Are We There Already?

The title of last week’s Brief “It’s Not That Bad” rubbed a few of our readers the wrong way. It was insensitive at best to those in the real estate industry and I apologize.US mortgage foreclosures are set to top 1 million this year and home prices are falling at the fastest pace since the Great Depression. In the real estate industry it is that bad. While there is still mixed thought on whether it will drag the economy into recession, more industry leaders and economists are calling for dramatic government action. They say we need significant fiscal (tax cuts and relaxed mortgage rules) and monetary stimulation (further Fed rate reductions).

The practice of packaging home loans into securities and marketing them as low-risk investments has been around for a long time, but problems began when demand increased dramatically with historically low mortgage rates. Greed took over and lending standards fell to criminally low levels. There will be a comeuppance in the months ahead. All the while, the rate of home ownership rose to an all-time high of 69.2% in 2004. As a result, there are a lot of people in homes that do not have the income to support home ownership. Bloomberg reports that the medianUShome price reached a record $230,200 in July 2006 and has fallen to $208,400 last month. In too many cases, that drop wipes out all of the equity in the house. The owner has no more flexibility and the borrower has no more cushion against his loan. Many of the CEOs of the companies who created this mess are calling the loudest for government action.

Unfortunately they will likely benefit from the help that is coming because there are greater risks for the broad economy. The Fed is doing its part and will likely drop rates again when they meet in March or before. The Administration and House quickly hammered out an effective stimulus plan that would put money in the hands of those who would spend it to give the economy a boost. It also enables mortgage lenders like Fannie Mae and Freddie Mac to guarantee larger mortgages than current regulations allow. Unfortunately a bill that was remarkably free of political wrangling between the oft-combative House and Administration faces just that in the Senate; a body that is supposed to be more senatorial and less directed by politics. Seems they want to give the unions and the seniors a larger gulp at the public trough.

My point last week was that the broad economy still showed signs of growth, but the signs are diminishing in number and frequency. A report today shows that manufacturing in theUSunexpectedly expanded in January. Business investment continues even as other parts of the economy weaken. The Institute for Supply Management’s manufacturing index rose to 50.7, from 48.4 in December, the Tempe, Arizona-based group said today. Fifty is the dividing line between contraction and expansion. Business from the international economy is the largest driver in these numbers. Yesterday, the government reported that gross domestic product increased at an annual rate of 0.6%, down from 4.9% in the prior three months. The pace of growth was half that forecast in a Bloomberg News survey and the slowest since the first quarter of last year.

Today government figures showed that theUSunexpectedly lost jobs for the first time in more than four years in January. Payrolls fell by 17,000 after an 82,000 gain in December that was larger than initially reported. None of the 80 economists surveyed by Bloomberg before the report predicted the decline. 

A drop in payrolls coupled with falling house prices, tighter credit, and a stumbling stock market all point to heightened risk that the economy is at risk. Payrolls are one of the indicators, along with wages, production, and sales, that helps determine the start of economic contractions. Signs are growing that recession is around the corner if not already upon us.

The warnings of slower forward-looking sales from a growing number of CEO’s is also troubling. But even when executives are upbeat on the economy their stock price belies that confidence. Today, Google, the powerhouse behindSilicon Valley’s economic recovery, said fourth-quarter revenue increased 51% and net income rose 17%. Top executives said they saw no effect of an economic slowdown. Yet the stock is down 8% today as investors expected stronger growth and fear it will slow going forward.

Microsoft Corp., the world’s biggest software maker, today made an unsolicited bid of $44.6 billion for Yahoo! Inc. to challenge Google Inc.’s dominance in Internet search services and advertising. The $31-a-share bid of cash or Microsoft stock is 62% more than Yahoo’s closing price yesterday. Yahoo has declined 18% this year and reported a drop of 23% in fourth-quarter profit. We recently bought Microsoft when its stock price cratered, but we will likely not stick with it on a decision like this one.

We will not know when or if a recession began for several months. The official classification comes many months later. But we can ascertain much from the clues mentioned before, including jobs, corporate sales and earnings, consumer spending, and productivity. The stock and bond markets have already cast their early votes for slowdown and, it could be argued, recession. We noted last week that markets on average fell peak to trough by 25% during the onset of a recession. From the October market peak the S&P 500 was down 14.1% through January 25th and the NASDAQ declined by 18.6%. (These returns do not reflect dividends) Given the extremely good valuations in stock prices now, it may be that the maximum declines have been reached. But that possibility rests on the assumptions that banks have discovered and disclosed the majority of their sub-prime risks, that bond insurers will not be downgraded (as billions of dollars of bonds they insure will follow forcing banks to further mark down their holdings) and that the global emerging markets can sustain sufficient momentum to pull the developed markets out of a slowdown or shallow recession.

Our tactical allocations are influenced by a view that we are in or very near a recession and that it will last 12-18 months. The duration will be closer to the short side of the range if global momentum continues and if the housing crunch begins a turnaround. Energy prices will continue to fall on lower demand and foster recovery. Our bond allocation will increase if it appears the recovery will be further away.

Have a good weekend.