
Total spending on natural gas used for residential heating will be as much as 50% lower than 2008.
Monthly rental prices for residential apartments have come down almost 20% in some very livable locations near me.
Many restaurants have been offering some sort of coupon.
The cost of high quality chicken and beef at the grocery store has declined almost 20%.
When on sale, which used to be only a Christmas time, the cost of dress clothes at department stores are the lowest in 5 years.
When on sale, which used to be never, the cost of power tools has decreased to the lowest in at least 4 years.
The price of televisions, although hard to measure because of increasing technology, has decreased 5% from last year.
Home prices continue to decline in my area. Considering that such a high percentage of someone's expenses that offsets a lot of price increases.
When on sale, which this is the first year I’ve seen them on sale, middle class lawnmowers are about 20% lower than the prices on the 2007 models.
Cement construction (aka cement driveways) are about 20% lower than 2008 prices.
Price increase wise (aka Inflation, but Inflation is technically an increase in the money supply such as the increase in the Federal Reserves balance sheet), here is what I see:
Trash removal costs have gone up. However the trash company advised that the increase was a direct result of passing on higher land fill taxes to the consumer.
Another increase due to higher taxes: Registration costs for automobiles have gone up.
Electricity distribution costs have gone up. For the time being this has been offset by the lower cost of the electricity itself.
Home owner’s insurance rates have increased; possibly because less people are actually paying their insurance.
Prices that have not gone down.
Gasoline. I don’t see any reason for it to go down for a sustained period of time either. It’s simply going to cost a lot more money to extract new oil to replace the oil currently being pumped.
Healthcare. Of the people that have money and/or jobs, they simply have more money available to spend on healthcare. More money chasing the same amount of resources leads to higher prices. Not to mention the inefficiencies of insurance, which easily increases the price.
The decline in rent and house prices doesn’t help most people. Only 40% of the population either rents or has a mortgage that they can walk away from.
Thoughts
- Much sooner than later the supply of treasury bonds will be too big for the current group of bond investors to buy and the natural way to entice other investors to buy them will be for the rates to go up. However, the Fed can simply step in themselves to buy the bonds or they could do some unnatural things like make the interest on treasuries tax free. Lately the Fed is doing all kinds of unnatural things to prevent rates from going up (like all these bailouts, without the bailouts rates would be much much higher right now) so it’s very hard to say if the rates will actually go up.
So should rates go up? Naturally they should. Will the Fed do something unnatural to keep them down? Probably. How well will it work? I think the 10 year treasury could go to 4.5% from 3.5% now, but at 4.5% the Fed will really start doing some unnatural things to keep it from going any higher.
If rates do go up that will be one more deflationary thing on what's turning out to be a long list of deflationary things: High unemployment, reduced hourly wage rates (unless you make minimum wage, in which case your pay actually went up), reduced hours per work week, reduced equity value in your house, reduced equity value in your stock investments (401k etc.), high gas prices in relation to prices from just a few years ago (2005), reduced credit availability, higher tax rates (especially state taxes in CA and NY), lower tax revenue, reduced income from interest bearing investments (this really hurts people that live on a fixed income from CD’s etc).
In regards to inflation, I just don’t see how it’s possible except for oil. In 2007 the US produced 15 million cars. In 2009 it looks like the US will produce 10 million. That means there is enough spare capacity to build 5 million more cars. Until that spare capacity is used up the auto makers will have a tough time increasing prices. This is the same for housing. There are millions of vacant houses out there. Until those houses are sold it will be very tough for house prices to go up. In regards to farming, it has one of the lowest barriers to entry so quite a few of these unemployed people will take up some sort of farming, which will reduce demand at the grocery store, which will entice grocery stores to reduce prices to increase demand. In regards to going out to eat, there are simply too many restaurants and not enough people that can afford to go out to eat anymore. You’ll notice all kinds of coupons and all you can eat gimmicks enticing people to go out to eat. Again, prices will have a tough time going up until people start going out to eat without needing a coupon to entice them. Clothing stores, especially the high end/mall type stores, are having an even harder time than restaurants, because at least if you go out to eat you satisfy a need (aka you need to eat). There is no need for high end clothing stores. Just read the latest Abercrombie & Fitch quarterly earnings release to hear how much things have declined in retail clothing. Also check out the latest Caterpillar Tractor earnings report to see how drastically thing have declined in the industrial equipment industry. Their revenue is down 47% if I remember correctly. This has a lot to do with residential house, but also because of commercial real estate. There is so much excess commercial real estate that rents are declining in an attempt to entice renters to rent more/fancier space. This caused General Growth Properties to miss their debt payment and forced them to file for bankruptcy. Most commercial real estate companies will experience the same problem as General Growth Properties, aka having so much debt that even a slight decline in revenue (from reducing rent rates and/or a decline in occupied capacity) leaves them without enough money to make their debt payment. All of these things lead to a decrease in tax revenue, although not necessarily a decrease in the tax rate as many states/cities have raised their income and/or sales tax rates. Except for oil, it’s going to be very difficult to get inflation under those conditions. Naturally, the price of oil should go down under those conditions, but it won’t take much to have a supply shock that could cause prices to go up drastically and that would really sink the economy.
Did I forget to mention the consumer and all the problems the consumer has? - China
At first glance you would think that there are better investment opportunities out there for China, but when you look closer you realize they really have no choice. If they don’t buy the US bonds then the interest rates on Treasuries will rise, which will set off a chain reaction of increasing interest rates with the end result of even lower house prices (as if they won’t go lower anyways).
