I my estimation the economic environment for 2007 will be

By Eric Watson,2014-05-13 21:48
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I my estimation the economic environment for 2007 will be


    By Marv Adams


    In brief summary, 2007 was a year of great volatility with the prices of commodities rising dramatically and stock markets setting new highs and then retreating broadly. Lenders, builders and financial companies took a beating while some tech, medical and many mid-cap stocks did well and while some emerging markets soared. The housing market was a bust as credit in many forms tightened and the “R” word (for recession)

    became much more common in conversation. It was a year of growing uncertainty. While 2007 has come to be known as the year in which the debate over a possible housing bubble burst had clearly come to an end, 2008 will be the year in which the debate over the possibility of a recession likewise, will clearly come to an end. My 2008 forecast will explain why I foresee a continued contraction of the economy, which will eventually evolve into the most significant recession of the post war period. I will also offer some possible methods to financially survive and thrive through it.

    My fundamental economic observations have not changed from last year. Specifically, that the US economy and more specifically the housing market, have been unsustainably propped up by recklessly available credit, which has now gone the way of the dinosaur. The result will be a strong retraction in the housing market, consumer spending and the US economy generally. There are several bits of data that are foundational in forming my premise, most fundamentally, the housing/mortgage data. Consider the following.

    First is the demise of sub-prime mortgage lending. According to the Wall Street Journal, in 2006 total mortgage lending in the US was about $6 trillion of which sub-prime and Alt-A loans (a category between prime and sub-prime) made up roughly a third or about $2 trillion. With rates of default approaching 20% in these loan types by the end of 2007, lenders and secondary investors have all but abandoned this market. In October of 2006 Countrywide financial, the largest home mortgage lender in the US by dollar volume made $3.3 billion in sub-prime loans. By October of 2007 that number had dropped to $42 million, a decline of 98.7%. With a third of potential homebuyers eliminated from the marketplace, US housing market pricing and volume simply cannot be sustained at prior levels.

    Next, according to data published in the WSJ (source B of A), $221 billion of adjustable rate sub-prime loans reset in 2007. In 2008 $357 billion will reset, with the highest levels being reached in the second quarter. Prime mortgages follow a similar curve with the dollar amounts being $283 billion in 07 and $502 billion in 08. With that flood of impending resets, many markets will be inundated with inventory as owners who are unable to refinance their homes, place them for sale or let them go back to the lenders. Government intervention may mitigate the extent of this wave, but proposals are many and likely to be a long time in coming to fruition and then will only effect a portion of borrowers. I expect the ramifications of mortgage loan resets in 2008 to have a profound effect on the real estate market.

    Third is the newly cautious state of residential real estate lenders in general. Lenders are literally under siege from every quarter. Both Federal and State regulators are throwing a myriad of new laws at lenders in an attempt to curtail “predatory lending” a concept akin to charging a Las Vegas show girl with predatory dancing. These regulations will greatly increase a lender’s limitations in making new loans as well as increase costs and complexity through greater compliance requirements.

    The attorney general of the state of New York has submitted a case charging Washington Mutual with coercing appraisers to inflate values in order facilitate lending. The city of Baltimore has filed suit against Wells Fargo for predatory lending in minority neighborhoods. If these types of cases are successful in any substantial measure, in any state of the union, attorneys will flock to this legal arena in droves with wrongful lending suits, further inhibiting lender’s ability and willingness to lend. The mere allegation of these charges can only drive lenders to reconsider their practices and tighten standards to eliminate the possibility of predatory lending and tort liability.

    Lenders are also suffering from the general rise in defaults. Not only are sub-prime home loans defaulting at a nearly 20% rate but prime home loans, car, credit card, and student loan defaults are at record levels. Countrywide financial reported at the end of 2007 that their loans of all types are experiencing a delinquency rate of 7%, the historical average is under 2%. This rise in defaults is causing once freewheeling lenders to reign in their standards to even the most creditworthy borrowers of every type. Homebuyers must now document their assets and income as well as provide the historically traditional 20% down payment in order to qualify for a loan. The lending pendulum has swung from laxity to scarcity, which will further delay a recovery in the housing market.

    To anyone willing to objectively examine the data it becomes clear that the driver of the “housing boom” of the early 21

    st century was abundantly available credit and that with

    this market driver deeply curtailed, the US residential real estate market simply cannot return to the price and volume levels realized from 2001 to 2006. The likelihood that investors and lenders will return to stated-income, sub-prime loans with $0 down payment is virtually zero. The financial conditions which created the recent housing boom are gone, and they aren’t coming back.

