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Countdown to Growth


Patience, dear investor, patience.

Today I drop back to take a look at the economy and its long term effect on our portfolio returns.

I'm in Orlando this week, speaking at the Newport Advisor Conference sponsored by the Newport Group. The attendees are primarily investment advisors focused on larger retirement accounts and pensions. This week's letter is the gist of my speech I gave yesterday. I want to thank the Newport Group for letting me do this, and thanks for the very kind way it has hosted me. Next week I will address the housing market, as was my intention this week.

The Muddle Through Economy: The Future of the Market and Your Investments

It is increasingly agreed that we are now in a recession as I predicted this time last year. The good news is that much of the underlying economy is not in that bad a shape, but it has had two serious body blows administered by the twin collapsing bubbles of the housing market and the credit crisis.

My position is that the recession will be rather long and relatively shallow, and the inevitable recovery will be longer and more drawn out than is typical, resulting in what I call The Muddle Through Economy for a period of several years. I define a Muddle Through Economy as one which grows below normal trend GDP growth of 3% for a period of time, typically in the 2% range.

So, one of the key questions is: "When does the recovery start and how long will it take to get back to 3% GDP?"

I think the answer is that it will not be before the latter half of the year and will take at least two years to get back to trend growth. The reason for such a drawn out recovery is simple. The twin causes (housing and the credit crisis) will take at least two years and possibly longer to normalize, and that process is going to negatively effect several other sectors of the economy.

But then I am an optimist. Duke University released a survey yesterday of Chief Financial Officers of major corporations. This is a gloomy bunch. 54% think we're already in a recession. My friend, Duke Professor Campbell Harvey, said: "In contrast, 90 percent of the CFOs do not believe the economy will turn the corner in 2008. Indeed, many of them believe it will be late 2009 before a recovery takes hold."

Let's look at a chart courtesy of John Burns Real Estate Consulting. This shows that part of the bubble in housing was in the number of transactions that occurred during the bubble years. In 2005 alone, there were 48% more housing transactions that occurred than should have been expected based on historical average sales per household. In large part this was caused by "investors," many of dubious financial strength, buying homes and condos on readily available credit with no real lending standards and no way to pay the loans if they were not able to sell them at a higher price.

As a result, there are now 3.5 million excess homes that need to be filled by qualified homeowners. Over time, due to growth in the population, the demand will eventually catch up, but that will be a process of several years. Housing prices will have to fall by another 15-20% or so to get to a place where homes become affordable to the marginal buyer. And that assumes rates can stay low.

Click to enlarge

Annual new and existing home sales are currently running at about 5.5 million. John Burns expect that will fall to about 4 million before we see the bottom of the market. Notice, in the above chart, the drop in sales after the increase in housing sales above the trend projection in the 70's. We have a long way to go to correct the recent bubble, and Burns's research suggests that we will get there sooner rather than later.

But this means that home values will drop another 15% or more. Homeowners are going to see $5-6 trillion in home equity vanish in the next year. Remember that point as we will address it in a minute.

Honey, I Vaporized My Customers

By now, everyone knows that the subprime crisis started with non-existent lending standards which resulted in the large numbers of foreclosures we are seeing today. Those foreclosures will be rising throughout the year. We are not near anything like the top of the rising number of foreclosures. Ben Bernanke said last July that losses from the subprime would be in the $100 billion dollar range. True confession. I think I wrote six months earlier that it would be $200 billion. I point that out to show that I'm an optimist by nature. The latest "bidding war" number for the amount of total losses is about $500 billion from Goldman Sachs (GS), and a neat $1 trillion from uber-bear Nouriel Roubini.

Add in hundreds of billions from losses which are piling up in other credit markets and you can easily get to $1 trillion in losses which are going to have to be eaten by all sorts of financial institutions, without being all that pessimistic.

Banks are being forced to reduce their loan and margin books in order to get the necessary capital required by regulatory authorities. Plus, credit is now more expensive as risk premiums rise from absurdly low levels in what more than one authority called a "new era of finance." Turns out it was just normal old era greed.

