A Distilled Markets and Macroeconomic Letter: November 2006
by Eric Hodges
Stocks - Short Term - Negative Outlook
With the recent run up, the market is in a positive mode. I believe that caution is strongly warranted. The VIX (the “fear gauge”) is at 11.08 (10/23/06), which is very low and can be a contrary indicator. There seems to be little fear in the markets. Other averages are not confirming the Dow Industrials. The housing downturn may weigh heavily on stocks.
Stocks - Medium Term - Negative Outlook
I believe that the risk is the market averages may have quite low returns for some time or potentially flat/negative returns when inflation is taken into account.
Bonds - Inverted yields pointing towards recession?
Yields continue to be inverted. In the short run bonds may rise in price with a slowing economy but the longer-term bonds (5 year and longer) may eventually fall significantly. Yields have been creeping up again.
Gold went down today (10/23/06) but the gold stock indexes held up. Further downside in gold might be pricing in economic downturn or worse.
Oil - Stays high unless we see a recession or more war(s)
Oil continues to sell off, but the risk is that a lower oil price is pricing in a coming economic downturn. Middle East risk has been subdued recently. More war(s) could raise the oil price even with a slowdown or recession.
Fed funds rate is at 5.25%. The Fed has made comments that they are concerned about inflation. My guess is that they will not raise before the elections. The risk is that the economy is slowing much faster than the major media pundits would have you believe.
Housing continues to slow and new car sales are off (see below). Consumers are loaded with debt.
The Dollar is still holding up and may well continue to do so near-term. I feel that dollar based assets are at risk in the medium to long-term.
Positive remarks on the market from the Wall Street Journal, in 1929, via John Mauldin’s letter of this past week:
16 Sept. 1929: “Because of the big short interest, it is the growing view that a good technical recovery is in prospect...and that the internal market structure is probably stronger than in some time.”
9 Oct. 1929: “Of course, the operations for a rally were aided by the technical position of the market which had become oversold in many directions by the bears, with the short interest larger than in some time.” (http://www.frontlinethoughts.com/pri...p?id=mwo102006)
We are hearing just such positive remarks these days from the popular media about the Dow going to new record highs and now well over 12,000.
Mauldin goes on to highlight Ed Easterling’s work on market valuations, which is excellent. Ed explains that bull markets simply do not start from high valuation levels that are we are currently experiencing.
From Nouriel Roubini’s blog:
March 2001: 95% of Forecasters Predicted No Recession....Too Bad the Recession Had Already Started Then... [and the stock markets had already started to fall. EH] (http://www.rgemonitor.com/content/view/145302/85/)
Last month I urged you to look at Robert Shiller’s chart of housing, adjusted for inflation, going back to 1890. Here’s the chart via the New York Times:
I view that chart as the most significant of our present situation. Roubini said recently that lower mortgage rates would not support home prices because too many homes are available for sale. So even if the Fed cuts rates, don’t expect housing to rebound. Please take a look at the Shiller chart. Although, if you happen to have a heart condition, you might refrain from looking. I would not be surprised at all to see home prices revert to the inflation adjusted levels of 2000 or even 1997. In other words, I don’t see any rational reason for permanent price gains from 1997 forward on an inflation adjusted basis.
Eric Janszen wrote a great article this last June on housing that predicted current developments: "Fifteeen Years to Revert to the Mean."
New Car Sales Indicator - Not good News
OK, here’s another must-see chart that I mentioned before, which is also from the New York Times, via the Big Picture. Floyd Norris came up with this indicator, which is now more negative than before.
Dow at record highs. The Transports are still not confirming, which is not good for those betting that stocks are in a new bull market.
The yield curve is inverted. Or, in other words, short duration bonds are higher in price when compared to longer duration bonds. This inversion along with other indicators point to a higher likelihood of recession.
Gold and Commodities
Gold has been off again as of late and may well go lower. Other commodities may be at risk to fall further as well in the near-term.
Reminder: fiat currencies are not tied to anything of tangible value. They are only worth whatever the market, and the public, feels they are worth. As more fiat money is created the value of this paper money should go down. In my opinion, the U.S. is creating too much money and so are China, Japan, and Europe.
Dollar | Currencies
The Dollar has been a bit stronger as of late. Long-term I’m still negative on the Dollar. More near-term strength is certainly possible. The real story is the Dollar against gold, where the Dollar has lost a huge amount of value and may lose much more.
Oil is at $58.70 (10/23/06). The risk is that oil stays high. If oil prices continue downward, they may be pricing in a recession. I’ve heard talk that consumers now have more cash to spend with gas prices lower. What happens when trillions of dollars of mortgages reset?
Much has been written about how the world is currently experiencing peak oil production. If we have a recession, especially a global recession, we might not have to worry about peak oil for a while. When the economy recovers from such a recession, oil could go much higher.
Will new sources of oil come firmly online in the interim?
The Fed is in pause mode. Near-term rates may go up slightly and if housing and the economy slow enough the Fed should start cutting rates again.
I feel that the housing picture could become much worse.
Barron’s reported (8/21/06) some interesting statistics on housing: 10% of all home owners with mortgages have no equity in their homes and $2.7 trillion dollars in loans will adjust to higher rates in 2006 and 2007.
I believe that many consumers have less home equity now than before because they have taken money out of their homes and spent those funds. Consumer savings rates are very low or negative. I believe that consumers are being gradually squeezed by high oil prices on one side and rising interest rates on another. Maybe next the consumer will be squeezed by their mortgage payments being reset.
My concept is to bring you a the most transparent look possible on the economy/markets via a quick read with plain language. This letter is geared toward the busy executive/business owner. If you are really short on time just look at the Snapshot section where I keep everything as brief as possible. In the Detail section I try to give a little more insight into my thinking without delving so deep that I stifle the reader.
When constructing portfolios, I take the client situation into consideration first and then combine that with the current economic/market factors presented in this letter.
If you have specific questions, or would like to discuss your portfolio, please feel free to contact me.
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