    The question then becomes to what extent the housing bubble burst will effect the US economy. According to a local Las Vegas news report, of the home appreciation realized from 2001 to 2006, 60% has been borrowed out in the form of home equity loans or refinance. To what degree that is true for the nation as a whole is unclear. Yet it is certain that a substantial amount of the equity created through home appreciation over the past 6 years has been borrowed against, to buy cars, trips to Hawaii, home remodeling, education and a breadth of other uses. Clearly, with the national median home price declining 6.7% in 2007 (Case-Shiller), this source of liquidity will no longer be available at the levels it has been in the past and the ramifications for the economy are inescapable.

    Unemployment has been a pillar of bullish sentiment in 2007 yet the numbers have crept up in the final quarter of the year until in December the figure reached 5%, a 2 year high. Possibly most notable is that the job losses were spread over a broad range of sectors indicative of a wide spread economic slow down.

    It has been postulated by many that the demands of foreign buyers for US manufactured goods would pull the American economy from the jaws of recession. Keep in mind that 70% of the US economy is generated by consumer spending and the remaining 30% is comprised of manufacturing, farming, entertainment, financial and other components which would all need to sustain substantial growth to offset a reduction in consumer spending. The Institute for Supply Management’s index, which tracks the productivity of

    US manufacturing, delivered numbers for December challenge the notion of foreign demand coming to the rescue. With a rating of 47.7% the index is at its’ lowest level since April of 2003 and represents a trending decline over the past year. Ultimately it seems highly improbable that if the American consumer significantly reduces his consumption of Nikes, Sonys and BMWs, that the Chinese, Japanese and German economies will carry on unscathed.

    Also noteworthy is the impact of declining real estate prices and consumer spending on State and local governments. State governments typically rely on three main sources of revenue, sales tax, property tax and income taxes. After adjusting for inflation, state revenues declined .6% in 2007, the first decline in 4 years. Continued declines in real estate prices and consumer spending can only impact the revenue streams of state governments in a negative way leading to less local governmental spending of all types. State governments will likely enact budget cuts to make up shortfalls, further constraining the national economy.

    There is such a wide breadth of data supporting the premise of an impending US recession that it is impractical to explore it all, consider just a few more; the savings rate for US households has been a negative number since 2005. Retail sales for the 2007 holiday season were the poorest in 5 years, household consumer debt is at 18.7% of household assets, an all time record. US auto makers, homebuilders, and brokerage firms will post multi-billion dollar losses for 2007. American express wrote off $440 million in bad debt consumer debt at the end of 2007 and forecasts more write-offs and slower sales, commercial real estate vacancy rates are rising nationwide. Mortgage insurers, bond insurers, home mortgage lenders, Fannie and Freddie are struggling. The national decline in the median home price was the first since the great depression. The dour statistics are numerous and poignant, but as always, with any swing in a market there is opportunity for profit.

    In 2006 John Paulson created two hedge funds with the purpose of creating wealth from the downturn in housing. Simplistically stated, his funds were able to short the bonds which backed sub-prime mortgages. As the sub-prime market imploded in 2007 his funds soared and were up $15 billion by year’s end. Mr. Paulson’s personal wealth rose and estimated $3 to $4 billion. Investors who bought a Brazilian focused mutual fund called Direxion:LA Bull 2x;Inv made 88.06% on their money in 2007. The Brazilian stock market average overall was up 43.6%. Holders of gold made 31.4% in 2007 and oil investors realized a 57.2% return. The average mid-cap mutual fund was up 14% as of the beginning of December. Hefty investment profits were made in a year in which the US housing market and economy in general clearly contracted, so the obvious objective is to correctly anticipate near future events and take a position to capitalize on them. Here is my vision of the coming year.

    It is most likely that political pressure will be brought to bear on the Federal Reserve to intervene and take action that will curtail short-term pain at the expense of the long-term remedies. The Fed will substantially lower its’ overnight funds rate and inject liquidity

    into the banking system in an effort to promote lending and stimulate the economy. These actions will be inflationary and I fear will have little impact on overall lending because of the uncertainty felt by lenders in an environment of record defaults. I will examine the impact of this action in the context of several arenas.

    The dollar’s value against foreign currencies will continue to fall, making a variety of imports more expensive, most notably oil. I expect oil to rise dramatically in 2008 partially due to the declining value of the dollar but also because of worldwide demand. According to the series “Planet in Peril” Chinese demand for oil will grow by 10% annually over the next 10 years. The growing economies of Russia, Brazil, India, and the Middle East countries are consuming an ever-greater amount of oil. Iran has already become a net importer of oil. Combining these two factors as well as the unknown potential of geopolitical instability, I expect the price of oil to spend much of the year over $100/ barrel and I think $150/barrel is likely. Energy sources of all types should follow suit, regardless of slowing of the domestic economy.

