"As a general rule, it is foolish to do just what other people are doing, because there are almost sure to be too many people doing the same thing." William Stanley Jevons (1835-1882)
Human beings are creatures of habit. We are comforted by the stability of routines. We prefer sameness to change, which is why we prefer the status quo. Markets are no different. Because markets abhor uncertainty we devise forecasts that are imbued with a degree of certainty when in fact no such certainty exists. The financial markets prefer to travel along a straight road rather than one that weaves and winds in unpredictable fashion. When trends are predictable, investment decisions are easier to make.
Herein lies the problem of investing. Life is never predictable. The world changes and so do financial markets. A boom can turn into a bust and a bull market can turn into a bear market. Nature itself is constantly changing from season to season. The essence of a living organism is movement. The same is true with the financial markets.
It comes as no surprise that making predictions has morphed into a mania. Peruse the bookstands at this time of the year and you'll find plenty of books and magazines making predictions for the New Year. The significant fact for investors is that the more prominence predictions receive, the more inaccurate they become. Most market forecasts are the product of collective thinking. Economic and market opinions have become habitual. If financial markets went up last year, they are expected to do the same this year. If the economy grew last year, more of the same is expected in the New Year ahead.
So, when contemplating the financial consensus, an investor needs to also reconcile the thought-patterns of the crowd as well as your own. Since the average investor doesn't think nor wish to think forecasts relieve investors from cerebral labor. However, going along with the consensus can be a dangerous proposition. All forecasts should be challenged. The pertinent question should not be "what is wrong" with current economic trends, but rather "what is right." It gives a fresh perspective to your thinking. Keeping this frame of mind, it's time to look at the forecast for the year ahead.
The Year of Goldilocks: A "Just Right" Economy and Stock Market
Listed in the tables below are this year's forecast. You'll find they look similar to last year's forecast. The only difference from last year is that stock markets are expected to head higher while the economy is expected to slow down.
One thing that is very clear is that there are very few bears on the stock market or the economy. Most of the bears are found with bond market mavens. In fact it is as if we're looking at two different views of the world. Stock market mavens think stocks are cheap, corporate profits will continue to rise albeit at a slower rate, the Fed cuts interest rates because of tame inflation, and companies will remain flush with cash, boosting dividends, share buybacks, or buying other companies.
In contrast bond market gurus see the world differently. They see a scary housing market that translates into a global economic meltdown. The Fed will be lowering interest rates because of major economic weakness as consumer spending comes to a standstill.
Obviously both sides can't be right. So what are the key issues? There are many issues at stake, but they can be boiled down to a select few.
- Will a housing recession sink the economy?
- Is the Fed's next move a rate cut or a rate hike?
- Will the profit boom turn to a bust?
- How will the global economy impact the U.S. economy?
- Uncertain geopolitical events, i.e. The Middle East—Iraq, Iran.
- Unwinding of the yen carry trade sparking a financial accident.
- Policy mistakes such as central banks tightening too much or protectionism.
The above list is enough to give those prone to worry enough anxiety to create some sleepless nights. Despite these worries it was hard to find a bit of pessimism anywhere. During the holidays, I read copies of almost every major business and financial publication. As shown in the magazine covers below, optimism reigns supreme everywhere you look.
2007 is a little different than last year when most forecasters were a bit subdued since the Fed was still raising interest rates and a new Fed chairman would be taking over the helm. The markets would have preferred the nebulous ramblings of Mr. Greenspan who could be counted on to flood the markets with liquidity should trouble erupt. Greenspan had the market's confidence. Mr. Bernanke was untested and so the markets were less at ease. New Fed chairmen are always tested. The numerous mishaps in the early days of Bernanke's term may be one reason why Mr. Paulsen was brought on quickly to succeed Mr. Snow. Another reason may be because the White House needed a Wall Streeter--somebody that understood how the markets function and who would be better able to garner the market's confidence while the new Fed chairman earned his stripes. Most Fed rate-raising cycles end up with financial accidents. Either the economy or the markets break. Sometimes it is both. Transitioning a new Fed chairman at the end of a rate cycle is risky business.
So, What Is the Key Issue for 2007?
Of the seven issues listed above, it's not one key issue. You can boil them down to two: global liquidity and the Middle East. Regarding the economy and the financial markets, if liquidity is fluid, then this will be another good year for the financial markets and the economy. As shown in the summary below, we could see new records for the Dow and the S&P 500 this year.
In case of the Dow we have already seen a record high. A record for the S&P 500 will take time to unfold. All of this depends on the continuous expansion of credit. The problem for policymakers is that the only way to avoid a recession is to keep the credit spigots wide open. In order to avoid an economic contraction, credit expansion must accelerate at an even faster rate. At the same time this credit expansion needs to be obfuscated. If expectations of inflation spread, the prices of consumer goods will rise faster than the factors of production. Money velocity would also increase as would interest rates. Flooding the markets and economy with credit and keeping inflation expectations down will be no mean feat. The financial markets will have to be finessed.