The amount of treasuries is already larger than the amount of money current buyers (including China) have. That is why the Fed is buying Treasury bonds and mortgage bonds. So the question becomes under what circumstances can the Fed no longer afford to buy the bonds? Some of those circumstances would be that buying more bonds causes either oil prices or interest rates to rise.
Unfortunately, all things financial can be delayed for a very long time. Those levy’s in New Orleans lasted for decades. So the point when the Fed can’t afford to buy bonds may be years away.
At some point the deflation will be obvious enough that interest rates will decline (in fact we may be seeing that now with interest bearing investments that mature in less than 12 months), however I think it will take higher interest rates (10 Year treasury at 4.5%) to spark the chain reaction of events that leads to events that will create blatantly obvious deflation.
China is very cleverly getting rid of dollars right in front of our eyes. They are doing it by offering to pay drastically more for natural resources than any other rational investor would. Problem for China is very few countries are allowing China to become major investors. At some point these countries will have no choice because they’ll need the money. As with all things financial that could take years.
Bottom line, leave your money in investment grade corporate bonds while you’re waiting around for things to happen. In the short run, you may not make as much money as speculating in the stock market. In the long run, things will be a different story.
A list of things that the government has done to prevent (delay) a depression:
- Banned short selling.
- Eliminated minimum listing requirement for stocks on the NYSE
- Eliminated mark to market.
- Allowed Vikram Pandit to send a memo saying (lying?) that things were going well back in March. The rally started shortly after.
- Reduced interest rates to 0%.
- Extended unemployment benefits.
- Running a $1 trillion budget deficit.
- Reduced finance rates for banks via the Discount Window.
- Bailed out Fannie Mae
- Bailed out Feddie Mac
- Bailed out AIG
- Bailed out GM, though temporarily
- Bailed out Chrysler, though temporarily
- FDIC has spent billions closing down insolvent banks
- Credit of $8,000 first time home buyers credit.
- Credit of $4,500 via Cash for clunkers.
- Credit of $600 via a rebate check.
- Guaranteed $250,000 bank account balances via FDIC, up from $100,000
- Guaranteed financial bonds
- Guaranteed money market accounts
- Guaranteed Bear Stearns assets
- Bought preferred stock in financial companies
- Bought agency bonds
- Bought Treasuries
A list of things that the government has yet to do, but probably will do:
- Bail out State governments (Bond guarantee?)
- Bail out Local governments (Bond guarantee?)
- Guarantee health care (which I would approve of)
- Raise taxes (The republicans will try to force democrats to admit it before the 2010 election. The democrats will have to admit it once the 2010 election is over.)
- Significant devaluation of the dollar. This is already playing out compared to the emerging markets, but will begin to play out more against the Euro and the Yen.
- Significant reduction in Social Security and/or Medicare benefits.
- Allow companies and or officials to either avoid telling the truth and/or flat out lie.
- Manipulate or stop providing data that shows how bad things are. Transparency anyone?
Reviewing The Previous 6 Months Forecast and Updating it for the Next 6 Months
There isn’t much point to having a forecast if you don’t monitor it and acknowledge when you’re wrong. Half way through the year this is where things stand:
- Original Forecast: I think the yields on long treasury bonds will continue to rise even though the Fed’s are buying.
- That has happened. The 10 year treasury currently stands a 3.54%. I think it will continue to increase over the next six months. China, Pensions, and Individual Investors simply don’t have the money to buy all the treasuries. And of course now that the stock market is going up Pensions and Individual Investors are looking to take more risk.
- That has happened. The 10 year treasury currently stands a 3.54%. I think it will continue to increase over the next six months. China, Pensions, and Individual Investors simply don’t have the money to buy all the treasuries. And of course now that the stock market is going up Pensions and Individual Investors are looking to take more risk.
- Original Forecast: As the yields rise, the Fed will buy even more Treasuries, hence increasing the money supply.
- That hasn’t exactly happened. However, I believe the 10 year treasury will continue to increase to the 4.5-5% range. I don’t think it will go much further than that because mortgage rates will begin to increase and the Fed will be forced to increase its “buyback program.” Not to mention there simply isn’t enough private wealth being created (people producing more than they are consuming) to buy all these treasury bonds. Sure, as a % of debt to GDP there are other countries worse off, but the size of their economies are much smaller than the US. I think the % of debt to GDP takes a back seat to the issue of the total size of the debt the US is issuing.
- That hasn’t exactly happened. However, I believe the 10 year treasury will continue to increase to the 4.5-5% range. I don’t think it will go much further than that because mortgage rates will begin to increase and the Fed will be forced to increase its “buyback program.” Not to mention there simply isn’t enough private wealth being created (people producing more than they are consuming) to buy all these treasury bonds. Sure, as a % of debt to GDP there are other countries worse off, but the size of their economies are much smaller than the US. I think the % of debt to GDP takes a back seat to the issue of the total size of the debt the US is issuing.
- Original Forecast: The inflationary result of this will be seen mostly in oil.
