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Summary of the Bearish Case

Fri, Jun 15 2007, 07:56 GMT
by Comstock Partners Team

Comstock Partners Inc.

Inflation fears are preventing the Fed from taking any action to save the economy from a hard landing or recession until it is too late.  As we have stated previously, the Fed is paralyzed between rising inflation on the one hand and a deteriorating economy on the other, and is therefore doing nothing.  Chairman Bernanke indicated that housing may get worse before it gets better, but still remains caught in a trap. The fact is that housing is a leading indicator and inflation a lagging indicator.   In our view, therefore, the inflation problem will be ameliorated when the economy sinks in the second half.    When the eventual rate cut comes the market will likely be far more focused on falling profits than the eventual benefits of easing.

The reported revision for 1st quarter GDP supports the view that the economy has entered the "hard landing" zone.  Although the quarter was adversely affected by some temporary factors, current numbers for housing and retail sales indicate that the economy is indeed softening at a rapid pace. 

The housing situation is continuing to weaken and is likely to get worse.  The Case-Shiller Home Price Index for the 1st quarter dropped 0.7% from the 4th quarter and 1.4% from a year earlier, the first decline since 1990—1991.  Existing home sales for April were at the lowest level since June 2003, and were down 10.7% from a year earlier.  Inventories of existing homes for sale were up 10.4% from March, amounting to 8.4 months of supply as compared to 7.4 months in March and only 3.6 months in early 2005.  The ratio of unsold homes to sales is at a 15-year high.  The highly anticipated spring selling season never got going and, according to housing officials, home buyer traffic is minimal.  In order to sell the huge inventories of both new and existing homes, prices will have to decline even more, a serious risk to the economy that was mentioned in the recent FOMC minutes.  In our view this is a strong probability rather than a mere risk.  In addition the tougher regulations that are coming will dampen home demand even more as mortgage approval requirements return to the rigorous standards that prevailed in more normal times.  And don’t forget the resets still ahead in existing mortgages that will add additional billions of dollars to monthly payments.

We strongly believe that the subprime problem will spread to the rest of the economy.  Tighter mortgage standards have only begun to be implemented and will have a significant impact.  On the demand side fewer people will get financing and fewer will be in the market for new homes.  Mortgage lenders will scrutinize applications much more carefully and require down payments and full documentation of assets and income.  As a result fewer people will apply and of those that do, some will be turned down.  In addition primary lenders know that they will have more difficulty selling off their loans as potential purchasers get more risk averse.  A recent New York Times article showed that even in the New York City area mortgages have become harder to get—and this is still one of the strongest markets in the nation.  All of this means that demand for new homes, already down 30% from a year ago, is almost certain to drop further.

Even in normal economic cycles when subprime lending was not a major problem housing has been the conduit through which tighter credit conditions has been transmitted to the rest of the economy.  In the last 47 years there have been seven occasions when housing starts declined 30% or more year-to-year.  In six of these instances a recession followed.  The only exception was in 1966 when the economy had a hard landing that barely avoided recession and the Dow Industrials dropped 26%.  As of February housing starts were down 30%.  With the addition of the subprime problem in the current cycle, the probability of a recession ahead is even greater than usual.

We have long argued that the housing malaise would spread to consumer spending which accounts for about 70% of GDP, and that appears to be happening now.  April same-store sales for 51 leading retailers tracked by the International Council of Shopping Centers were down an average of 2.3%, the worst showing since the organization began tracking the data in 1970.  In three decades there have been only two previous negative readings.  The Council’s Chief Economist stated that falling home prices were weighing on consumers more heavily and that mortgage equity withdrawals had dwindled.  Wal-Mart added that shoppers expressed concerns about their personal finances, the cost of living and high gasoline prices.

With factors making up over 70% of GDP now slowing down or declining it is difficult to see where any economic rebound will develop.  Typically capital spending does not pick up after consumer spending growth drops.  In fact, capital expenditures, on average, trail consumer spending by two quarters, while exports are too a low a percentage of the GDP to make much of a difference.  The most likely outcome is either a hard landing or recession. The latest FOMC minutes continue to show that the Fed is paralyzed between the risks of inflation on the one hand and further economic decline on the other.  This makes it highly likely that they will not cut rates until it is too late to matter.  Although the stock market is still fixated on the favorable forecast of a benign soft landing and eventual cut in interest rates, in our view the time is fast approaching when the incoming data renders that outlook no longer tenable.

The employment market, too, is weaker than it seems on first glance.  Even the dubious figures supplied in the establishment payroll report show a year-over-year jobs increase of only 1.4%, a number usually preceding economic recessions.  In the first five months of the year average monthly jobs rose by only 132,000, compared to 201,000 in 2006.  In addition the increase of 157,000 jobs in May showed construction jobs virtually unchanged.  However, the BLS birth/death adjustment added a mythical 40,000 construction jobs to achieve that figure.  Given the condition of the housing industry, we find that hard to believe.

