A Distilled Markets and Macroeconomic Letter: December 2006
by Eric Hodges
Stocks - Short Term - Negative Outlook
A bit of a pull-back yesterday but the market is still in a positive mode. I believe that caution is strongly warranted. The VIX (the “fear gauge”) is at 11.62 (11/28/06), which is very low and can be a contrary indicator. There seems to be little fear in the markets. On a valuation basis, I believe that the market is very expensive. 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 have become more 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.
Gold and gold stocks have been rising from early October. It will be interesting to see if gold will break above a key resistance level that it is near.
Oil - Probably Stays High
Oil has popped back up above $60. Middle East risk has been increasing recently, in case you missed it. More war(s) could raise the oil price even if we have a slowdown or recession. Oil could also fall significantly.
Housing continues to slow and new car sales are still off. Consumers are loaded with debt. Christmas spending is not clear yet, but there is risk that it will not be that great.The Dollar has now slipped. Will this be significant? Yes, it may if the Dollar index falls below 80 ($USD). I feel that dollar based assets are at risk in the medium to long-term.
Fed funds rate is at 5.25%. The Fed has continued to make comments that they are concerned about inflation. The risk is that the economy is slowing much faster than the major media pundits would have you believe.
A Deer in the Headlights?
Bernanke was out and about today and Calculated Risk caught the TV coverage, which I missed. Their comment was that Bernanke looked like a deer in the headlights while he was trying to paint a nice picture of our economy. I made a comment a while back that Bernanke, when testifying to congress, looked quite nervous to me. I just don’t think it’s a good thing to have a Fed Chief that seems to be nervous about what is going on with the economy. I know, it’s completely subjective, but that’s how I feel.
So what was Bernanke saying anyway? Housing may be worse than they thought. All of the iTulip.com readers are ahead of this game, though, right? You have all looked at the Shiller chart of housing, right?
Just in case, here’s the chart via the New York Times:
Purely Anecdotal Stories on Housing
I have heard, via word-of-mouth, some very unsettling stories. Some home buyers here in the San Francisco Bay Area are still stretching to buy as much as they can in a home. I have heard stories of clients wanting certain information to be fabricated in order for a home to be purchased. Most interestingly, I have heard stories of mortgage brokers fabricating the income of clients without the client’s knowledge. And, apparently these things have been going on for some time during the boom. The story has been out for a while that clients were fabricating their income, but I had not heard of the brokers doing this without the client even knowing or asking. This is all, if true, symptomatic of a speculative bubble in my opinion. Gary Shilling’s recent piece on housing via John Mauldin is excellent and very doom and gloomish.
Recession in 2007?
Eric Janszen has written a great three part article on a potential recession in 2007. That’s on itulip.com for my email list readers. I also continue to read Nouriel Roubini’s, commentary on the same subject. Both iTulip and Roubini have done a great job of breaking down the statistics that you hear out of the mainstream media. Roubini is dead-set on a recession in ‘07 and Janszen leans strongly in that direction as well. I feel that there is substantial risk for a recession or worse, but the timing is hard to call.
The Dow has come down a bit from record highs. The Transports are still not confirming, which is not good for those betting that stocks are in a new bull market. I suggest reading Richard Russell’s excellent articles on this topic. Earnings are at record highs by about 100%. If earnings were at the historic median level, the market would then be judged to be very expensive. Most commentators are ignoring this. Take a look at John Hussman’s work.
The yield curve has become more 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 a coming recession.
Gold has now been moving higher and may be close to breaching key technical levels on the upside.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 become weaker recently but has not gone down through the key technical level of 80 ($USD). Long-term I’m still negative on the Dollar. 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 $61 (11/28/06). The risk is that oil stays high. If oil prices move downward substantially, they may be pricing in a recession. 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 prices could go much higher.
Will new sources of oil come firmly online in the interim?
The Fed is in pause mode and it seems that they will stay in pause mode for a while. If housing and the economy slow enough the Fed should start cutting rates again. Richard Russell thinks that there is risk that the Fed will not cut even in the face of a recession in order to support the Dollar.
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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