A few months ago, many were thinking we had lost our marbles when we turned cautious on the stock market. Despite the possibility of a pause in interest rate hikes, there are just too many headwinds to call for the beginning of a new bull market. A new bull market will come eventually, but we do not think that will happen until we get a major shakeout later this summer/fall.
The recent downdraft in the market may be the beginning of the shakeout, but our instincts are telling us that there will probably be one more attempt at the 2006 highs before the correction begins in earnest.
Why We Remain Cautious
My initial concern for the economy and the markets have been inflation. The causes of inflation were very apparent to consumers, but the skewed economic numbers we were receiving were saying otherwise. I have a difficult time believing economic reports that are carefully designed to hide the obvious. We all were aware of the skyrocketing price of energy, but commodity prices were also skyrocketing due to the massive growth in China. When economic reports do not account for inflation in area's like food and energy, I have a hard time buying into the "no inflation" spin.
Commodity Inflation
The loose monetary policy by the Federal Reserve since 2001, lead to an extraordinary expansion of credit. This credit expansion eventually fueled the ramped speculation we witnessed in real estate. This loose monetary policy, and soaring budget deficits, have lead to a decline in the dollar which also has an inflationary effect on our economy.
After the feds easy money policy began, interest rates (fed funds) fell to 1% sparking a real estate boom like no other. The building boom created tremendous demand for building materials which are made from raw materials. To help slow the inflationary pressures in commodities and raw materials, the Fed aimed its cross-hairs squarely on the real estate market. We are seeing the slowing of real estate as we speak.
As the economy slows, and potentially teeters with recession, the rise in commodity prices will subside, but eventually pick back up because of demand from China and the emerging markets. Also, when the U.S begins a new cycle of growth, this will add to the demand of commodities as well.
High energy prices increase inflationary pressures because some commodities are made with, or derived from, various energy products.
Commodities are in almost everything we use on a daily basis. Petroleum products are in ink, crayons, bubble gum, dishwashing liquids, deodorant, eyeglasses, records, tires, ammonia, and heart valves to name a few.
The companies making these products have a choice. One, pass on the increased costs to their consumers, or two, eat the cost and report lower earnings to their shareholders.
So, the bottom-line is, we have much higher inflation than what we are led to believe.
Demand from China & India
Commodity prices react to two things, inflation and deflation. If you believe that developing nations like China & India are going to slow their development, then inflation may cool. But, until then, don't hold your breath.
Real Estate Inflation
The housing bubble is also something I have been pointing to for over a year. Unfortunately, many investors cannot see the bubble when everything is in a state of euphoria. Consumers and investors only recognize a bubble after the fact. The deflating of the housing bubble may actually benefit the stock market as cash gets sucked out of one investment and into another. I just don't know when that will happen.
Mis-Leading Inflation Data
When inflation data is released, we are constantly told to focus on the "core inflation" number. The "core" number is the what is left over after removing the "all things inflationary" from the PPI. At best this number is unreliable. As I have said many times before, we do not have to wait on the so called "official data" before we react to a trend. I think the inflation trend has been obvious for quite some time, but of course too many people react to what they read or hear from the media.
The Employment Numbers
Some other area's of concern are the employment numbers. We are being told that unemployment is only 4.8%. On the surface one would say "wow, that's great". But, if you dig a little deep you'll see that the Labor Department does not include the number of jobs lost due to outsourcing. That's right! The unemployment rate does not include the millions of jobs lost to foreign countries due to outsourcing.
If we are really at "full employment" as the jobs figures suggest, then why did 25,000 people apply for 325 openings at a Chicago Wal-Mart.
The stock performance of the investment banks have been stellar ( Goldman Sachs, Merrill Lynch, etc). This is due to the huge wave of mergers and acquisitions taking place in the U.S. and abroad. There is a major downfall to the large number of mergers and acquisitions taking place. The main one of course is lost jobs.
Recently, AT&T said they "plan to cut an additional 10,000 jobs as a result of its merger with BellSouth Corp." When AT&T and SBC merged, 13,000 jobs were eliminated.
There was a lot of merger activity in the 1920"s. With these mergers came a large number of job losses. Layoffs, outsourcing, and corporate restructuring will eventually take their toll on the US economy.
A Potpourri of Other Concerns
Consumer Debt: In the1929, 80% of Americans had little or no savings. From 1925 thru 1929, buying on credit increased from $1.38 billion to over $3 billion. The current level of debt is much higher, and now that the real estate bubble has popped, the future for free spending Americans looks bleak.
The expansion of credit created a stock market bubble in 2000, and a real estate bubble between 2000 and 2005. This expansion of credit is responsible for the huge number of mortgage refinancing, and the creation of all the exotic mortgages created by lenders in recent years.
Many consumers are stuck with interest only loans, and lines of credit on the appreciated value of homes. As interest rates rise (7.25% on most credit- lines), and consumers losing their jobs, whose going to pay the note?
Repeal of Glass Stegal: Glass- Stegal was a depression era protection put into place to help prevent another depression from occurring. The repeal of this act has lead to the large number of mergers in the banking industry, as well as the large number of job losses that came with it.
In addition to the mergers has come a softening of regulations. Many of regulatory agencies have looked the other way as financial institutions suckered consumers into exotic mortgages, and interest only loans.
Change of the Bankruptcy Laws (October 2005): Knowing that the consumer is up to his eyeballs in debt, the financial lobby convinced congress to pass "The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005."
If you don't believe the consumer is in financial trouble, all you have to do is remember the "Lending Tree" commercial where a guy mowing his lawn says he has all of these possessions because 的知 in debt up to my eyeballs." Here's an article from the San Francisco Chronicle
I don't know how all of this is going to shakeout, but its not going to be a pretty picture. In the months ahead, many real estate speculators are going to have to go to closing on their real estate speculations. From what I am hearing, many expected to flip their properties before the closing date, but the buyers have suddenly dried up.
Stay tuned, things could get very interesting in the months ahead.