- That has happened. Oil currently stands at $64.99 a barrel. (I believe they are 40 gallon barrels, no?) It is possible that an international conflict could arise, especially since, from what I’ve read, Iran is roughly 6 months away from developing a nuclear weapon. Can issues like this really be factored in? I think they should. So the way I’ll factor that in is by adding the international conflict issue to the list of reasons why stocks are overvalued. As far as the oil goes, an international conflict would increase the price drastically, but it wouldn’t last more than a few months. So barring an international conflict, I believe that oil will slowly decline over the next 6 months to the $45 range. I think it will decline because there is simply more supply than demand. However at $45 I believe that demand does increase and supply does decrease. From what I’ve read, the variable cost to deliver oil is roughly $25. So $25 would be the ultimate floor, but I think that is unlikely in the next 6 months, but possible in the next 18 months.
- That has happened. Oil currently stands at $64.99 a barrel. (I believe they are 40 gallon barrels, no?) It is possible that an international conflict could arise, especially since, from what I’ve read, Iran is roughly 6 months away from developing a nuclear weapon. Can issues like this really be factored in? I think they should. So the way I’ll factor that in is by adding the international conflict issue to the list of reasons why stocks are overvalued. As far as the oil goes, an international conflict would increase the price drastically, but it wouldn’t last more than a few months. So barring an international conflict, I believe that oil will slowly decline over the next 6 months to the $45 range. I think it will decline because there is simply more supply than demand. However at $45 I believe that demand does increase and supply does decrease. From what I’ve read, the variable cost to deliver oil is roughly $25. So $25 would be the ultimate floor, but I think that is unlikely in the next 6 months, but possible in the next 18 months.
- Original Forecast: There won’t be much inflation in food.
- There hasn’t been much inflation in food. I’m not certain the best way to measure it, but I haven’t noticed many headlines about food inflation nor have I noticed any price increase at the grocery store. (Though that is very hard to measure) My farming contacts have advised me that grain prices have declined quite a bit in the past few weeks. Going forward I think food prices, especially end user prices, will continue to decline. People simply can’t afford to waste food they way they used to so demand will be down. Farming has one of the lowest barriers to entry so supply will be up. Food processors had raised prices during the inflationary times of 2008 and have yet to fully roll them back, not to mention that they will be reducing prices to offset the loss of demand.
- There hasn’t been much inflation in food. I’m not certain the best way to measure it, but I haven’t noticed many headlines about food inflation nor have I noticed any price increase at the grocery store. (Though that is very hard to measure) My farming contacts have advised me that grain prices have declined quite a bit in the past few weeks. Going forward I think food prices, especially end user prices, will continue to decline. People simply can’t afford to waste food they way they used to so demand will be down. Farming has one of the lowest barriers to entry so supply will be up. Food processors had raised prices during the inflationary times of 2008 and have yet to fully roll them back, not to mention that they will be reducing prices to offset the loss of demand.
- Original Forecast: Real estate will continue to decline.
- That has happened, especially in commercial real estate. I believe both residential and commercial real estate will continue to decline, probably for years unless some event causes a major decline in the next 6 months. Real estate isn’t as liquid as the stock market so it takes more time for the true prices to be uncovered. There is simply too much supply and not enough demand. (At least not enough demand from people that can actually afford to buy.) Not only are there a bunch of vacant houses and apartments, but many houses are large enough for more than one generation to cohabitate. It should be no surprise that more and more families have more than one generation living in the same location. They simply can’t afford to do otherwise.
- That has happened, especially in commercial real estate. I believe both residential and commercial real estate will continue to decline, probably for years unless some event causes a major decline in the next 6 months. Real estate isn’t as liquid as the stock market so it takes more time for the true prices to be uncovered. There is simply too much supply and not enough demand. (At least not enough demand from people that can actually afford to buy.) Not only are there a bunch of vacant houses and apartments, but many houses are large enough for more than one generation to cohabitate. It should be no surprise that more and more families have more than one generation living in the same location. They simply can’t afford to do otherwise.
- Original Forecast: Natural gas prices will continue to decline.
- That has happened. Prices are a little under $4 for the next month’s delivery. I’m not sure how much further they can decline because the variable costs start to become higher than $4/mcf. I don’t think they’ll decline much further than that, though I think it will be possible to see $4/mcf even during the winter months. Anecdotally I can tell you that many rigs have been shut down with the hopes of starting them back up in 6 months.
- That has happened. Prices are a little under $4 for the next month’s delivery. I’m not sure how much further they can decline because the variable costs start to become higher than $4/mcf. I don’t think they’ll decline much further than that, though I think it will be possible to see $4/mcf even during the winter months. Anecdotally I can tell you that many rigs have been shut down with the hopes of starting them back up in 6 months.
- Original Forecast: Higher oil prices will force the consumer to reduce spending further.
- That isn’t really much of a forecast. Going forward I will reword that to say “Consumers will continue to reduce spending.” That has happened. I believe it will continue to happen especially since millions of unemployed will be losing their unemployment benefits. How exactly that is going to play out should be interesting. I’d hate to be president of a country that has more unemployed young males than personnel enrolled in the military. That’s grounds for some real change, which may include some violence, but hopefully minimal death. What's more is that many people are underemployed and those that had any saving have seen it decline because of the declines in the stock market and the real estate market. Not to mention the retirees living off the interest on their bonds are receiving less money. To top it off, credit has been drastically scaled back. To sum it all up, people simply don’t have the money or the credit to keep spending.
