In a recent post I quoted the prophet Isaiah, who apparently foretold the housing bust. Okay, not really, but he did wisely warn against the perils of greed, and the consequences of excess.
Here's one more gem from Isaiah, this time chapter 15, verse 9:
"Dimon's waters are full of blood, but I will bring still more upon Dimon ..."
For the uninitiated, the CEO of JPMorgan Chase, which acquired what was left of Bear Stearns in a federally-assisted shotgun wedding in March, and which is rumored to have forced the sale of Merrill Lynch to B of A by calling in Merrill's lines of credit, is a man named ...
Jamie Dimon.
Back when Dimon was CEO of Bank One, he was reported to have once said about the banks' competitors, "I hate them! I want them to bleed!" Hmmm.
Now, I'm no Isaiah, but I thought I'd retrace some of my prognostications over the past year and a half. Not to pat myself on the back, but to establish some street cred - or should I say Street cred, as in Wall Street - before talking a bit about what's coming. And that needs to be talked about, because no one in the media is talking about it, nor is anyone in Washington, or on Wall Street, or on Main Street (by the way, if I hear a politician utter the "Wall Street - Main Street" sound bite one more time, I swear I will vomit).
April, 2007. In an article titled, "The US Economy in 2007: Headed South for the Winter?", which appeared in our company's newsletter, MarketCast (you can read it at www.cnbsnet.com; click on "MarketCast," then "Search all MarketCast articles," then use the pull-down menu to pick the month and year), I predicted a recession in late 2007 or early 2008.
The tools I used to make this call were the behavioral patterns of three economic indicators that have proven to be generally reliable predictors of recessions: the Chicago Purchasing Managers' Index, the Leading Economic Indicators index on a year-over-year basis, and the spread between the two- and ten-year Treasury note yields. All three signs pointed to a recession six to 12 months hence.
Now, we have not yet met the traditional definition of a recession, defined by the National Bureau of Economic Research (NBER) as two or more consecutive quarters of negative GDP growth. But the last recession, in 2001, didn't even meet that definition, even though the NBER recognized it as a recession.
And many economists - including yours truly - believe the NBER definition is useless, as it means a recession can only be identified in hindsight. It's like driving a car on a mountain road, with tight curves and steep drop-offs, navigating with nothing but your rear-view mirror.
And many economists are now saying we've been in a functional recession since the first quarter.
May, 2007. I followed up with another MarketCast article whose title was taken from a famous quote by then-President George H.W. Bush: "As Housing Goes, So Goes the Economy?" In that piece, I used the historical relationship between the National Association of Home Builders (NAHB) sentiment index and the S&P 500 (as a proxy for the health of the economy) to predict a recession, and a downturn in the stock market.
A steep one.
The correlation between the NAHB index and the S&P, lagged about 18 months (the idea being that housing downturns lead economic contractions by about that length of time) is quite high - over 83% at the time I wrote the article. Also at that time, the NAHB index appeared to have begun to turn up. So on that basis, I predicted we'd see the S&P start dropping, and fall for about 18 months, which would have put the bottom at about November of this year. I called for a "sharp correction," but stopped short of pegging the S&P's ultimate low at the point suggested by the trend.
That low was 600. The S&P closed at 899 Friday, and traded below 840.
But, the NAHB index did not continue rising. It fell further, and sharply. At the time of the article's publication, the latest reading was around 40, after it had hit a bottom of 30 a few months earlier. It ultimately fell as low as 16, just a couple months ago. Then it ticked up to 18 last month.
It's due out next week, and is forecast to have fallen back down to 17. In other words, we may not have seen the bottom yet. Even if we have, though, the bottom in the S&P is likely about 16 months from now. I don't want to think about the level.
December, 2007. I wrote a follow-up piece titled, "Recession Indicators Revisited." In it, I noted that there had been significant fluctuation in the Chicago Purchasing Managers' Index, thus the signal was not entirely clear. But I noted that the only support for the factory sector in 2007 had been foreign demand for US exports, which were cheap due to the dollar's weakness versus most foreign currencies, as economies abroad were, at the time, relatively healthy.
I maintained my LEI year-over-year prediction, and I noted that the duration of the most recent yield curve inversion might lengthen the time between the two-year/ten-year spread reaching a positive 50 basis points (half a percent) and the onset of recession. And I noted the reversal of fortunes for the NAHB index.
I also added this warning:
"[T]he domestic economy has been sustained to some degree this time by a more global economy. That latter point has resulted in strong foreign demand from robust economies abroad that have sustained output in the U.S., owing in large part to the ever-weakening dollar. But some of those economies are at fragile points themselves, and several have their own mounting housing crises. We've seen the spread of the U.S. housing contagion overseas; it'll be that much worse when other countries' housing slumps hit full bloom. And the worst isn't yet over for our own housing market."
Finally, I addressed the Dow Theory, which holds that holds that a bearish trend in the Transportation Index, accompanied by the testing of a recent low in the Industrials, indicates the beginning of a full-fledged bear market in the Industrial Average. I noted that those conditions had been met in November, signaling a bear market may be underway.
