Saturday, October 27, 2007

Bull@#$% Market

If you were just paying attention to the financial markets and the official government statistics, you would surely think the American economy is zooming.

The Dow Jones Industrial Average ended the week at 13,806, just a few of hundred points off an all-time high. The S&P 500 Index finished the week at 1535, just 60 points off its all-time high. The Nasdaq is nowhere near an all-time high, but it did finish the week at 2804, the highest level since the crash of 2000-2001.

With the the Federal Reserve set to cut its benchmark interest rate next week by either a quarter or a half point, the equity markets are sure to go even higher in the near-term.

The government says unemployment remains well under 5% and core inflation (inflation stripped of food and energy costs) is running at 1.9%.

Wow - everything is great!!! We've got low inflation, low unemployment, relatively low interest rates that are set to go even lower, and the financial markets are near all-time highs!!!!

What a great economy!!!

And yet a new LA Times/Bloomberg News poll finds that 2/3rds of Americans are very sour on the economy and expect a recession within the next year. That finding jibes with an August Wall Street Journal/NBC News poll that also found 2/3rds of Americans believe the nation is either in a recession or soon will be in one.

Both polls found Americans have little-to-no confidence in political leaders in either party, in corporate heads in the financial, energy, insurance or real estate industries, or in Federal Reserve Chairman Ben Bernanke to handle future economic crises. Many Americans feel they are getting screwed as they have to work longer and harder to make less, but pay more for the things they need like food, housing and gas. As Journal/NBC News pollster Peter Hart said:

"There's a combination of anxiety and loathing," Mr. Hart said. "There's a sense that every single one of these institutions is totally out for their own betterment, versus the public they serve."

What's going on here that so many Americans can be so pessimistic about the future and gloomy about the direction of the economy while unemployment and inflation are so low and the financial markets are doing so well?

The answer lies in two rarely stated truths:

The first is that the economic gauges/numbers the government uses to measure unemployment, inflation, home sales and the like are rigged and manipulated to make conditions look better than they really are.

The second is that Wall Street doesn't need the people on Main Street to be doing well financially to do well itself. In fact, Wall Street tends to do better when people on Main Street are getting screwed (for example, watch what happens to a stock when a company announces lay-offs or wage cuts; also watch what happens to stocks when the government announces consumer debt has increased and savings decreased...)

Let's take a look at the first rarely stated truth - they're funking with the numbers to make things look better.

The Bureau of Labor Statistics does not count people as unemployed if they are not working for pay and have no interest in finding a job. Homemakers, some retirees, incarcerated people and students fit this description and since they are not willingly looking for work, it is apt.

But BLS also does not count workers who have stopped looking for work because they cannot find any or because they cannot find any that they are willing to take. Middle-aged workers who have lost their jobs to downsizing or outsourcing constitute a fair amount of the kinds of workers who are unemployed but are not counted in the unemployment stats because they are no longer looking for work. Almost certainly, unemployment numbers would be higher were workers who have lost good paying jobs but refuse to stock shelves at Walmart or sling coffee at Starbucks counted in the statistics.

Another problem with using the unemployment rate to measure the overall health and wellness of the economy is that it only measures whether people are working, not whether they are working and making good pay.

The American economy has seen a steady erosion of good-paying manufacturing and tech jobs over the last seven years due to outsourcing, downsizing and other factors. Many of those good-paying jobs have been replaced with lower-paying service jobs. While it is technically correct to say that the country has replaced lost jobs with new ones, is it correct to say that a lower-paying job in the service sector is equal to a better-paying manufacturing or tech job?

No wonder Americans are feeling so insecure about the future. Many worry that they will reach middle age and lose their jobs to downsizing or outsourcing. They worry that they will have to take a lower-paying job that lacks benefits just to make a paycheck every week. They worry that just because they give their loyalty to a company doesn't mean they won't be part of a corporate downsize or exercise in belt-tightening. Yet, this anxiety is not measured by in the official stats.

The way the government calculates the inflation rate is also particularly deceptive. The government looks at two measures of inflation - headline inflation (the rate at which the cost of living is rising) and core inflation (the rate at which the cost of living is rising minus food and energy costs, which are considered volatile and subject to rapid fluctuations.)

When you see a headline in the paper or hear a talking head on TV say "Inflation is in check," they are talking about the headline inflation numbers. Currently, headline inflation is in check - the cost of clothes, computers, electronics, cars, even houses are rising at a very low annual rate of inflation. In some cases, prices are actually falling (housing in many markets, for instance.)

Now if you were able to live by just purchasing clothes, computers, electronics, cars, et al., you could say that inflation is pretty much in check. But you can't. You need food and energy and that's where inflation is really increasing. Currently oil is at $91.86 a barrel and expected to go even higher after the Federal Reserve cuts rates next week. The price of oil has gone from $18 a barrel in 2001 to near $92 now, an increase of more than 510% over that time period. While the increase in oil prices hasn't filtered through to gas prices at the station pumps yet, it will soon enough. The all-time high for oil, adjusted for inflation, was $101.70 dollars and it came in 1980. We are less than 10 bucks away from breaking that record in 2007.

Food prices are also up over the last year. While the price of corn has fallen since the summer, wheat, soybeans, coffee, and livestock are either at highs for the year or near highs for the year. When I went to the farmers' market this week to buy produce, the prices of tomatoes, lettuce, carrots and fruit were all up - in some cases as much as 50%-75%.

It is dishonest to measure inflation stripped of food and energy costs and declare inflation under control. And yet, that is how the Federal Reserve looks at it. Federal Reserve Governor Frederic Mishkin said this week that inflation measures that exclude food and energy costs are a "better guide'' to underlying changes in prices because they strip out volatility. Part of the increase in food prices is due to higher energy costs, of course - it costs more to produce food and transport items - but since oil has been on a long, steady climb since 2001, it's not as if anybody should expect energy costs to decrease soon and cause wild fluctuations in prices. The price of energy has gone all one way - up.