- That isn’t really much of a forecast. Going forward I will reword that to say “Consumers will continue to reduce spending.” That has happened. I believe it will continue to happen especially since millions of unemployed will be losing their unemployment benefits. How exactly that is going to play out should be interesting. I’d hate to be president of a country that has more unemployed young males than personnel enrolled in the military. That’s grounds for some real change, which may include some violence, but hopefully minimal death. What's more is that many people are underemployed and those that had any saving have seen it decline because of the declines in the stock market and the real estate market. Not to mention the retirees living off the interest on their bonds are receiving less money. To top it off, credit has been drastically scaled back. To sum it all up, people simply don’t have the money or the credit to keep spending.
- Original Forecast: Stocks will continue to decline if the above theses are true. The sectors most likely to decline will be discretionary and financial stocks.
- The most important forecast of all and I have been wrong. I’m disappointed that I didn’t factor in one of the most basic rules of all time: The market can be irrational longer than you can be solvent. I still believe that stocks are overvalued. I think they’ve gotten more overvalued. However the heard thinks otherwise and they want (need) to think otherwise in order to avoid depression. (Both economically and psychologically.) Over the next 6 months, even after factoring in irrational investors, I think the stock market will be flat. Fundamentally, stocks are overvalued and the more time that goes by the more investors will realize this. That won’t be the main reason stocks decline though. It will be because investors won’t be able to afford to prop it up any longer. (The Government included.) People will be forced to cash out their investments in order to pay their living expenses. The government will be forced by higher interest rates on Treasuries to reduce the budget deficit. The only investors left to buy will be investors such as myself that aren’t willing to pay current prices. This is going to take longer than 6 months to play out. Especially since the government has a vested interest in keeping stock prices high for both social and economic reasons. So, unfortunately, over the next 6 months stock prices may be flat or decline 15% at most. Investors will probably get all excited about the results of the 3rd quarter, but towards the end of the 4th quarter reality will set in. The reality will be that a double dip recession is on the horizon and the Government can’t afford to do much about it because the Treasury rates are prohibitive. Not sure if that would be a checkmate or a stalemate. So over the next 24 months, as people consume more than they produce, the stock market could (should) fall much further.
- The most important forecast of all and I have been wrong. I’m disappointed that I didn’t factor in one of the most basic rules of all time: The market can be irrational longer than you can be solvent. I still believe that stocks are overvalued. I think they’ve gotten more overvalued. However the heard thinks otherwise and they want (need) to think otherwise in order to avoid depression. (Both economically and psychologically.) Over the next 6 months, even after factoring in irrational investors, I think the stock market will be flat. Fundamentally, stocks are overvalued and the more time that goes by the more investors will realize this. That won’t be the main reason stocks decline though. It will be because investors won’t be able to afford to prop it up any longer. (The Government included.) People will be forced to cash out their investments in order to pay their living expenses. The government will be forced by higher interest rates on Treasuries to reduce the budget deficit. The only investors left to buy will be investors such as myself that aren’t willing to pay current prices. This is going to take longer than 6 months to play out. Especially since the government has a vested interest in keeping stock prices high for both social and economic reasons. So, unfortunately, over the next 6 months stock prices may be flat or decline 15% at most. Investors will probably get all excited about the results of the 3rd quarter, but towards the end of the 4th quarter reality will set in. The reality will be that a double dip recession is on the horizon and the Government can’t afford to do much about it because the Treasury rates are prohibitive. Not sure if that would be a checkmate or a stalemate. So over the next 24 months, as people consume more than they produce, the stock market could (should) fall much further.
Fundamentals vs. Everything Else
I’m not sure if a discussion on fundamentals is even worth having. That’s not a new phenomenon. For as long as I can remember the stock market has been over priced only to get more over priced. The real phenomenon occurred in March when stocks were actually on their way to being fairly priced. Holding investment grade corporate bonds while waiting around for stocks to become cheap may not appear to be the best idea in the short run, but the long run, or as Hussman calls it “the full cycle” is what counts.
Economic and Stock Market Forecast
I think the yields on long treasury bonds will continue to rise even though the Fed’s are buying.
Supporting Arguments:
- 1. Investors that used to buy the bonds (China, pensions, and individual investors) simply don’t have new money coming in to buy with.
- 2. Investors are concerned about inflation risk.
- 3. Investors are concerned about default risk. Although, default risk is really just inflation risk because they Fed will simply print money to pay for the bonds.
Opposing Arguments:
- 1. Flight to safety will continue. Treasury bonds are “said” to be safe or at least less risky.
- 2. Investors will shift their asset allocation to bonds.
- 3. Investors will increase their savings rate, hence increasing the demand for all investments.
- a. This creates a slippery slope though, where more savings means less spending, and less spending means more people unemployed, which would mean less money to invest with.
- a. This creates a slippery slope though, where more savings means less spending, and less spending means more people unemployed, which would mean less money to invest with.
As the yields rise, the Fed will buy even more Treasuries, hence increasing the money supply.
Arguments supporting this thesis are:
- 1. The Fed just announced it is going to purchase $300 Billion worth of treasuries. In the last 24 months the Fed has not reduced the size of any program like this. Instead, the Fed has only increased not only the size, but the scope as well.
Arguments against this thesis are:
- 1. Somehow the government steps in to prevent the Fed from devaluating the dollar. It appears Congress has no control over the Fed so this appears unlikely.
- 2. The dollar decline becomes so significant that the Fed will be forced to stop or risk civil unrest.
The inflationary result of this will be seen mostly in oil.
Arguments supporting this thesis are:
- 1. Oil supply in Mexico has been declining significantly over the last 12 months.
- 2. Drilling has declining significantly.
