Serious Money: It is almost 100 years to the day since the infamous "rich man's panic" began on American stock exchanges, writes Charlie Fell.
Stock prices dropped by 40 per cent from late-March to the end of October. The savage bear market was precipitated by an earthquake in San Francisco during the spring of the previous year. The earthquake propagated a liquidity crisis that caused a severe recession. One century later and a series of seismic shocks have been delivered to America's "humpty dumpty" consumer in the housing market. Does a weak housing market matter? The economists from their ivory towers at the Federal Reserve in Washington say it doesn't and the perennial bulls on Wall Street concur. They are wrong.
Asymmetric thinking appears to dominate. Rising house prices stimulate economic growth but declining property values have a muted impact, according to the experts. Multiplier effects are supposedly minimal. The same is said of energy prices - the rise in the cost of oil following the modern version of Carter's hostage crisis in Tehran is deemed to be irrelevant. Serious investors should see such arguments for what they are - nonsense.
The US housing market is in a dreadful state and despite protestations by the money-manager gurus, it is unlikely to hit bottom until late next year at the earliest. At the current time, the weakness appears to be confined to the sub-prime market or people who should not have been afforded mortgage financing in the first place. Banks are tightening their lending standards at the most rapid rate since 1991 and Senate hearings on the negligence of the Federal Reserve are in full swing. In the last month alone, the number of sub-prime lenders who have shut down or filed for bankruptcy since the beginning of the year has catapulted from 28 to 44, but the economists say it doesn't matter.
The housing market does matter for many reasons. Firstly, academic evidence says that wealth effects arising from the property market are twice as large as those that emanate from the stock market. Secondly, the current economic expansion has been largely financed by households' ability to extract funds from the equity in their homes, which is no longer possible. Finally, multiplier effects are alive and well. Trading up becomes far more difficult as mortgage providers tighten lending standards. How easy can it be for a household to trade up when banks restrict the population of potential buyers?
The blue-sky merchants cannot accept that a recession may be on the cards. The most reliable indicators through cycles past suggest that a downturn is on the way. The yield curve, which charts short-term relative to long-term interest rates, says so, as does the Conference Board's series of leading economic indicators. The extent of the downturn in the housing market, which is far from over, says the same as does the employment market, which happens to be pretty weak. The number of jobs created during the current cycle is anaemic and payroll growth peaked ages ago.
The economy is clearly in trouble, despite the protestations of the optimists. The US economy is on track for a sustained period of sub-par growth at best. The blue-sky merchants will undoubtedly say so what - the corporate sector is in great shape and earnings will continue to grow. The corporate sector is inextricably linked to the economic cycle and when nominal GDP is sustained at 4 per cent or below, as seems certain for the next year or more, revenue growth slows and profit margins decline, which inevitably leads to an earnings downturn. Estimates of market earnings for the first and second quarters of this year have already been subject to major reassessment but consensus estimates call for a re-acceleration in the pace of growth during the year's second half. Such forecasts should be consigned to the dustbin. Aggregate profits have exhibited a sequential decline in the latter half of 2006 but the so-called experts didn't notice as low-quality growth arising from share repurchases added as much as 2 percentage points to the bottom line. Share repurchases will come to a halt as the economy slows and excess cash balances disappear.
The "humpty dumpty" US consumer is fat on debt but the more than 60 consecutive quarters of further spending may be close to an end. The US economy should succumb to recession before the year is out and a bear market is at hand. A key question for investors is whether the powers that be can put "humpty" together again - perhaps, but almost certainly after the coming bear market and recession.
charliefell@sequoia1.ie
