Thoughts from a day in the bleachers

My next interest rate/economic forecast class will be held on June 10th in Los Angeles at 6pm or for those outside the area I will present the same class in a webinar format on June 11th at 6pm (PST). Registration is limited, for more information: Class  Webinar

My best thinking usually occurs in the quiet of a shower, late night at the office or in the empty bleachers at a baseball game. The amount of information available each day on the economy and markets can be overwhelming and most investors need to see a consensus of opinions before making the decision to act. Very few investment professionals urged their clients to exit stock positions in October 2007 and those that did found very few followers because the majority was drinking the Kool-Aid that the sub-prime crises was contained and the economy was on the verge of another rebound. Looking back it is easy to see why they were wrong but it’s a good exercise to keep a journal of all investment decisions with the reason given at the time and then go back a year later and analyze whether you were correct and for the reason given at the time. One of the hardest obstacles for real estate investors that are now caught with holdings they “can’t sell” is that they made $$$ despite themselves. Because we only see the future from our own experiences and not many live more than 80-90 years it limits the amount of personal history we use as the basis for our investment decisions. Every leveraged real estate investor knew instinctively that the boom was too much but because profits and cash flow kept flowing they were convinced they would survive and be the only one not affected by any setback in values. Everyone used recent history (1980’s and 90’s) for their reasoning that any decline would represent another buying opportunity and were far more worried about missing the next move than taking chips off the table and watching the real estate crumble. It’s far easier to lose in company than win alone and many real estate and stock investors rationalized the past year’s destruction of their wealth with comments like “everyone else lost” or “no one could have seen this coming” because it is too difficult to follow your own reasoning or thought process if everyone on business television, newspapers, friends & family, etc. is going the opposite way (getting out). Who wants to get off a train that is on its way to profit heaven? All of this is compounded by the fact that all real estate investors look to the upside (led by always optimistic agents) because it is virtually impossible to make $$ when prices fall. Stock investors can and do go short but during the entire bear market analysts on business television were asked daily what they were buying when clearly they should have been asked what they were selling to make money. The bottom line is we all need to find empty bleachers where we can think and come to conclusions we can act on without the need for other fans/analysts to tell us what they are doing. The biggest mistake investors and traders have made in the past 18 months is not the selection of investments but not using stop losses at pre-determined levels so that you have enough capital remaining to try again. The main reason most stock investors never sold all the way down was the fear of missing the next rally but forgot that if you lose 50% of your capital a 100% rally is needed just to break even and those aren’t good odds for anyone.

The Fed and the direction of long term interest rates

Today’s Fed announcement was basically a repeat of last month’s with a few exceptions that give no indication of a change in current Fed policy. Both stock and bond markets were hoping that the Fed would announce an increase in the amount of bonds and/or mortgages purchased but since the Fed hasn’t come close to reaching the previously announced amounts it would be premature to show its next hand in this long running game of chess with the markets. The Fed is well aware the magical line of 3.00% has now been crossed and bears (betting on higher rates) will be increasing positions the longer we stay above this mark. It’s important to remember three items when forecasting long-term interest rates for the remainder of this year. 1) The Fed did NOT say they would only buy $300 billion of Treasuries only that they would complete their purchases by Autumn. My forecast is for them to continue these purchases after reaching the $300 billion target announced last month. This Fed and its Chairman (Bernanke) are more aware of traders and investors positions than any Fed in history and would like nothing more than to set a trap where bears are caught with short positions above 3% and then forced to cover on more Fed buying closer to 2.50%. 2) Inflation is NOT a problem now nor should it be despite the massive printing of dollars by the Fed. Excess reserves are soaring as banks place funds received from Treasury sales back at the Fed for safe keeping and not loans. Capacity utilization is at record lows preventing prices from rising due to high demand and low supplies of goods. 3) Seasonally May and June have been months where long rates have risen 7 out of the last 10 years. In 2008 the 10-year peaked at 4.27% on June 16th, In 2007 the 10-year peaked on June 12th and in 2006 the 10-year peaked at 5.25% on June 28th. History may not repeat in 2009 but it is always important to use this data when formulating an opinion about the future. There is an old expression that comes from years of experience: “Never fight the Fed” and those betting on higher long term interest rates will soon learn a painful lesson after a misleading increase in rates over the next two months.