- 3. Oil supply everywhere would be declining naturally. (The world does not naturally produce 85 million barrels of oil a day, but it does consume it.)
- 4. World population is increasing.
Arguments against this thesis are:
- 1. Demand for oil is declining along with the rest of the economy. This decline is enough to offset any of the arguments supporting the thesis.
- 2. Alternative energy is reducing the demand for oil.
- 3. Technology (fuel efficiency) is decreasing demand.
There won’t be much inflation in food.
Arguments supporting this thesis are:
- 1. People will be less wasteful and use less food to meet the same demand.
Arguments against this thesis are:
- 1. Food supply is at decade lows.
- 2. Population growth.
- 3. Land is producing less yield because of over farming.
Real estate will continue to decline.
Arguments for this thesis are:
- 1. There is simply too much supply.
- 2. Real estate is not consumed the way food and oil is.
Argument against this thesis is:
- 1. Buyers have money for a down payment, have a good credit score, have a job and actually want to buy real estate at these prices.
- 2. The government is giving an $8,000 subsidy to buy a house.
Natural gas prices will continue to decline.
Arguments for this thesis are:
- 1. There is simply too much supply.
- 2. The decrease in economic activity make the over supply even worse.
Arguments against this thesis are:
- 1. Producers will stop producing; reducing supply.
Higher oil prices will force the consumer to reduce spending further.
Arguments for this thesis are:
- 1. People can’t spend money they don’t have when the credit markets are closed.
Arguments against this thesis are:
- 1. The government will give people money to spend and they’ll actually spend it unlike the last stimulus.
Stocks will continue to decline if the above theses are true. The sectors most likely to decline will be discretionary and financial stocks.
Arguments supporting this thesis are:
- 1. Stocks are overvalued or at best fairly valued. They are not cheap.
- 2. The valuation of discretionary and financial stocks can drastically change with just a small change in the economy. For example it only takes a small decline in real estate prices to wipe out all the equity in a finance company that is levered 20 to 1 and owns mostly real estate loans.
Arguments against this thesis are:
- 1. Stocks are undervalued and investors have the wherewithal and mentality to buy them.
Thoughts
Things To Anticipate Over The Next 2 Weeks
- Major bank stocks and bonds going to $0 (not necessarily bankrupt). Update: This may take longer than previously thought now that the government is going to buy bad assets (presumably at prices significantly higher than current bids)
20 Investing Criteria: The Time To Buy Is Near (Especially If The Current Pace Of Decline Continues) Update: The price decline has clearly reversed.
- Business Model
- Liabilities (Debt, Healthcare, Lawsuits, Pensions, Lease Obligations) are low (Balance sheet, foot notes, foreign country subsidiary etc.)
- Consistent (5 Year Rolling Average) Sustainable Owner Earnings (This translates into sustainable revenue, margins, prices, and cash flow)
- Diversified: Multiple customers and products (Not a 1 hit wonder, but no need to diversity just to diversify)
- Independent (If a competitor goes down they don't all go down. Unlike airlines, drug companies, banks, etc)
- Monopoly or close to it (Buffett's "Wide Moat")
- Liabilities (Debt, Healthcare, Lawsuits, Pensions, Lease Obligations) are low (Balance sheet, foot notes, foreign country subsidiary etc.)
- Product
- Consumable (Translates into sustainable consistent demand)
- Established. (Product mostly sells itself) Hasn't changed in years. (Coke, Heinz, Mars, Electricity) Unlikely to change in the future. (Unlike electronics. Unlike a start up. Unlike the next "something.")
- It's what the customer needs, wants and does. You'll be surprised what customers ultimately need and want. (Cell phones)
- Value (Affordable): Price is what you pay, value is what you get. (Amazon, DeWalt, Honda, Visa)
- Consumable (Translates into sustainable consistent demand)
- Management
- Adaptable (It's not the strongest or the most intelligent that survives, it's the one most adaptable to change)
- CEO is realistic (You can judge this by watching them speak. VERY RARE!)
- Disciplined (Unlike Time Warner when they bought AOL)
- Employees have a good relationship with the company (Unlike Unions)
- Executes (Translates into earnings growth etc)
- Honest (Translates into reliable financial statements)
- Adaptable (It's not the strongest or the most intelligent that survives, it's the one most adaptable to change)
- General Rule
- Simple: Simple product. Simple business model. Simple financial statements. That way any idiot can run the company.
- Know the Competition
- Simple: Simple product. Simple business model. Simple financial statements. That way any idiot can run the company.
- Litmus Test
- Consumers would be affected negatively if the company went out of business
- Personally understand the company and use the product.
- Willing to invest 10% of your net worth into the company
- Consumers would be affected negatively if the company went out of business
- Real estate, but mostly if you’re buying a house. I haven’t heard of rent coming down much.
- Gasoline (Still high compared to 2004 prices)
- Natural Gas
- Car Insurance
- Restaurant Prices (Especially if you have a coupon, which I’ve seen the frequency of coupons increase.)
- Interest payments (If you have debt.) However, for the people that have savings, the opposite is true and the savers are earning much less interest on their savings.
- Electricity
- Insurance (Medical, Dental, Vision, Life, Homeowners)
- Clothing (Even with all the “sales” I haven’t noticed the sale prices being lower then previous sales prices I saw years ago; especially in business clothing.)