Recession: Three Possible Scenarios
Scenario #1 Credit Expansion Slows
A recession can be avoided if the authorities can successfully expand credit and avoid three scenarios in which credit slows down or contracts. The first scenario is when credit expansion slows down or in fact contracts due to fear by lenders as a result of losses in their loan portfolios. Under this scenario money becomes tight and loans become more difficult to get. We are seeing some sign of this today with subprime lenders either going under or experiencing losses. IndyMac Bancorp Inc., the second largest independent U.S. mortgage lender, reported fourth-quarter earnings that were substantially below its own forecast. The loss in earnings reflected deteriorating credit quality and higher finance costs. Surging home prices and the Fed's 17 rate increases have curbed demand for mortgages.
Scenario #2 Slowdown in Consumer Spending
A second scenario that could lead to recession is when the rate of credit growth slows to the point that you see a slowdown in consumer spending. Regarding credit expansion, the picture is still expansionary. Fed bank credit is growing at nearly 10% in the last three months, commercial bank credit is still growing at rates above 10%, while commercial and industrial loans have fallen to a 5.5% rate. As the graph below illustrates, sharp declines in year-over-year consumer credit portend a recession. If you want to know where the economy is heading this year, watch the consumer. More importantly, watch consumer credit for clues on a slowdown.
Scenario #3 Massive Credit Expansion: Inflation
The third scenario involves massive credit expansion by the banking system whereby the rate of change in credit expansion accelerates. Under this scenario the financial markets realize that the rate of inflation is growing. The result is that there is a flight toward real assets. This results in a sharp jump in the prices of goods and services. If this trend persists, it could lead ultimately to a hyperinflationary process that eventually destroys the monetary unit of exchange. We saw the beginning signs of this last year with a sharp rise in headline and "core" inflation rates along with inflationary expectations. It was the main reason why last May and June the Fed's "open mouth" committee moved aggressively to quell inflationary expectations. It was also the reason that there has been such a blatant attempt by authorities to hammer the commodity complex. This was done through propaganda efforts and misinformation as well as more blatant attempts to change the weighting of commodity indexes.
Source: Chris Puplava. Note: Core inflation is the headline less Food & Energy (blue line) while headline CPI is represented by the red bars.
As the table below indicates, a slowdown in the rate of credit or a contraction in credit is a prelude to a recession. Between 1999 and 2000, total credit contracted by almost 0 billion.
* annualized, ** growth in chained dollars | Source: Bureau of Economic Analysis. Table courtesy of The Richebächer Letter, Sept. 2006
The result was a mild recession in 2001. Following the brief recession of 2001, total credit has expanded each and every year. More importantly as this last rate-raising cycle began, total credit expanded at an even faster rate. This bears out the points made above of accelerating the rate of credit expansion in order to avoid the day of reckoning. Monitoring total credit will be the key to understanding whether the real estate market plunges and leads the economy into a recession.
Watch Real Estate
In addition to monitoring credit, another key variable to watch this year will be real estate. Whether the real estate recession carries over to the rest of the economy will depend on the credit factors mentioned above. However, I do not believe the real estate market has bottomed as so many in the financial press believe. The jump in new family homes in November appears to be more of a statistical fluke. New home sales are tallied by the Census Bureau based on a sampling of contracts signed by homebuyers. So if there is a rush to buy homes in November, as appeared, it shows up as an increase. The problem is if a contract to buy in November is registered, that contract may be cancelled the following month in which case the cancellation isn't counted. The National Association of Home Builders reported that cancellations in November were running at a rate of 38%. Recent earnings reports such as D. H. Horton reported that cancellations in recent most quarter were running at 33%, a slight improvement from the previous quarter when they were at 40%. The November rebound in the housing market now appears to be a statistical fluke. If the housing cycle runs its typical cycle, we should not see a bottom in the market until the end of this year or the first half of 2008.
As the tables below indicate, employment and home sales are closely related. Looking at past real estate cycles, existing home sales peak on average 18 months prior to the peak in employment and bottoms 10 months prior to the bottom in employment growth. Furthermore in terms of time, the average from peak to trough has averaged around 38 months. We have a way to go before the bottom is reached.
Source: Chris Puplava, Market WrapUp September 6, 2006
Two indicators that have been very effective in spotting when the recession in the real estate market is over is the average monthly supply of new homes for sale and the average mortgage rate each quarter. Of the eight indicators that are used as leading indicators of housing (new and existing home sales, housing starts, mortgage applications, housing affordability, and home builder confidence) the monthly supply of new homes and mortgage rates have been the most reliable in terms of spotting the bottom. The monthly supply of new homes has generally peaked one quarter before residential investment bottomed every single time since 1961. Mortgage rates have a similar lead time. Presently, reported sales are too high, and by consequence inventory levels may be underreported. Therefore, we are still a long way from reaching the bottom.