Of course, we now know the market peaked in October, and now easily meets the definition of a bear market.
I've also given numerous presentations over the last year where I predicted housing would not recover before 2010; that credit market conditions would become dire; that the more the government intervened, the worse things would get; and that we could face a prolonged and painful downturn - by "prolonged and painful" I mean something akin to Japan's "Lost Decade," or, with sufficient government monkeying, a depression. Some of this doom and gloom you've read here.
A quick recap of some other, recent warnings:
1. A week before Labor Day, I predicted Fannie and Freddie would fail by the holiday. Missed that one by six days.
2. On Friday, September 12, I predicted that Lehman would go belly-up or be rescued the following Monday. Nailed that one. I also predicted that WaMu was toast. The toast was done two weeks later.
3. In our firm's quarterly economic outlook contest, my predictions for the third quarter were the most dire that I or anyone else in the company had ever made.
They were also the most accurate since we've been doing the forecast.
4. I should also point out that I bailed out of stocks in my daughter's 529 plan last October, and in the rest of our accounts in March. We even went short the market in my wife's IRA, which is up a healthy 60% since then - and that's not annualized.
Now, I'd like to turn my attention to a brief (for me) overview of what's to come - and these things are not yet fully priced into stocks.
Manufacturing
As I noted, the factory sector, normally a casualty of an economic downturn, remained resilient through 2007 and the first half of 2008 due to the weak dollar and strong foreign demand. But my prediction that foreign economies would soon weaken has come true, in spades. Heck, the entire nation of Iceland may go bankrupt, and take much of the British banking system with it.
The result of the rapid weakening of foreign demand has been a most unwelcome inventory bulge in US factories and businesses. That's evident in the Wholesale and Business Inventories series, both of which were still rising at last check. But these data series lag, so "last check" in this case is August.
More recent evidence is available from the regional Fed banks' survey-based manufacturing indices, plus the Chicago Purchasing Managers' Index noted above, and the national Institute for Supply Management Index. These measures are coincident, meaning the data is released during the month for which it reports. We'll see the first of these numbers for October next week, for example. And the forecasts are gloomy.
But - more important - beginning in September we started to see the inventory components of those measures come down. Way down. How do factories reduce inventory overhangs, when nobody's buying anymore?
1. Slash prices, which hurts profits.
2. Slash production, which idles workers.
Both measures result in layoffs.
So here's the factory sector outlook: a sharp contraction in the fourth quarter, and weakness throughout 2009, and at least until both domestic and global economies gain strength. Which could be quite a while.
Retail
Retailers are bracing for a dismal holiday season. Consumer credit actually contracted - meaning people paid off more than they borrowed - for the first time in more than a decade in August, posting the sharpest drop ever.
Why is that significant? Three reasons. First, August is back-to-school shopping month, the penultimate month in the retailer's season. Second, August saw a spike in auto sales due to deep end-of-model-year discounting. Absent the auto lending that took place in August, how much more would credit have contracted? And third, August pre-dated the current "credit freeze" everyone's screeching about.
Look for retailers' fourth-quarter numbers to be down. Way down. And look for major retrenchment in the sector after year-end.
Employment
One of my predictions throughout the first quarter of 2007 was that we'd see jobless claims begin to trend higher in the second quarter. I was wrong. I missed it by a quarter. Claims began trending upward in July, with the pace accelerating in November, then going vertical of late. The US economy has suffered net job losses every month this year, and the total loss is around 800,000 jobs.
That's about half what we'll lose next year.
Part of the reason for that is the continued decline in the financial sector and construction. Part of it is that companies that have been able to hang on by just letting attrition run its course and freezing new hires, will have to start cutting. That hasn't been widespread yet. It will be in 2009. And part of it is that the previously resilient factory and retail sectors will, as noted above, slow sharply.
Housing
The correction is not done yet. The bottom hasn't arrived. Inventories are still too high. And now the negative wealth effect from stocks' decline is sidelining more would-be buyers, which will prolong the downturn.
And, starting in 2010, we're going to see the beginnings of a non-bubble-related, systematic housing correction, one that has to do with the aging of the Baby Boomers and their reduced demand for housing, with fewer Gen X, Y, Z, Millennials, and whoever else is coming up the ranks to fill those vacated homes.
Stocks panicked last week, primarily over the "credit freeze," and lawmakers' impotence in staving off a recession, which market participants should know is impossible. So in essence, we've begun, finally, to price a recession into stocks.
But we have yet to price in the earnings numbers we're going to see from the factory sector for the fourth quarter, and the outlooks they'll print for 2009. We have yet to see the retailers' holiday numbers, or their 2009 guidance. We have yet to see the labor trends. And we have yet to see the bottom in housing, or the end of bank failures.
None of that is priced into the market. So when those things come to realization, the market will go down further.
Tomorrow, we'll take a look at the consequences of excess and leverage, and why government should stop the madness and just leave the markets alone.
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