In addition there is even more reason to doubt the accuracy of the monthly payroll report.  The BLS also does a retroactive adjustment of the payroll data based on a much more inclusive state-by-state calculation that does not include a birth/death adjustment.  Unfortunately, that data is about nine months behind, but here is what the BLS has reported.  The original BLS reports showed that payroll employment increased 500,000 in the 3rd quarter of 2006, including positive growth in construction jobs.  However, the recently released state-by-state data for the same period showed a rise of only 19,000 jobs and a 37,000 drop in construction employment.  Given the recent weakness in the economy there is a good reason to believe that current payroll employment is being significantly overstated as well.

Adding to the case for continuing housing weakness is the strong prospect of tightening by the leading home lending regulators.  According to ISI’s Washington office, John Dugan, Controller of the Currency, strongly criticized so-called "stated income loans".  These are loans that are made without documentation of income or assets by the borrower.  The prospective borrower merely states his income and gets the loan.  Dugan states that studies show that income is inflated by 50% or more in 60% of stated income loans and that 43% of mortgage brokers know that the borrower wouldn’t otherwise qualify for the loan.  It is not without reason that the trade refers to these as "liars loans".  Regulators believe that loans with little or no documentation are not appropriate in the sub-prime loan market or in the alt-A market as well.

Until relatively recently the inability of so many borrowers to meet their periodic payments was masked by the big appreciation in home prices.  Now, however, the regulators are beginning a strong crackdown that is certain to reduce the availability of credit as well as the number of people who qualify for loans.  The downward pressure on home sales and prices is therefore likely to continue for some time.  As we have previously shown (please see archives for past comments) the housing mess is already having a negative effect on consumer spending and will probably spread to the rest of the economy.  The peak in industrial production usually lags the peak in real consumer spending by one quarter, while the peak in capital expenditures lags by two-to-four quarters.  Even in normal residential building cycles a sharp decline in housing sales has almost always led to a hard landing or recession.  Given the recent speculative boom in housing we see no reason why this time will prove to be an exception.

The market is living in a low-probability world that assumes a benign soft landing in the economy, a stimulative second-half Fed rate cut and continued economic strength from the rest of the globe.  While possible, we think the odds of this favorable outcome are low.  First, if history is any guide a hard landing or recession is highly probable.  In the past recessions have occurred under the following circumstances:

1)      Whenever GDP growth was below 3% annualized for 5 consecutive quarters.

2)      When the Fed tightened monetary policy (8 of the last 10 times).

3)      When the yield curve was inverted (6 of the last 7 times).

4)      When the Conference Board Leading Indicators were 0.5% or more below a year earlier (9 of the last 10 times).

5)      When new building permits were 25% or more below a year earlier (7 of the last 9 times).

6)      Whenever payroll employment growth dropped to 1.4% over a year earlier.

All of the above has now occurred.

On the other hand the consensus of economists has never predicted a recession in advance—NEVER.  Although anything can happen in the world of economics and financial markets, we would rather go along with a group of indicators with a high probability of being correct than with a group that has never gotten it right.

Second, as for the beneficial effect of Fed rate cuts on the stock market, we have to take the context into account.  It’s true that with the exception of the rate cut in January 2001, Fed decisions to ease have almost always resulted in rising markets following the move.  However, it is extremely important to note that the upward moves only happened because the market declined significantly prior to the rate cut.  In fact, of the ten Fed moves to ease in the last 50 years, the Dow Industrials dropped by an average of 23% prior to the first cut, and declined in every instance.  So the chances are that the market will move up after the first rate cut—whenever that occurs—but only after a damaging major decline.

The third argument being made is that any softness in the U.S. economy will be largely offset by a strong global outlook.  According to Northern Trust Chief Economist Paul Kasriel, this is not likely.  He points out that the weakening segments of the U.S. economy—consumer spending, housing and capital expenditures—account for 85% of GDP, compared to exports accounting for 11.5%.  In addition domestic demand as a percentage of GDP is declining in the EU, China and Japan, meaning that exports are accounting for most of their growth at the margin.  He estimates that U.S. consumer spending accounts for 29% of the rest of the world’s GDP, and is, in essence, their locomotive for growth.  It is therefore unlikely that global growth prospects can be split off from the growth outlook in the U.S.

In our view, therefore, a hard landing or recession is probable; a Fed rate cut won’t help unless the market declines significantly beforehand; and global economic growth is not likely to provide enough offset.  Since this is virtually the exact opposite of what most investors are counting on, we think that the current risks in the market are extremely high.

Published on  Fri, Jun 15 2007, 07:56 GMT