Jeff Saut Presents: Fed May Propose, But...?!
...with higher interest rates, rising housing inventories, and subsequently declining home prices, will the American consumer continue to spend and bolster the economy?
Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.
"As every short seller says every morning, credit is contracting and asset values are falling. So, to avoid an old time financial panic, the authorities call off the bank examiners and the Fed eases by expanding the monetary base. Ergo, the Fed buys Treasury Bills with the money that didn't exist before and credits this money to the accounts of the banks, or dealers, which sold the Bills. The banks have excess reserves and the economy revives as the life-giving oxygen of liquidity is pumped into it.
The ugly black fly in the scenario is that if the banks don't make the loans, the new reserves lie fallow. And if the public, for whatever reason, choose to hold the currency rather than bank deposits, as the statistics say it is in fact doing, nothing happens. In other words, the Fed may propose, but the banks and the public will dispose. My nightmare is that this time there is no disposing, or at least not as much as is needed to arrest and reverse the cycle of asset deflation. The bankers are too demoralized by the remembrance of loans past and bank examiners present to lend, and the money supply actually declines, just like the days of yore . . ."
. . . Barton M. Biggs, Morgan Stanley & Co., 10/29/90
I found the above quote from Barton Biggs, venerable ex-strategist of the House of Morgan, as I cleaned out some old files in my office over the weekend. While many of Barton's 1990 points seem to be a "stretch" in the current environment, his comments about "asset deflation" are right to point given the state of affairs in housing. Plainly, the appreciation in housing prices over the past few years, combined with the public's ability to monetize that appreciation via Mortgage Equity Withdrawal (MEW), has been a large driver of GDP growth, as seen in the chart below. Former Fed Chairman Paul Volcker even commented on it in February of 2005 when he stated, "Homeownership has become a vehicle for borrowing and leveraging as much as a source of financial security." Manifestly, with much of the nation having extracted most of their home equity, the question becomes; with higher interest rates, rising housing inventories, and subsequently declining home prices, will the American consumer continue to spend and bolster the economy?
To answer that question one first needs to understand that the American consumer is a bifurcated group with the top 10% of wage earners doing just fine, while the bottom 50% wage earners are struggling under the burden of higher mortgage payments and $3.00 a gallon gasoline. As noted in a recent Federal Reserve survey:
The median family has about $3,800.00 in the bank, does not have a retirement account, has a home worth $160,000.00 with a mortgage of $95,000.00 (excluding MEW). No mutual funds or stocks/bonds. They jointly make $43,000.00 and struggle to pay off their $2,200.00 in credit card debt.
Ladies and gentlemen, since these are "median" figures it implies that 50% of Americans are in worse shape than the "median family!"
Anecdotally, it appears that an increasingly cash-strapped consumer is reining in his/her spending habits given the recent reports from numerous retailers and casual dining chains. This mindset is also being seen in the consumer sentiment polls as the University of Michigan Consumer Confidence Index (UoM) fell to 78.7 in August from 84.7 (July), leaving consumers at their gloomiest levels since 1993 and more downbeat than they were following the attacks of 9/11! Equally disconcerting is the fact that the "current conditions" component of the UoM's report slid to 100.8 (from 103.5), while the forward looking component collapsed to 64.5 from 72.5.
All of this is being reflected in a number of my firm's proprietary consumer discretionary indicators. Interestingly, however, the increasing tendency of the consumer toward "cocooning" has turned our media sector indicators positive as "coach potatoes" stay at home to save money. This shift has potentially positive ramifications for names like News Corporation (NWS), Time Warner (TWX), Viacom (VIA), and Lions Gate (LGF), all of which are rated Outperform by our research correspondent Credit Suisse. We also think the recent terrorist events will cause further "cocooning" not only at the retail level, but the business level as well, which is why we like the teleconferencing stocks.
As for the stock market, the top performing sectors year-to-date have been Oil & Gas (+17.50%), Telecommunication (+15.86%), and Utilities (+8.99%), and we have been bullish on all three of these sectors. More recently, we have emphasized our sense that natural gas prices (not oil prices) were bottoming as we approach the winter heating season. To capitalize on that sense, we recommended Ultra Petroleum (UPL) for growth accounts, as well as the more conservative Chesapeake Energy's (CHK) 4.6%-yielding convertible preferred "D" shares (check conversion details).
As for trading accounts, we issued a trading "buy 'em" recommendation on June 13th at the market "lows" (SPX/1222). We were not as bullish on the S&P 500's (SPX/1295.09) subsequent downside retest of those lows in mid-July (at 1224) because our proprietary indicators were not nearly as oversold as they were in mid-June. Still, we have tended to favor the upside since June 13th, believing the markets would likely "shake off" negative news and work irregularly higher into the late-summer/early-fall timeframe. After Labor Day, however, we are cautious given our belief that the equity markets may decline into the typical four-year "cycle low" during the September/November timeframe, which should provide a pretty decent buy-point for investors.
In conclusion, we leave you with the following comments from the astute Churchill Management organization, which notes:
"We are in a high risk distribution phase. With the market lifting over the last couple of weeks, the big concern is whether the bull market is re-establishing itself. That would be confirmed if both the DOW and the breadth on the NYSE made new highs. Closing out the breadth divergence could extend the bull market but even if that were to happen, it would not dispute the fact that we are in a very high risk period. The number one technical reason is that we already had a breadth divergence. In the past, there have been two instances where a breadth divergence was closed after a bull market was more than two years old. One was in 1936 and the other in 1986. Both occurrences ultimately had another breadth divergence within a year and had a 50% (1937) and 41% (1987) decline afterwards. Other concerns we have include the weakening housing market, a discount rate equal to that in 2000, historically high valuations, and the fact that this [cyclical bull] market is currently almost four years old. The bottom line is that the risks are high and the big question is when we will get the cleanout necessary (typically a bear market) to set the stage for a low risk buying opportunity."
The call for this week: We agree with the cautious approach suggested by the savvy folks at Churchill Management thinking that the question the markets are currently contemplating remains, "Is this just a mideconomic cycle slowdown, or something worse?" Clearly, what happens to real estate (REO) will play a HUGE role in answering that question. If REO stops its price slide, the "Fox Trot" economy (fast/fast economic figures followed by slow/slow figures) can extend for the foreseeable future as the economy regresses to a "muddling" environment. On the other hand, if REO continues to TANK in price, we ask you to consider the attendant chart conceived by the insightful David Rosenberg at Merrill Lynch and reconstructed by us. Said chart is the National Association of Home Builders Index (NAHB) over-laid by the S&P 500 with a 12-month time-lag. We continue to trade and invest accordingly as we consider the question, "Is the FED pushing on a string?"
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