- Food (Milk, Cheese, Meat, Cat Food)
- Internet
- Cell phone
- Parking
- Trash
- Beer
- Real estate taxes
- Income taxes (Federal, State, Local, Social Security, Medicare, and Medicaid)
Reasons The US Economy Will Get Worse
- Employment
- More people will lose their jobs. As of 3-25-09 there are 5.5 million people on State unemployment and 1.5 million on Federal unemployment. Expect about 2 million more to become unemployed to bring the total number to 9 million. That can easily be accomplished by losing 650,000 per month for 3 months. Once you start thinking about it 5 million job losses is possible if the 250,000 job losses per month continues into 2010.
- More people will have reduced hours.
- More people will have reduced pay or no pay increase
- More people, especially the baby boomers, who would have retired won’t retire because they need the money, hence increasing the supply of labor. This creates a negative feedback loop where baby boomers staying in their jobs prevent other generations from advancing in the labor force. The end result is the baby boomers end up doing all the work and having to give a significant amount of their money away (either as straight gifts to their children or as taxes) just to sustain all those other people that can’t get a job. This scenario partially explains the current economic situation we are in now because the baby boomers were the ones making all the money over the last few years.
- More people will lose their jobs. As of 3-25-09 there are 5.5 million people on State unemployment and 1.5 million on Federal unemployment. Expect about 2 million more to become unemployed to bring the total number to 9 million. That can easily be accomplished by losing 650,000 per month for 3 months. Once you start thinking about it 5 million job losses is possible if the 250,000 job losses per month continues into 2010.
- Real Estate: Housing
- House prices are still unaffordable (relative to income, which is declining.). In 2000, the average home price was $150,000. (I agree, I don’t like to use averages, but this is the information I have available.) At the end of 2008 the average home price was $175,000. Do you think people are making more money, or that more people are employed, then there were in 2000? No. So for the average home price to drop to $150,000 seems very realistic. That would be a 15% decline from today. And to boot, just like prices overshoot to the upside, prices overshoot to the downside. At a 2007 median HOUSEHOLD income of $50,000 the average American can’t afford much. I’ll do some math on that later.
- House inventory is still too high. In 2008 4.5 million existing homes were sold. Problem is realtor.com has 4 million listings alone. That is at least 10 months supply. The norm is 6 months.
- Vacant houses have increased to 2.23 million.
- Home ownership was at an all time high, which means demand for houses will decrease.
- Housing starts are still higher than the amount of new houses sold. Technically, new home completions, at 750,000, are almost 100% higher then new home sales, at 400,000, as of December 2008.
- Mentality towards housing has changed and people are looking for smaller houses.
- Mentality towards housing has changed also because speculators and investors are no longer considering real estate as an investment.
- It is taking significantly longer to sell houses. It used to take 3-6 months. Now it takes 6-9 months.
- Mortgagee’s would rather default than refinancing their loan.
- More people will default on their mortgages, including Alt-A and Prime
- Shadow inventory of houses is huge. People that want to sell have not put the for sale sign up because they know they can’t sell their house at the price they want (more than it’s worth) in this environment. REO’s that aren’t listed and foreclosures that are being delayed are also adding to this.
- House prices are still unaffordable (relative to income, which is declining.). In 2000, the average home price was $150,000. (I agree, I don’t like to use averages, but this is the information I have available.) At the end of 2008 the average home price was $175,000. Do you think people are making more money, or that more people are employed, then there were in 2000? No. So for the average home price to drop to $150,000 seems very realistic. That would be a 15% decline from today. And to boot, just like prices overshoot to the upside, prices overshoot to the downside. At a 2007 median HOUSEHOLD income of $50,000 the average American can’t afford much. I’ll do some math on that later.
- Real Estate: Commercial
- Demand for commercial space is declining.
- For many tenants, commercial real estate is unaffordable.
- Inventory is still growing.
- Demand for commercial space is declining.
- Credit: Consumer
- FICO score requirements have increased while many consumers have actually seen their FICO scores decrease.
- Consumers are simply reducing their demand for credit.
- Income requirements have increased while many consumers have obviously lost their job.
- Down payments requirements have increased (From zero to 20%)
- FICO score requirements have increased while many consumers have actually seen their FICO scores decrease.
- Credit: Business
- Business’s balance sheets will deteriorate further.
- Business’s balance sheets will deteriorate further.
- Spending: Consumer
- Consumers are trading down in quality and quantity.
- Consumer spending is declining from an unsustainably high level.
- Spending frugally is now considered “cool.”
- Consumers are trading down in quality and quantity.
- Spending: Business
- Many companies are reducing the amount of CapEx they will spend compared to previous years.
- State and local government are also reducing the amount of projects.
- Many companies are reducing the amount of CapEx they will spend compared to previous years.
- Spending: Government
- State tax revenue is down so the state budget is being cut accordingly.
- Local tax revenue is down so the local budget is being cut accordingly.
- Federal tax revenue is down, but they can just print money.
- Borrowing costs have increased for state and local governments.
- State tax revenue is down so the state budget is being cut accordingly.
- The Consumer
- Consumers don’t have any savings to fall back on.
- Consumers that do have savings saved in stock. When they need to use their savings they’ll have to sell stock.
- People are saving more (paying down debt), which means they are spending less.
- Savings are still too low so consumers will have to save even more.
- Growth from real estate and stocks is no longer a substitute for savings.
- More consumers are falling behind on their mortgage.
- More consumers are falling behind on their credit cards.
- Consumers don’t have any savings to fall back on.