    I expect other commodities to continue their upward climb as investors seek to shelter their wealth from the declining value of the dollar. Traditional stores of value, gold and silver will likely rise 50% or more in 2008 while manufacturing related metals such as platinum, titanium, copper, zinc, steel, etc., will rise at rates related to their scarcity and use in manufacturing. I believe most commodities will represent a good investment in 2008 excepting those associated with housing and construction.

    The residential real estate market will not rebound in 2008, it will get worse. While that is not a comforting statement for many, it is the only logical outcome. With the impending flood of mortgage loan resets, current rates of default and lender fear, there is no other conclusion to draw but that the US housing market will continue to founder. I would recommend careful consideration of any real estate investment until the winter of 2008/2009 at the earliest, and even then only after conservative reevaluation of the local market.

    Commercial real estate has long been thought to be immune from the woes of the residential market but I see 2008 as the year the commercial real estate market falters. Many people are unaware that commercial real estate finance is securitized in large measure the same way sub-prime residential finance is. Loans are made with, or sold to investors who fund these investments based on estimated rents and vacancy factors. With a sagging economy, vacancy factors will likely continue to rise and rents will fall making commercial property investors less likely to provide financing for everything from new San Diego high rise projects to New York office buildings. Look for some conspicuous defaults in commercial real estate in 2008, especially in markets such as New York that have recently set record sales prices on properties that do not cash flow. I do see low and medium income residential rental properties as a potential bright spot in real estate investing. Displaced homeowners, indeed all people have got to live somewhere.

    I see stock markets as being very erratic in 2008 with a few winners but the majority of stocks declining as an outgrowth of lower consumer spending. There is a very real possibility that we will see a sell off along the order of magnitude of the tech bubble burst of 2001. I expect the S&P and Dow to end the year lower than they started. Traditional wisdom holds that investors move into defensive stocks in a declining economy but since the masses are already lining this path, it seems likely to be hard ground for garnering profits. I see greater opportunity in companies that produce a product or service that has strong worldwide demand. These could be biotech, pharmaceutical, energy, mining, technology, farming, manufacturing or other sectors that have strong international markets. They will most likely be small or mid cap stocks but could include large caps like GE or Boeing. It will be a good year to be generally bearish on stocks.

    Inflation will continue to plague the country as the declining dollar value causes a dramatic rise in the price of oil and consequently, everything that oil produces, moves or preserves. While the government will report a “well contained” core inflation rate, the prices of milk, tennis shoes, gasoline, watches, computers, motorcycles, paper, skydiving lessons, college education and nearly everything else will be 10% or more higher at the end of the year.

    Inflation is the result of a government or banking system creating more money and pumping it into an economy without a commensurate increase in the production of goods and services. That is what Washington will do in an attempt to stimulate the economy. Given the choice of inflating the currency or allowing the pain of recession to fall on the public, governments will always inflate the currency.

    While emerging markets will not be immune to the effects of a declining US economy I still see these investments as a better opportunity for growth than US stocks. China’s rate of GDP expansion has been in excess of 10% for 5 years. In the event this rate of growth were to be cut in half it would still far exceed the projections for US GDP growth. However, I believe the days of easy windfalls in China are past and that a correction in their stock markets is due. So while dramatic growth opportunities may exist in such sectors as Chinese auto manufacturers, I think investors must use caution with formerly highflying Chinese stocks. Of the 5 highest performing US based mutual funds of 2007, 2 were focused on emerging markets in Latin America. Investing in foreign markets also takes advantage of the decline of the dollar against foreign currencies.

