Sunday, November 11, 2007

So Much For That Bull Market

On October 27, I took a look at the state of the American economy in a post called Bull@#$% Market.

At that time, both the Dow (13,806) and the S&P (1535) were near all-time highs. The Nasdaq (2804), while not near an all-time high, was at its highest level since the bust in 2000-2001.

The Federal Reserve was meeting in three days and was expected to cut the benchmark interest rate another 25 basis points to 4.5%, further stoking already hot equity and commodity markets.

On the same day that the Federal Reserve Open Market Committee cut interest rates, third quarter Gross Domestic Product numbers were released showing the American economy grew at an annual rate of 3.9% - far higher than what analysts were expecting.

Two days after that, the October job numbers were released showing the economy added 160,000 jobs. This number was also much higher than analysts expected and seemed to indicate that the American economy was not in danger of falling into recession.

All seemed right with the world that week, or as right as things can be while the U.S. is fighting two foreign wars with borrowed money, the domestic real estate market continues to tank, banks are writing down losses from the sub-prime mortgage fall-out, and oil is over $90 a barrel.

Optimism abounded on Wall Street and many people assumed the Fed's interest rate cuts (with at least one more expected in December) would help the Dow and the S&P hit all-time highs before the end of the year.

Since November 2, however, the Dow has fallen to 13,042 and is in danger of dropping below the 13,000 level. The S&P plummeted past the 1490 support level and now stands at 1453. The Nasdaq dropped to 2627.

We're now not that far from having an official "correction" in the market (a drop of 10%-19%).

In addition, plenty of financial companies have announced more write-downs related to sub-prime mortgage exposure (Citigroup, Morgan Stanley, Wamu, Wachovia, E-Trade, Merrill Lynch) with both UBS and Bank of America warning of additional write-downs expected in future months.

S&P downgraded its outlook for Washington Mutual Inc. and IndyMac Bancorp Inc. to "Negative" from "Stable," and for Capital One Financial Corp. to "Stable" from "Positive" as a result of continued credit problems.

Compounding problems for Washington Mutual, NY Attorney General Andrew Cuomo announced an investigation into whether WaMu improperly pressured home appraisers to provide inflated home values (and inflated profits for the bank) in order to justify making home loans to consumers.

WaMu stock has fallen precipitously as a result, following Citigroup into the toilet.

Cuomo also warned that other banks that colluded with appraisers to inflate home values are in his sights and will receive subpoenas in the near future:

``I don't believe it's just about Washington Mutual,'' Cuomo said at a press conference in Manhattan today. ``I believe it's widespread. I believe it's the rule not the exception. And we're investigating Fannie Mae and Freddie Mac and other investment banks as to the underlying practices that have allowed this to go on for so long.''

Cuomo is also suing First American for conspiring with WaMu to inflate home values.

Further problems for mortgage lenders could hurt an already horrible real estate market.

According to the latest Case-Schiller Home Price Index,U.S. home prices fell 4.5% over the last 12 months and at an annual rate of 8.5% in August.

Home prices are now 5.3% below their peak in June of 2006.

20 out of the top 28 markets in the U.S. are seeing serious declines in prices while inventories are an all-time high.

In a series of articles published today (see here, here, here, and here), Newsday reports that the housing slump is already hurting the Long Island economy as consumers can no longer tap their homes for equity loans and go shopping at the mall or the local car dealership.

Long Island's economy is heavily dependent on consumer spending and with consumers pulling back on purchases and foreclosures increasing in many areas, Long Island is looking at a serious recession in the near-term.

Marketwatch wonders if California, a state responsible for 20% of the nation's GDP, is already in a recession as a result of falling home prices, rising foreclosure activity, slowing consumer spending and rising unemployment:

"California seems to be sliding into recession," wrote Jan Hatzius, chief economist for Goldman Sachs, in a research note earlier this week. Hatzius based his appraisal on the sharp increase in the unemployment rate in the state from 4.7% in November 2006 to 5.6% in September 2007.

While a 5.6% jobless rate may seem low, the important thing is how much it's risen. Hatzius said any increase of more than 0.6 percentage points in California's unemployment rate has always been associated with a national recession.

The consumer is slowing nation-wide, a concern because 70% of the nation's economic activity comes from consumers.

October's retail sales were particularly bad.

2/3rds of retailers missed analysts' expectations.

Same-store sales rose just 1.6 percent last month, the slowest growth since October 1995.

Even when retailers did show growth, much of it came from higher food prices, an inflationary indicator rather than an indication of true growth.

Speaking of inflation, while the Federal Reserve continues to insist that inflation is in check, U.S. consumers aren't buying it.

Consumer confidence is at its lowest level since the immediate aftermath of Hurricane Katrina.

With gas over $3 a gallon nation-wide and oil near $100 a barrel, consumers say they expect inflationary pressures to increase in coming months and think they will have to spend less on other goods to meet increasing food and energy costs.

That doesn't bode well for the Christmas sales season.

Indeed, some retailers are already cutting prices very early in the season to stoke purchases.

Nonetheless, most analysts estimate that this year's Christmas retail sales will be dismal and worry that a poor X-mas season will further pressure an already weakening economy.

Back on the real estate front, a couple more homebuilders filed for bankruptcy (see here and here) while another of the nation's largest homebuilders, Beazer, stopped paying subcontractors working with them.

The New York City real estate market hasn't taken a hit
from the bursting of housing bubble yet, but that's not exactly good news for the American economy either.

With the dollar at an all-time low against a host of other currencies, foreigners are coming in to snap up New York real estate at bargain prices.

While that helps prop up the real estate market for now, it does suggest that long-term economic growth will be hurt as the American dollar approaches bargain basement status.

As Steve Forbes is so fond of saying on CNBC, no country has ever devalued itself into prosperity.

As for the New York market, demand continues to outstrip available homes and apartments in every borough but Staten Island, but much of the demand is fueled by healthy activity on Wall Street.

If the markets continue to tank and Wall Street companies ratchet up lay-offs (so far lay-offs have been limited to divisions of financial companies related to sub-prime mortgages, CDO's, et al.), the New York real estate market will take a hit just like most of the rest of the country already is.

Which brings me back to what I was saying a couple of week's ago - the problems bubbling under the surface of what looks to be a fairly good economy (4.6% unemployment, 1.9% core inflation, stock indices still up for the year) are going to start exploding.

With hundreds of billions of sub-prime and Alt-A mortgages ready to reset to higher rates by the middle of next year and with foreclosure rates already increasing all over the country, the write-downs resulting from the mortgage mess by the financial companies aren't close to being finished.

Which means Wall Street hasn't seen an end to turbulence just yet.

Usually the end of the year brings a stock market rally and big Christmas bonuses for many Wall Streeters.

This year may be a little different.

The Dow has already fallen 7.9% from its record close just one month ago.

As I wrote earlier, a couple of percentage points more and we'll officially be in a correction.

With commodity prices through the roof and the dollar through the floor, it seems unlikely that the Fed will be able to cut rates much more before doing serious harm to the economy (like stagflation.)

Consumers, already overburdened by high debt levels and falling home values, are going to be further hurt by increased commodity prices.

If the consumer stops spending (and the October retail sales data seems to show this already happening), you can bet the economy will fall into an official recession by the middle of next year.

Which means the bull may be out of this market for a while, no matter what Helicopter Ben and his merry money printers at the Fed do to try and save it.
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