- Consumer Psychology
- Consumers spend less when their assets decline.
- Asset declines beget more asset declines. Aka negative feedback loops.
- Consumers with the money to spend feel guilty spending it so they save it instead.
- Consumers spend less when their assets decline.
- Velocity of money will slow down further.
- Less kids will go to college which means less people need to be employed at the college.
- More frauds, like Madoff, will be uncovered. (As if the whole finance industry isn’t)
- As the US currency weakens the demand for interest rates on US assets increases.
- Investors are looking to decrease risk, not increase it.
- The recession is global.
- The Federal debt is increasing. It’s either going to have to be paid back or defaulted on.
- The Federal deficit is increasing.
- Unexpected natural or man made disaster may strike.
- There is too much supply of everything except jobs and income.
- There is too little demand for everything except jobs and income.
- Retail inventories are too high.
- Retail revenue is declining. Certainly in total cost, but maybe even units sold.
- Deleveraging will continue to reduce demand.
- Until very recently the dollar had been strengthening and exports have been declining.
- Stimulus package won’t be enough to offset job losses etc.
- Oil demand is declining, which means less oil will be sold.
- Oil prices are still too high (Only at 2004 prices.)
- Many companies that should be bankrupt aren’t because of all these bailouts. When these companies finally do go bankrupt there will be significant job losses.
- The number of uninsured people is increasing and hospitals have to find a way to pay for them.
Reasons The US Stock Market Will Decline
- Companies will have no earnings!!! For a long long time!!!!
- Commodity prices have declined drastically, especially oil, so earnings from commodity companies, which had the largest percentage of the S&P 500, will decline drastically.
- Pension costs have increased because the value of the pension, which was mostly in stock, has decreased drastically.
- Companies have significantly more fixed costs (manufacturing plants, hotels, etc) then there is demand for.
- Revenue has declined significantly.
- Share buybacks will continue declining.
- Healthcare costs are increasing.
- Investors will sell stocks because:
- They need the money to pay living expenses. Especially people who’ve lost their job(s).
- They are panicking and just want to stop losing money
- Pension funds that have to meet obligations
- Hedge funds have to meet redemptions
- Funds that have to sell if a company gets downgraded or share price falls too low
- Investors that have to meet margin calls
- They need the money to pay living expenses. Especially people who’ve lost their job(s).
Reasons The US Stock Market Will Increase
- Layoffs mean employee costs are decreasing. Problem is demand is decreasing faster than they can lay people off. The more people they lay off the less demand. Aka negative feedbacks loop.
- Interest rates are decreasing. Problem is the interest rates for many companies are actually increasing if they can even get credit at all.
- Commodity costs are declining. Problem is most of the earnings in the S&P 500 were from the most important commodity of all: Oil. Without that they S&P 500’s earnings will decline from $75 to $50.
- Investors, who have to cash to buy with, will buy stocks because:
- Short sellers will cover their shorts
- 401k investors who blindly contribute to stock mutual funds (ever notice the market goes up on pay day)
- Long term investors that believe current prices are fair if not cheap and are able to withstand further declines (though very few have cash)
- Unfunded pensions will have to contribute to their plans. If they don’t change their asset allocation then they’ll have to buy stocks.
- Short sellers will cover their shorts
Reasons the US Economy Will Improve
- Inflation is declining, especially oil. However, price declines don’t help on a global basis because any increased savings from cheaper prices in the consuming countries decreases the spending in the producing countries.
- Interest rates are declining. Problem is credit is harder to get and demand for credit is much lower.
- Unemployment benefits are increasing. Problem is the money received from unemployment benefits is less the job they had paid.
- Few homebuilders have gone bankrupt, so those jobs have not been lost yet. The problem is at some point these companies will go bankrupt and the jobs will be lost.
- Few banks have gone bankrupt, so those jobs have not been lost yet. Problem is at some point these companies will go bankrupt and the jobs will be lost.
- Few retailers have gone bankrupt, so those jobs have not been lost yet. Problem is at some point these companies will go bankrupt and the jobs will be lost.
- Few casinos have gone bankrupt, so those jobs have not been lost yet. Problem is at some point these companies will go bankrupt and the jobs will be lost.
- The government is spending like mad. Problem is one day all this spending is going to have to be paid for. Of all the problems out there, this is the biggest problem. Especially if this problem is paid for via war.
- The government is bailing almost everyone out. Problem is one day all the bailouts will have to be reversed somehow or another. If it’s through the natural course of inflation then expect to be in a recession (no growth or outright decline) for years if not decades.
- The US dollar will reverse its recent strength and begin the decline, which is good for exports. Problem is the economy is global so any increase in exports in the US decreases exports somewhere else.
Ways to improve the economy
- Let the free market work. Otherwise we will simply delay the depression. Only provide jobs for people that would have to be paid unemployment benefits anyway.
- Let the automakers fail. If we don’t the whole auto industry will be worse off will worse cars.
- Let the banks fail. If we don’t the whole financial industry will be worse off will higher rates.
- Increase taxes on new building permits to deter building more houses.
- Increase taxes on old houses and commercial buildings, especially energy inefficient ones, and provide tax break to tear them down.
- Provide tax breaks for investors to buy abandoned assembly plants and build windmills.
Things To Anticipate Over The Next 90 Days
- Service industries (retail, restaurants, hotels and affiliated) that had job growth in 2008 will begin to show declines along with everyone else.