The only reason to publicize the core inflation numbers over the headline numbers is because they look better. But people who buy food and use energy know better.

One last piece of data that the government manipulates that I'd like to look at is the new home sales numbers. This week the U.S. Census Bureau and the Department of Housing and Urban Development released new home sales for September 2007. The government reported that new home sales increased by an annual rate of 4.8% from the previous month. The news media, particularly the business press, wasted no time in hitting the news wires with stories like "Has Real Estate Hit A Bottom?" and "New Homes Sales Rebounding," but as Barry Ritholtz at The Big Picture noted on his blog, the increase in new home sales for September needs some context to be truly understood.

First, the July and August home sales numbers were revised downward, making the increase in September sales marginal at best.

Second, year-over-year new home sales were down 23.3% from September 2006 to September 2007 (margin of error 8%, therefore statistically significant)

Third, the margin of error for the 4.8% September increase in new homes sales was 10.3%, making the increase statistically insignificant.

Fourth, new homes sales are subject to major revisions in coming months - July and August, for instance, were both revised downward. September's sales contain some questionable stats (38% increase in new homes sales out West, for example) and if those numbers are revised downward as expected in coming months, September new homes sales will actually have decreased.

Finally, cancellations of new homes sales are not calculated in the statistics. As Barry at The Big Picture notes, cancellations of new home sales are huge:

Cancellation rate for Quarter
Centex (CTX) 35%
MDC Holdings (MDC) 57%
KB Homes (KBH), 50%
Lennar Homes (LEN) 32%
D.R. Horton (DHI) 48%
Beazer Homes (BZH) 68%
NVR (27%)

Add all this together and you can see that the real estate market for new homes is not getting better. Yet how would you know this unless you dig deep into the stats for the context? You certainly cannot count on the veracity of the government stats or the news media to provide the context for you.

As for existing home sales, they were released on Tuesday and they were dismal. Sales of previously occupied homes in September dropped 19% from the same month a year ago and The Wall Street Journal's quarterly survey of housing-market conditions in 28 major U.S. metropolitan areas showed that inventories of unsold homes are still rising in most areas, prices are falling and overdue loan payments are piling up.

Take a look at the default rate in California to get a good idea of where things stand in the housing market:

Remember that many of these mortgages that are in default are backing bonds owned by investors, hedge funds, pension funds, etc. Just yesterday, Moody's downgraded $33 billion dollars in CDO's (collateralized debt obligations) backed by sub-prime mortgages to junk bond status (some of these CDO's were rated as high as AAA, but today they're garbage.)

As defaults and foreclosures continue to increase and problems in the mortgage industry spread (and they will - see this Associated Press article from today for some reasons why), you can expect even more CDO's backed by sub-prime, Alt A and even some prime mortgages to be relegated to junk status. Yet so far, investors on Wall Street have chosen to focus on the coming Fed interest rate cuts and continue to bid up the financial markets.

Apparently only the people on Main Street are worried about the economy.

And they should be. Because Wall Street does not care one whit for how people on Main Street are doing. So long as the people on Main Street are kinda employed, paying their credit cards and mortgages on time, and continuing to fuel the economy with consumer purchases, Wall Street is happy.

Which brings me to my second rarely stated truth: Wall Street does better financially when Main Street is not doing so well.

70% of the U.S. GDP comes from consumer purchases. Corporate profits are clearly driven by the people on Main Street. But Wall Street doesn't really care if the people on Main Street can actually afford the consumer purchases they are making, just so long as they are making them and making their credit card bills. It's only when bankruptcies and defaults start to rise that Wall Street worries. And then, they can always count on the politicians in Washington to rewrite the bankruptcy laws or come to the rescue with a government-sponsored bail-out to save investors from harm.

And as I said earlier, there is no better move a company can make then downsize its workforce if it wants its stock price to increase. Countrywide Financial saw it stock rise 32% yesterday despite the problems in the housing and mortgage industries primarily because they have promised large job cuts and increased productivity in the next quarter. Boston Scientific, plagued by weak sales and debt problems, saw its stock rise after it announced thousands of lay-offs last week. Circuit City laid off 3,400 hundred "overpaid" employees back in March of this year in order to cut costs and make Wall Street happy. It didn't work - Circuit City stock has plunged since then - but the move often works for most other corporations.

Lay-offs are great for Wall Street, not so good for Main Street.

Crushing levels of debt are also bad for individuals but good for investors. This is why the housing boom of the last few years was so good to Wall Street. Investors were happy to see many Americans refinance their home mortgages to adjustable rates in order to splurge on home improvements, vacations, or cars. Wall Street likes it when people borrow money in order to spend money. So does Washington. Former Fed Chair Alan Greenspan urged homeowners to switch to adjustable rate mortgages and of course President Bush famously told America it was their patriotic duty to go shopping after 9/11.

But the results of all this spending are very, very bad. Currently the total credit card debt of all Americans is equal to 100% of GDP. Total credit market debt (credit card debt, car loan debt, mortgages, government debt, etc.) is equal to almost 325% of GDP. The savings rate in this country is negative (and has been for a while.) The dollar is at an all-time low against a host of foreign currencies. We are financing two foreign wars completely with borrowed money (adding $1-$2.4 trillion dollars in government debt.)

We are a nation of debtors living on borrowed money and borrowed time. At some point, these debts will come due, but we do not have the money or strength of currency to pay them.

And yet, if you were just looking at the official government stats and the state of the financial markets, you'd think all is well.

To which I say - bull@#$%.
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