The Middle East
A second key issue for 2007 is the Middle East. Geopolitical events are difficult to predict, but movement is afoot in the crescent of civilization. The popular consensus is that an Israeli or U.S. attack on Iran is unlikely due to political weakness of both Israeli and U.S. administrations. Therefore, there is "nothing to worry about." However, the economic strangulation of Iran continues as pressure is applied on international banks and financial institutions to cut their ties with Iran. Top international banks from Japan's Bank of Tokyo-Mitsubishi, Credit Suisse to Commerzbank have cut banking ties with Iran. In addition two carrier battle groups, the USS John C. Stennis and the Dwight D. Eisenhower along with the Boxer Expeditionary Strike have moved into the region. U.S. Admiral William Fallon, head of Pacific Command, is taking over as the top commander of U.S. forces in the Middle East. The transition of command from the Army to the Navy is striking. There have been other leadership changes in Iraq as well with General David Petraeus replacing General Casey.
Both sides are provoking each other: the U.S. with the economic isolation of Iran and Iran with its attempt to foment civil war in Iraq. You also have other great powers involved with the Russians ready to deliver billion TOR M-1 surface-to-air missile defense system to Iran. Both Russia and China have asked Iran to join their Shanghai Cooperation Pact.
When you have a change in command and a military build up in the region as well as a step-up in sectarian violence, a match is ready to set fire to the tinder box of the Middle East. The best guess by experts is that the attack comes from Israel, which has the most to lose from a nuclear-armed Iran. The U.S. battle group sent to the region would act as a shield to deter Iran from retaliating in response to an attack by Israel against Iran's nuclear facilities.
Should this scenario unfold, turbulence would immediately beset the financial markets. Risk assets would be dumped, credit spreads would widen and the vulnerabilities of leveraged speculation in high risk assets would be greatly exposed. The immediate result would be a waterfall decline in the financial markets as the flight to quality takes hold. The beneficiaries of such a scenario would clearly be oil, gold, and short-term Treasuries. The speculation regarding such an event is that the upheaval in the financial markets would be brief. Central banks would pour hundreds of billions of liquidity into the markets to contain the fall out, similar to the Asian, Long Term Capital Management, and Russian debt default rescues.
Whether this event takes place, and if it does, whether it will be short and brief is pure speculation. Nobody knows. However, it should be pointed out that leveraged speculation is greater today than what is was in 1997-1998.
There is some degree of speculation that the reason the oil markets have been attacked the way they have since the latter part of December is a prelude to an attack coming in late spring. We know the markets and the economy can handle oil. Oil at 0 is another story. Clearly the recent drop in oil goes beyond weather.
Some may think the talk of attack is nothing other than conspiracy. However, I regard the markets to be far too complacent on this issue. It is not as if we haven't been warned by both warring factions. Iran has stepped up its violence in Iraq as we witness the bombings of the last few days. President Ahmadinejad has provoked Israel by his repeated speeches threatening to annihilate the country as soon as it is able. The U.S. is escalating economic pressure on Iran as well as building up its military forces in the region. The Middle East is clearly the most volatile and unstable part of the world. It is the world's largest gas station where you have madmen running around lighting matches. [See Lutz Kleveman 2004 interview.] Given the sequence of recent events and the increase in provocation by both sides the markets could be in for a major shock.
For those who are skeptical about this possible scenario, I refer you to:
9 January 2007 "Attacking Iran: The market impact of a surprise Israeli strike on its nuclear facilities," ING Special Report by Charles Robertson and Mark Cliffe
9 January 2007 "Widening War? If Iraq Worsens, Allies See 'Nightmare' Case," The Wall Street Journal Online article by Neil King Jr. and Greg Jaffe
8 January 2007 "Energy Dumped," New York Post article by Michael Norman
11 January 2007 "Bush Administration Works to Sell Troop Buildup to Defiant Congress" The Wall Street Journal Online AP article
11 January 2007 "Bush's Iraq Plan Faces Obstacles on Two Fronts: Democratic Opposition, Divisions in Baghdad May Hamper New Push" The Wall Street Journal Online article by Yochi J. Dreazen, Greg Jaffe, and Neil King Jr.
11 January 2007 "The Plan for Economic Strangulation of Iran," Online Journal article by Dr. Abbas Bakhtiar
8 January 2007 "War with Iran Is Imminent," WorldNetDaily article by Jerome R. Corsi
10 January 2007 "Iran Begins to Feel the Financial Squeeze" The Wall Street Journal Online article by Michael Connolly
For those interested in the history of the Middle East and how it ties into the current scenario, I refer you to my recent discussions with John Loeffler on Financial Sense® Newshour's Big Picture about this topic.