It is not just the mortgage market. It is commercial mortgages, safe municipal bonds, credit card debt, student loans and a host of credit that is under fire and cannot find a buyer at what should be a realistic price.

We should not be surprised at the lack of liquidity in the credit markets. We have essentially vaporized 60% of the buyers of debt in the last six months. The various alphabet of SIVs, CLOs, CDO, ABS, CMBS, and their kin that were the real shadow banking system are either gone or on life support. It took decades to build these structures and it is not realistic to think we can replace them in six months. This is going to take some time.

And time is what the Fed has bought this week by offering to take AAA mortgage paper and swap it for T-bills. They will start with $200 billion on offer. Remember you read it here first that that number will be increased and increased again. From the markets initial euphoric response, you would think the problems have been solved and banks will once again start lending. Sadly, this is probably not true.

This is similar to the action by the bank regulators in 1980, when nearly every major bank had losses that were greater than their capital on Latin American loans which had defaulted. The Fed, with a wink and a nod, allowed the banks to carry these worthless loans on their books at full face value. It took six years before they started to actually write them down. But without that measure, every major bank in the US would have gone bankrupt. And technically, they were for several years. But the Fed action simply bought the banks time to re-liquefy. It was the right thing to do.

This week's action by the Fed is essentially the same thing. It buys time. This 28 day auction will be around for a long time. If the banks had to write down the potential losses on their AAA Fannie Mae (FNM) paper and other similar assets, it could have brought the banking system to its knees. Eventually, we will get a market clearing price for all this paper, but the key word here is eventually. We are going to see foreclosures and losses for another 18 months. It is going to take a long time to know exactly what the losses will be.

I think the losses on many of the various forms of debt have been marked down way too far by the various derivative markets. (I would hasten to add this does not include the subprime markets, as many of those assets are going to zero.) I doubt the loss in a lot of the debt paper will be nearly as much as the current credit default swaps prices indicate. For instance, some municipal bond debt is priced for 10-15% losses, when losses of less than 0.5% are normal. When there is a buyers strike, prices fall, and sometime to quite low levels. In the fullness of time, the price of these bonds will rise back to "normal" levels. There is a reason Bill Gross is buying municipal bonds by the train car load. Many are simply at the best prices we will see in my lifetime.

But if that debt is now on a bank's capital books, they have to write it down to the latest mark-to-market. The Fed's move simply allows the banks to move what will eventually (or maybe the better word is should eventually) be marked back to reasonable values. It avoids a crisis today.

The next crisis? I read a very chilling piece from Michael Lewitt this morning. He speculates on what if the rumors were true that Bear Stearns is basically bankrupt. Bear is in the too big to fail category. It is at the heart of the chain of Credit Default Swaps which run like fault lines throughout the world's financial system. If Bear were allowed to collapse, it would simply cascade throughout the world so fast it would truly make the current level of the credit crisis seem small potatoes.

So, why can I be so sanguine? Because the regulators (the Fed and the SEC) would step in and whatever large bank was failing would be merged or bought very fast. Liquidity and assets would be provided. The Fed and the rest of the world's central banks get that we are in a crisis. They will do what is necessary. Those of us sitting in the cheap seats in the back of the plane may not like it, as it will look like a bailout of the big guys who caused the problem, but you have to maintain the integrity of the system. A hedge fund here or there can go, but not one of the world's premier banks.

(I wrote the above paragraphs on Thursday, and sure enough, the NY Fed and JP Morgan stepped in to bail out Bear. This will not be the only time or bank. The regulators may have been asleep, but the depth of this crisis has awakened them.)

But this is a boost for my contention that we will be in a Muddle Through Economy for a long time. The latest Fed actions simply draw out the time over which the market will correct. But that's a good thing, as a too swift, dead drop correction could spawn a very deep recession, destroying vast amounts of capital, which would take much longer to come out of.

Now, let's look at the implications of this crisis on our long term returns and retirement portfolios.

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