    I have saved my view of bonds for last as I see this as the greatest area of potential tumult. News at the end of 2007 is rife with reports of the tenuous positions of bond insurance companies like Ambac and MBIA. Defaults on sub-prime mortgage securities and on exotic investments known as credit defaults swaps are already straining the assets of bond insurers. With the reduction of revenue streams to State governments it is likely that states will struggle to meet the payment of interest on bonds, further straining insurers. Should these companies falter in a substantial way, it would set off a chain reaction of events that would effect many investors and institutions. It could indeed lead to times of great economic upheaval. While the government would surely get involved in some sort of bail out of these firms, we must consider that the US government is simply not capable of funding a resolution to all problem areas. Financing sub-prime homeowners, bond insurers, two foreign wars as well as providing domestic funding is beyond the scope of what the government can do. Raising taxes would crimp the economy, issuing abundant new debt could devalue the currency, cutting programs would be politically risky, yet the government simply cannot fund it all. There is no easy solution and Washington must consider the credibility of its debt. The value of a bond is based on investor confidence in the ability of a bond issuer to pay the debt. US government debt has been viewed for decades as the most stable in the world because of the perception of wealth enjoyed by the country as a whole, but with sagging real estate and stock markets; investor perception of wealth could wane. Creating substantial additional debt risks that scenario. The entire domestic debt market is in a tenuous position, yields are low, inflation is high and I conclude therefore that domestic bonds do not constitute a good place to store wealth.

    Indeed the origin of current US economic uncertainty was the abandoning of the dollar’s tie to gold or any other asset of enduring value and subsequently by the enormous debt created by Washington in an attempt to placate everyone. From foreign aid to school lunch programs to oil for American automobiles, government debt has paid for it all and just like a family which lives on credit cards, a day of reckoning must come.

    So what can one do to better prepare? First, reduce debt, possibly by liquidating non-revenue-producing assets. Everything from the Jet Ski in the back yard to negative cash-flowing commercial buildings could be looked at. Should the economy sag significantly, the value of these assets will fall as more and more people attempt to raise capital by liquidating assets. Selling sooner rather than later will garner greater revenue which can be used to liquidate debt. From my perspective only those with the liquidity to carry an asset at it’s negative flow for several years (3+) should maintain that asset/debt load.

    In finance classes a concept called, “The rule of expanding wants,” is taught, which states that the first thing a person does when their income increases is to increase their life style. Conversely the last thing that person does when their income decreases is to decrease their life style. Lifestyle reduction is another viable option to reduce debt; trade the new BMW in for a Toyota, take fewer/shorter vacations, go to ARCO instead of Starbucks, buy at target instead of Nordstrom’s, buy Casio instead of Rolex, just go without. While

    these options may seem distasteful for many, carrying large debt loads in a down economy could be crushing, resulting in loss of the BMW anyway.

    Next, a potential buyer or lessor of property may be well advised to postpone purchase or lease for a year, seeking short-term leases, options, or postponement instead. I believe everything from raw land to homes to commercial office space will be cheaper in 12 months. Of course landlords would want to lock in longer-term leases now, and sellers might sell now if they cannot hold out for 3+ years as the economy cycles.

    Stay liquid. Conventional financial planning suggests maintaining a readily available supply of capital to meet 6 months of living expenses. I suggest that now is a crucial time to maintain this reserve. Any relatively stable asset that can be readily converted into cash within a week would qualify. Reviewing the strength of the institution where funds are held would also be prudent. I also believe shifting assets to more conventional stores of wealth to be wise. These assets might include commodities like oil, metals or other commodities and assets denominated in strong foreign currencies. The extent to which one makes this shift would depend upon their agreement with the premise of an impending significant economic down turn. Storing other resources like common coins is never a bad idea, a penny is currently worth about $.03 in copper.

    Finally, learn from the past. The great depression saw deep economic hardship for the majority of Americans, however for a few, it was a time of great wealth creation, specifically for those who held cash or equivalents. These people were able to buy assets for pennies on the dollar and then resell them when the economy rebounded. Undoubtedly there are a wide variety of success stories and strategies that came from the great depression, it would be prudent to learn of them. If those who do not learn from the past are doomed to repeat it, then those who do learn from the past can prosper from it. In times of great economic change wealth is both gained and lost, I hope these perspectives will be helpful to you in attaining the former. I welcome your comments.

    As a final note, one must consider the possible, and I believe likely ramifications of real or even perceived upheaval in the US economy. The US has been the world’s big brother for decades, coming to the rescue of imperiled nations like China, Russia, England, Viet Nam, Somalia, South Korea, Kuwait, Israel and many more. Should perceived US economic power wane, look for adventurism by countries no longer concerned with the potential for US intervention. Hot spots could include former Soviet states, Taiwan, Korea, and of course Israel. Additionally the possibility of domestic unrest in times of domestic economic stress cannot be dismissed.

     This information is provided without cost and may be distributed at will. It does not constitute an offer to sell or buy anything and is intended for educational/informational use only. Data was gathered from the

    Wall Street Journal, Las Vegas Review Journal, USA today and the Las Vegas Business News. Marv

    Adams has a background as a Certified Financial Planner, stock and real estate broker.

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