The U.S. economy

Today’s 1st quarter GDP report showing a 6.1% fall in output was not surprising and the stock market rallied on expectations that things can’t get any worse. The intermediate term rally that began in March has been impressive and caused shorts and those in cash to jump in for fear of missing the next bull market. There is no question that some of the billions that have come from the federal government and Fed are seeping into the broad economy and consumer spending despite the dramatic increase in the savings rate. My forecast of a bottom in January 2013 remains on target as the credit contraction has to end before we can see any expansion. The Fed’s weekly H.8 report continues to show a consistent decline in commercial and industrial loans and those for real estate (especially commercial). The stock market’s message is one of relief that the rate of descent is not increasing more than we have hit bottom. The U.S. economy is similar to a large cruise ship and turns are not sudden but take time and this ship remains in the harbor not yet ready to sail.

Summary

Investors should remain in cash awaiting a “back up the truck” opportunity that will arrive if long-term rates rise in the next two months. Purchase of the 2-year Treasury above 1.00% will offer an excellent vehicle for investors (held to maturity) and traders that wish to take advantage of a borrowing rate of 0.25% while the Fed keeps the overnight funds rate on hold for the next 2 years.

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Four more questions that must be answered

Why not join the growing list of nightly readers who were warned in advance of this economic/credit crises and given specific recommendations that helped them create profitable investments. 

April has been a month for questions with four asked at Passover and then this week Fed Chairman Bernanke asking four related to the ongoing economic and credit contraction. Today we ask four questions that are on the minds of every person that must make crucial decisions this year regarding their personal finances, jobs and investments. Because we only see the future from our own past experiences the past 18 months have caught the majority by surprise and caused a massive loss of wealth cushioned slightly by the fact that most would rather lose in company than win alone. Only those that are willing to change their way of thinking will be able to profit in the next four years as we continue to travel on a path not seen in our lifetime.

1) Has the stock market begun a new bull market that will lead to highs surpassing those seen in October 2007?

The S&P rally that began on March 10th has lifted investors’ confidence levels and wealth by over 28%. At this point it is only a strong intermediate term rally climbing a wall of continued bad economic news. Today all 50 states reported their unemployment rates and 10 states rose to a level of between 9-10% while 8 states are above 10% with Michigan leading the nation at 12.6%. If jobs are not being created it will be difficult for profit growth and a continuation of the recent stock market rally. Bulls are seeing the recent economic decline slowing and hoping that we have reached bottom and the bears are in hiding for a few months waiting to strike again later in the summer. The memories of last year’s massacre won’t be forgotten for many years but in reality we are probably in a broad trading range where rallies that appear to be headed higher should be sold and declines that remind us of last year can be purchased. The average investor should stay far away as there are much better opportunities with less risk in government guaranteed debt instruments.

2) With massive government borrowing isn’t it a sure bet that long-term interest rates will move much higher?

“Never fight the Fed” is one way to stay in the game of investing. $2 trillion of government borrowing has forced the Treasury to issue a massive amount of Treasury bills, notes and bonds every week. The fear is that this debt will eventually go down in price and up in yield as foreign investors keep money in their own countries or gold. During the oil crises of the 1970’s the consensus view was that Middle Eastern countries would liquidate Treasury holdings sending our interest rates soaring at a time of economic stress. It didn’t occur because there is no place safer in the world than the U.S. and probably no market that could handle an influx of trillions of investment funds without a major price distortion. The Treasury is selling notes and bonds but the Federal Reserve is buying these same securities creating a tug of war between those betting on higher rates and the Fed intentionally pushing down rates as they attempt to help mortgage borrowers and consumers lower their monthly payments. It is the equivalent of playing in a poker game where your opponent continues to lose but somehow has an unlimited bankroll. Eventually a lucky hand and he wins the growing pot, it doesn’t ever pay to fight the Fed and they will do whatever is necessary to drive long term interest rates lower.

3) The housing market seems to be stabilizing, is the worst over for real estate prices?

Unfortunately the worst bear market in history is far from over and even the most optimistic agents are learning that in order to survive you must be objective in your analysis. Three years ago I wrote (see archives) that we would not experience a normal cycle but a period that has never been seen before in history. Because real estate prices don’t trade on a centralized exchange (like stocks and bonds) price discovery takes much longer and will stretch this bear market for at least another 4 years. The inability to sell short (bet on lower prices) prevents buyers (who would be covering shorts) from entering bids under the market as occurs daily in the stock market.

