Economic & Market Update
By Richard Morey

August 17, 2009

Those who have read these reports over the last year know I became ultra-cautious one week before the stock market and economy began to implode last September. Managing retirement accounts since that time has seemed similar to piloting a sailboat during a hurricane. However, the last year has proven just how important it is to have retirement money managed by a company that has risk control expertise at the helm. Since the crisis began last September, our accounts have gone down, on average, in the low single digits, while some of our most conservative accounts have actually had modest profits. In contrast, the stock market is still down over 20%, and many, many investors have lost substantially more. Like physicians, our motto at Secure Retirement could be “first do no harm,” which is the same as Warren Buffett’s first rule of investing, which is “don’t lose the money.” And through a year in which we had the second worst stock market downturn in history, we have accomplished this overriding goal.

You might think this would make us optimistic looking forward. Having avoided the train wreck, the economy and markets will surely be better going forward. Not necessarily. In fact, I would say controlling risk with your retirement money is more important right now than at almost any time in history. There are many reasons for this, and they are big ones.

First, in our year-end report sent to clients this January, I shared the results of a study of every financial crisis in the world over the last century. Here is the summary of that study: “The negative repercussions of the crisis we have had in our financial system is likely to lead to a fairly long and difficult recession. The “average” financial crisis (around the world over the last 100 years) resulted in a severe recession (or depression) lasting 3.4 years, during which time the stock markets affected went down, again on average, 56%. So if the severity of our current financial crisis turns out to be average, it would last another two years and a few months (as this recession began in late 2007), and the stock market would go down another 20% (from where it ended 2009).” This means that, if this financial crisis turns out to be average the stock market would be over 30% lower than it is today, as it has gone up this year – and it would not hit its final bottom until mid-2011.

Unfortunately, nothing that has happened so far in 2009 has changed this bleak picture. Despite the investor enthusiasm we have seen since March, the hurdles our economy and markets continue to face are very large indeed. I will describe them below, but before looking at these challenges, a few words about why the market has gone up so much recently are in order. This rally has been primarily fueled by emotions. Investors experienced a great deal of relief when the “crashing” phase of this downturn ended in February, and everything has certainly looked better since then. Plus, most economic indicators have become “less worse” than they were earlier in the year, with many sectors of the economy dropping at a significantly slower rate. As a result, analysts and investors have decided growth is on the horizon.

However, all of this enthusiasm overlooks the larger economic picture. There are three huge reasons why caution and not enthusiasm should be our focus:

1. Unemployment. In the first three months of 2009 we lost an average of 690,000 jobs per month, while in July this number went down to “only” 247,000 jobs lost. That is certainly much better, but where does this put us in terms of employment? Thus far we have lost a total of 6.7 million jobs since the beginning of 2008. But we also have 8.8 million people who have either quit looking for a job or who want a full-time job but can only find part-time work. Combined, this means that over 25% of our workforce is either unemployed or working part-time instead of full-time. And this number is likely to continue to rise until mid-2010. These are staggering numbers. Unemployed people have little money to spend, which helps explain why consumer spending unexpectedly went down again in July (this certainly wasn’t unexpected to me). Since two-thirds of our economy consists of consumer spending, and since we are likely to continue to have over one-quarter of our workforce unemployed or underemployed for the foreseeable future, it seems highly unlikely the economy can truly rebound in this environment.

2. While massive unemployment would be enough of a concern to dampen any objective economist’s enthusiasm, it’s not even the biggest concern we face. This involves residential real estate and mortgages, which combined are the largest asset in the country and the one that our economic problems were based upon. I presented the following information on real estate and mortgages to my clients last month, at a time when the financial headlines were talking about how the real estate market seemed to be stabilizing. But then last week we learned that in July we had a record number of new foreclosures. Again, this did not surprise us at Secure Retirement.

The chart below shows the dollar amount (in billions) of mortgages that have their first “reset” each month. These are mortgages that had low fixed rates for the first few years, after which the monthly payments increase by an average of 60%.



As you can see from the chart, in 2008 a huge number of subprime mortgages had their first reset. As we now know, when their rates went up it led to millions of foreclosures and the unraveling of our financial system. While the subprime mortgages are largely resolved, many through foreclosure, we still have trillions of dollars worth of “Alt-A” and “Option Adjustable” mortgages coming due. Most analysts believe a significant number of these loans will also go into foreclosure. The homeowners in question will have a difficult time paying 60% more in monthly mortgage payments – particularly if they are unemployed or underemployed. And very few will be able to refinance, as most have no equity. In fact, millions who owe much more than their home is now worth are likely to walk away.

Looking at the chart, you can see that we have had a “lull” this summer. But the numbers of mortgages hitting their reset point are now starting to go up again. The number then retreats early next year before spiking up to and beyond 2008 levels before our mortgage debacle essentially ends in early 2012. Loan Resets Combined with a meltdown in commercial real estate mortgages, which is in the early stages, do not be surprised if our financial system once again begins to experience some shocks. Due to lax accounting regulations that were put into place on April 2, the large banks are now supposed to be financially sound. This is only the case because they are now allowed to ignore the losses they have in their loan portfolios. Instead of reporting the value of their mortgages as the prices they would receive if they sold these mortgages today, they are now allowed to simply state that they don’t have losses on their mortgages until they foreclose on a property. However, in reality the large banks have hundreds of billions of losses that they (and the markets) are now ignoring. But the mortgages have not disappeared, and a continued deterioration of the mortgage market will eventually lead the major banks to report more dramatic losses.

An even more immediate concern involves regional banks. This is due to the facts that they are overweight in commercial real estate loans and the Government is unlikely to bail them out. It came as no surprise to hear that we had the largest bank failure since Washington Mutual last week (Colonial BancGroup Inc).

3. Stock Prices. Determining if stocks are over or under valued is actually quite difficult, as there are so many ways to come up with the numbers. For this discussion, let’s look at the numbers the majority of analysts are using. Right now most stock market analysts are saying stocks are essentially fairly valued, with a p/e ratio (the price of a stock divided by its earnings) of 15.7 for the S&P 500. Since the p/e of the market has averaged 15 throughout history, most analysts are saying stocks are priced about right. However, you should note that this number is based not on the amount companies earned last quarter or over the last year. Instead, it is based on analysts’ projections of how much they believe companies will earn over the next year. And according to Standard and Poor’s, the company that tabulates these expected earnings, corporate earnings are expected to rise faster over the next two years than at any time in history! So stocks are fairly valued if we have higher economic growth than we have ever had in the history of our country. While we normally cannot make economic predictions with certainty, I can tell you that it is impossible for corporate earnings to grow more over the next two years than they ever have in history. As a result, while we cannot say with any certainty how much stocks are overpriced, we know for sure they are.

Summary

Please note that none of the above cautionary notes necessarily means we are going to again have a meltdown, in the economy or stock market. However, consumer spending, which accounts for two-thirds of our economy, is nearly certain to remain weak for a significant time due to high unemployment levels. And the largest asset in the country, real estate and mortgages, is also nearly certain to continue to depress the economy. Finally, we know for sure that stocks are overpriced.

When the largest parts of an economy remain deeply troubled, and stocks are overpriced, investors should be very, very careful with their retirement money. While enthusiasm for recent gains feels good, risk control should remain center stage, and that is our dedicated position at Secure Retirement.