- Oil prices to continue falling (Still way too much supply out there in the short run)
- Citigroup going the route of AIG.
- Automaker(s) going bankrupt.
- Significant amount of companies being downgraded, which will mostly affect on bonds.
- Declining bond prices (Especially CMBS)
- Some companies will not be able to afford to rollover their debt and that will bankrupt them
- Even with all these problems, expect the government to NOT intervene as they wait for the new administration to take over. Looks like the short sellers are counting on it.
Things To Anticipate Over The Next Year (Updated 20090807)
- The recession to last all through 2009. (Does 1 quarter of positive GDP end a recession?)
- State and local governments continue to reducing spending significantly unless they get bailed out.
- Another $500 billion fiscal stimulus package in 2010 that focuses on rebuilding the US.
- The government will continue to react to problems instead of anticipate them.
- The market to bottom. Probably when you least expect it. I doubt March 2009 was it.
- Big name retailer declaring chapter 11 if not 7.
- Big name home builder declaring chapter 11 if not 7.
- Big name mortgage insurer declaring chapter 11 if not 7.
- Big name airline declaring chapter 11 if not 7.
- Big name regional bank declaring chapter 11 if not 7.
- Big name casino declaring chapter 11 if not 7.
- Home prices to continue declining.
- Increased savings.
- Decreased spending.
- Unemployment to rise to 10% (That’s a HUGE number)
- Very few Private Equity buyouts.
- Underfunded unemployment trusts.
- Very few IPO’s.
Things to Anticipate that Happened (Updated 20090807)
- Whatever solution the Fed comes up with, they will overdue it, but not before it’s too late. Looks like that answer to this one is too much liquidity and it’s all in the banking industry.
- Car manufactures did go bankrupt, but no one else significant has since Lehman.
- Highly dilutive secondary stock offers of which the proceeds will be used to pay down debt. You see this especially in the REIT industry and the banking industry.
- All time low interest rates. Happened as of 3-25-09.
- No IPO’s. There have been very few IPO’s. Happened as of 20090807.
- Net earnings on the S&P 500 to be $25. Happened as of 20090807.
- No Private Equity buyouts. Happened as of 20090807
Things to Anticipate that Didn’t Happen (Updated 20090807)
- Borderline depression near the middle of 2009 if things get worse than the current trajectory. Didn’t happen as of 20090807.
- GDP to decline 5%. More like 3%. Didn’t happen as of 20090807.
- Limited corporate bond issuance. Things seem to be fine in the IB area. Didn’t happen as of 20090807.
- Underfunded unemployment trusts. Didn’t happen as of 20090807.
- Retailers, homebuilders, mortgage insurers, insurance companies (think annuities), banks, casinos and airlines all going bankrupt at the same time, their stocks and bonds go to zero, and they start over. Didn’t happen as of 20090807.
Things to Anticipate of the Next Decade
- Under funded Medicare (Federally Run) and probably more pressing Medicaid (State Run).
Things To Be Prepared For (Not that they’ll necessarily happen)
- The S&P 500 declining to 500 and staying there for 5 years.
- The treasury market (especially long dated treasuries) declining 30% (the principal that is).
- Have enough money saved up to buy the basic necessities in case you lose your job.
- Have enough food in your house right now in case there is a run at the grocery store.
- Have enough cash (gold?) on hand in case there is a run on the bank.
- Have a way to defend yourself in case there are riots.
- Have a TV antenna just in case the cable goes out.
- Have a generator, but this is severely limited by how much gas you can store.
Best Type of Investments As of 20090807
- 5 to 10 year corporate bonds of non financial companies that have significant amounts of cash and/or consistent revenue streams.
- Cash
Which Companies Will Be The First To Go Bankrupt?
- Naturally, it would be companies that don’t have enough money to make their interest payment. Next in line will be companies that don’t have enough cash to pay off debt that is rolling over. They will be forced to either reissue debt with 15% interest rates if they can get financing at all. This includes state and local governments. However, we know nothing happens naturally with as many politicians as there are living in the US.
Quotes
- Unknown: “The more things change the more they stay the same.” The new sound, just like the old sound.
- Someone from the beginning of time: “A bird in the hand is worth 2 in the bush.”
- JFK: “A nation that is afraid to let its people judge the truth and falsehood in an open market is a nation that is afraid of its people.” China? US in regards to the Fed?
- LeFevre, Edwin (1932): “Reckless fools lost first because they deserved to lose, and careful, wise men lost later because a world-wide earthquake doesn't ask for personal references.”
- Einstein, Albert: "Never expect the people who caused a problem to solve it."
- Munger, Charlie: “A small leak can sink a great ship”
- US Sec. of the Treasury Andrew Mellon, 1929: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people."
- Morrow, George:"When you’re a little guy operating out of a garage, you pay all your own bills.
When you get a bit more successful you get a line of credit, and the bank starts paying your bills.
When you get even more successful your vendors start paying your bills.
When you get even more successful venture capitalists pay your bills.
When you go public then the public starts paying your bills.
Then when you reach the pinnacle of success – insert your favorite government run company – you’re so successful that you can’t be allowed to fail, and the government starts paying your bills." - Chuck Prince “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” FT July 2007.
Rules to Live by
- Deep breath. Relax. Slow down.
- Know Yourself
- Think for Yourself
- Execute (The other rules don’t matter if you don’t execute)
- Write for YOURSELF. Especially any lessons learned.
Invest Accordingly
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