The commercial real estate market is in the early stages of its own “mother of all bear markets” as it does not have the same political constituency as the housing market. The securitized lending done for most commercial transactions is in the deep freeze and it will be years before banks have the capacity (capital) to refinance many of the notes coming due in the next 24 months. Retail centers are the hardest hit as job losses cut consumer spending and rents have begun to plunge taking property values down below recent purchase prices. With high leverage that was normal a few years ago most owners will soon have no equity and non-recourse loans will allow them to walk away. Unlike residential lenders commercial lenders are not prepared to take back shopping centers, office buildings and land and will soon need to hire many out of work bankers to help manage and liquidate the properties.

4) Inflation and the U.S. economy

Inflation is NOT caused by an excess of money being printed by the central bank (Federal Reserve) if the $$$ isn’t being used in the economy. Today’s Fed H.8 report shows total bank credit FELL $62 billion last week and is $278 billion lower than it was in October 2008. No economy can grow if credit is being extinguished and this is why the Fed is printing $$$ and using it to buy Treasury and mortgage securities hoping the $$ goes into the banking system. Thursday’s Fed H.3 report clearly shows the $$$ is going back to the Fed for safekeeping because banks don’t want to lend money where the value of the underlying collateral continues to decline (real estate). It’s called pushing on a string and the more the Fed prints the less it is being used by banks to lend to businesses and investors. Banks claim they have money to lend but borrowers aren’t interested because who would want to borrow $$$ to buy an asset whose value is falling? Capacity utilization is under 70% and falling rapidly giving plenty of room for producers to manufacture goods without raising prices. Monthly job losses are increasing and the competition for jobs is fierce with many accepting lower wages to maintain current employment. Everything points to a continuation of DEFLATION and a slowing economy.

The remainder of this year will see periods of what appear to be the beginning of a new trend but in reality is nothing more than a mirage as too many are seeing the world as they need it to be and not the way it is. Survival and prosperity will only come to those not afraid to change their way of thinking and having the courage to separate from the pack. The stock market rally may continue for a few months increasing confidence levels among many investors and consumers.

The big question remains: Do you have the courage to win alone when everyone else is losing? Or do you need the comfort of knowing you have plenty of company when you making decisions that have proven wrong in the past 18 months? Stop using the excuse that no one saw this crises coming….and make the decision to change. If not you will be repeating the same mistakes again and again over the next four years.

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It’s a heavyweight fight and we are in the early rounds

The biggest question for April comes from the recent action of the U.S. stock market which rose for a fourth consecutive day on Friday despite dismal economic stats. Have we seen the bottom of the bear market that began on October 9, 2007? Or is this just another rally that traps investors who are afraid of missing the next rally? Friday’s 0.97% advance in the S&P places us in rarified air as we have witnessed 9 instances of four consecutive days up and only 1 for five days up since the peak on October 9, 2007. Obviously 8 of the 9 were followed by down days and the only five in a row also saw the next day down. On the other side when we review each significant rally since the peak we find the current rally of 26.82% (19 trading days) is close to the largest rally of the bear market which took 29 trading days (11-21-08 to 1-06-09) and rose 27.37%. Bear markets are very deceptive and there have been 188 days higher and 186 days lower since the peak in October 2007 but the down days have been much larger than the up days. There is no question the shorts (or those in cash) have been caught offside and forced their way back in to the market. I doubt seriously this stock rally is the beginning of a new bull market rather a strong intermediate term counter trend rally. The stock market’s correlation with the Aussie dollar remains strong and should give us clues to the next move in stock prices.The U.S. 10-year is trading just under the key 3.00% level with the inflation component at 1.40%.

Friday’s job number was down 663,000 as expected with February unrevised (highly doubtful) and January revised lower by 86,000. The markets are not focused on the past and are looking for a significant rebound in economic activity later this year. The Labor Department’s seasonal adjustment number added 114,000 jobs last month which is even more ridiculous when one considers that this faulty birth/death model added 142M in March 2008, added 128M in March 2007 and 135M in March 2006. When the final revisions are announced in a few months an extra 200M+ jobs will have been lost but until the markets care it doesn’t pay to stand in the way.

There are quite a few important parts of the jobs report that are worth reviewing beginning with the startling fact that a year ago the unemployment rate for women and men was almost identical at 4.5 and 4.6%. Today the gender rates have widened to record levels with women at 7.0% and men at 8.7%. Temporary jobs fell 72,000 in March and followed a 77,000 drop in February. Retail payrolls fell 48,000 as consumers are saving and not spending. Aggregate hours worked fell 1.0% after a 0.6% fall in February and 0.7% in January. Employers are cutting hours as a first move and then laying off after as they try to hold onto long time workers. Europe is suffering from a multitude of situations where workers are kidnapping bosses to protest massive layoffs. The only private sector category showing an increase in jobs (+8,000) is education and health services. The scariest chart of the day shows the number of people working part-time because they can’t find a full time job. If this trend continues (there is no reason to believe it won’t) a 10% U.S. unemployment rate should be seen before the end of this year.  The last chart shows the number of people unemployed for a second consecutive month but the Labor Department only has figures that go back 15 years. The key to this chart is the fast rate of ascent and its almost perfect correlation with the unemployment rate.

Those without a job will soon run out of jobless benefits despite Congress extending aid twice last year. Originally a maximum of 26 weeks were allowed but Congress added 20 weeks and then another 13 weeks for people in high unemployment states. At least 46 states are witnessing higher joblessness and I’m sure Congress will hear cries soon to raise the maximum weeks again or why not just make it permanent relief?  A few of the newly unemployed are trying anything and everything to find a job including TV ads for possible employers.  With the number of unemployed soaring it is no surprise that over 32 million Americans or one in ten are receiving food stamps.

The Fed’s weekly H.8 report was released on Friday and shows why Fed head Bernanke will continue to purchase Treasury and mortgage securities for many months (and years) into the future. I want ALL readers to spend a few minutes reviewing this report to really understand how credit is contracting in the U.S. banking system. On line 21 it shows that banks have accumulated over $200 billion of CASH in the past month that is literally sitting at the Fed earning NO interest because banks are afraid to loan the money to anyone other than the Fed! Line 5 shows the total amount of credit from loans and leases and has fallen over $100 billion in the past 30 days and is lower than it was in September 2008! It is any wonder Gold is down almost $25 today at $873? It’s called DEFLATION!!!!

Consumers and banks are saving and that means less spending and less tax revenue for states. Massachusetts reported on Friday that March tax collections fell $309 million in the last year (16.1%) and were $53 million less than their most recent forecast. It is the negative feedback loop I have been writing about for months. Consumers spend less and states reduce their forecasted revenue and then businesses see declines in sales and lay off workers who spend less and the circle begins again.

The high end retail market is suffering from deflation with Prada, Saks and Christian Dior offering new low end ($700) handbags.

The DEFLATION can NOT end until asset prices end their decline and house prices are the most important asset that must hit bottom before they can show a small advance. Quietly last week Fannie and Freddie lifted their moratorium on foreclosures and that is NOT good for house prices. It is interesting that when they initially ended the foreclosures it received a lot of publicity but now I’m sure they don’t want to wake up Congress.

A few years ago FHA loans were a small part of most lenders originations but 2009 has brought them to the head of the pack but BIG trouble is coming soon and a government bailout may not be far behind. 20.7% of all FHA loans issued in 2008 are at least 60 days late whereas only 14.1% of subprime loans that were issued in 2007 are 60 days late. This should not be surprising to anyone as a 3.5% down payment is lost almost immediately with home prices falling every month. We are not even close to the end of the housing crises but the government is too busy wrestling with Congress over AIG, the banks and more regulations to see what is so clear to anyone outside of Washington.

The Comptroller of the Currency released a report Friday that showed re-default rates for modified mortgages continued to rise at the end of 2008. 41% of modified loans in the first quarter of 2008 were 60 days or more late by the third quarter and 46% for loans modified in the second quarter. If house prices continue to fall (and they will) every modified loan will be delinquent within months because homeowners won’t make payments on a house loan when the amount due is more than the value of the house. Add a rising unemployment rate and it’s a recipe for many more years of the U.S. recession/depression.

Banks will not begin loaning money until asset prices stop declining and borrowers believe that asset prices will rise and that borrowing $$ for purchases will create future profits. BUT banks must have adequate capital underlying their loans and a margin between their cost of funds and the rate they are charging their borrowers. Tonight’s final and most important chart shows the net interest margin at ALL US banks for the past 25 years.  Notice how it has shrunk to record levels due to a decrease in short and long term interest rates. If a bank’s margin between cost and return is small banks will continue to invest in Treasury notes and bonds that are seemingly risk free. The Fed is aware how important bank profitability is to any potential recovery and Bernanke has made it clear that the Fed will keep the overnight funds rate near zero for a very, very long time. Until asset prices stabilize banks and borrowers will have no reason to come together and the economy will continue to contract.