Economic & Market Update
By Richard Morey

January 4, 2010

THE ECONOMY

Throughout the last half of 2009 these reports focused upon the continuing economic problems we face. While our intermediate-term outlook has been consistently negative, one major economic problem may be receding. Unfortunately, the way in which it is being resolved is likely to lead to even greater long-term problems.

The area that is changing involves the “big one,” consisting of the toxic mortgages still on the books of our banks (which have been estimated at $2 trillion), the $2 trillion worth of mortgages that are resetting in the next two years, and the $1 trillion worth of commercial real estate that will need to be refinanced. While it doesn’t appear as if anyone can precisely predict the magnitude of the combined losses, they are clearly large enough to potentially bring down our financial system once again.

However, the Federal Reserve Board and Treasury Department may have figured out how to make sure the banks do not get overly upset as another cascade of bad loans inundates them. For its part, the Federal Reserve has purchased nearly $1.5 trillion dollars in mortgage-backed securities issued by Fannie Mae and Freddie Mac, the quasi-government mortgage agencies. And last week the Treasury Department said it will now give Fannie Mae and Freddie Mac unlimited financial support for the next three years.

The details on all the financial transactions the Federal Reserve and Treasury are taking are beyond the scope of this article. In fact, they are extremely complicated, and are made even more so because we have no way of knowing if we are being told everything they are doing. Many of their actions, in fact the largest financial obligations they are taking on, are being done with no mandate from Congress and in some cases directly against the Housing and Economic Recovery Act of 2008 that was passed by Congress. The topic is so complicated that the press can’t begin to understand what is going on. In fact, it would be difficult for anyone who is not an expert on central banking and monetary policy to understand the details as to how the banks are continuing to receive taxpayer support.

But while the details are unclear, the broad net effect of their actions is straightforward. The U.S. Government is essentially attempting to make sure our banking system has no more major disruptions by purchasing and then guaranteeing their bad loans. This should work to keep us from having another financial crash in the near future. But the longer-term financial implications for our country are very bad indeed. Without authorization from Congress, and largely out of the attention of the public, the citizens in our country are assuming huge new debts and losses instead of the banks who made the bad loans.

Personally, I might be able to stomach what the Fed and Treasury are doing a little better if it meant that average homeowners were thereby getting a break on their mortgages. However, only three groups are benefitting from these actions: 1) bank executives, 2) bank stockholders and 3) bank bondholders. Most of the money at stake is actually held by the third group, those who loaned money to the banks through purchasing their bonds. Banks have borrowed trillions of dollars from these investors over the last few years – enough to cover all the losses the banks then generated through their ignorant, greedy lending practices. Yet even those who loaned money to Lehman Brothers, the one firm that was allowed to go bankrupt, haven’t lost a penny of their money. Instead of allowing those who loaned money to banks to pay for their unwise decisions, our Government is working overtime to make sure that the losses are passed on to the taxpayers.

This concludes the ranting portion of this report, but the actions the Fed and Treasury are taking have large ramifications for our economy and markets. First, the $1.5 trillion worth of mortgages they have purchased have been key to the upswing in the stock and bond markets since April of last year, as the institutions who sold the mortgages to the Fed reinvested much of the money into stocks and other bonds, driving their prices up. And while I have stated that the press and the public haven’t been paying attention to these Fed actions, some members of Congress do know what is going on – and they are not pleased. Bill Gross of PIMCO says his reading of the Fed is that they are indeed going to stop these purchases. This means that the single largest economic stimulus we have had going on (which is far, far larger than the stimulus bill passed by Congress) will most likely be ending soon.

Before looking at where this leaves our economy in 2010, let’s take a look at what the Federal Reserve and Treasury Department actions will do to our economy longer-term. When all is said and done, the Fed and Treasury will most likely have managed to transfer several trillion dollars worth of losses from the banks to the taxpayers. This would be a bad thing any time, but it is especially serious at this time in history. This is due to the fact that we were already facing over $60 trillion worth of deficits in Medicare and Social Security over the next few decades. Our aging population was already going to present serious challenges to our future economic growth – challenges that many respected economists considered to be nearly insurmountable. By greatly expanding our national debt now, it will make future growth even more difficult to achieve.

Specifically, our ballooning debts are almost certainly going to lead to inflation and a falling U.S. dollar. These will most likely end up being very serious problems. However, they probably won’t affect us for a number of years. And when our debts do start to negatively impact us, there are investments we can purchase that will protect us and actually deliver good returns. In a few years, I expect our portfolios to be largely overweight in international bonds, stocks, and inflation-protected securities. This does not mean the best U.S. companies will not continue to be excellent investments – they undoubtedly will – but it does mean the average company in our country will have a more difficult time growing going forward.

Now let’s look at the present. The Government may indeed be able to “kick the can” down the economic road by transferring losses from the banks to the taxpayers. Unfortunately, preventing the banking system from nearly collapsing once again does not mean all our problems disappear. In addition to any remaining banking problems, there are three major roadblocks we still face before our economy can sustainably attain a reasonable level of growth:

1. Deleveraging: While the banks may continue to be bailed out to avoid bankruptcy, they still are not able to provide the level of lending needed for good economic growth. Thus far I have not heard anyone who has a clear picture as to when this will be corrected, but I don’t know of any banking expert who believes normal lending will resume soon. Without regular lending from the banks, it will be difficult if not impossible to achieve steady economic growth once Government stimulus ends.

2. Unemployment: Over 17% of the workforce is either unemployed or underemployed, which means that nearly one out of every five households cannot spend at normal levels. Without consumer spending, solid economic and corporate earnings growth cannot be achieved.


3. Foreclosures: While the banks and their stock and bond investors are being protected from losses due to mortgages, homeowners are still in deep trouble. When huge numbers of people lose their homes, this negatively affects their finances, and the net worth of all their neighbors. This in turn further dampens consumer spending. And another massive wave of foreclosures is now beginning.

Summary: When you put this entire economic picture together, we end up with a muddled, fairly negative picture. No matter how hard the Government tries to assume the losses and debts from the banks, there is still a chance that a number of large banks, and hundreds of smaller ones, could go under. This would lead to another round of panic and losses throughout the economy.

A more likely scenario is that we will not have a plunging economy, but will have unusually slow growth for the next two years. We could easily slip back into recession at some point, or we may go up slowly from the present, low level of economic activity. This is probably the best we can hope for. On the bright side, (very) slow growth is, I would say, more likely than either another crash or a return to negative economic “growth.”

The Stock and Bond Markets

Stock Market: While transferring losses from the banks to us taxpayers will be bad for the economy long-term, keeping the major banks solvent is certainly good for the markets on a short-term basis. As a result, we are unlikely to have another massive selloff in the stock and/or bond market. Still, we do expect the stock market to have a substantial (20%+) pullback at some point this year. This expectation is based on two facts:

1. Corporate earnings growth: At this time stock market participants are counting on a return to historically high corporate earnings growth. Unfortunately, this will be nearly impossible to achieve. With deleveraging, i.e. lowered levels of lending, in the financial system combined with deleveraging in terms of lower levels of borrowing and spending on the part of consumers, corporations will simply not be able to ramp up their earnings as the market is expecting. The market became quite enthusiastic when many companies stopped losing money last year, but investors are going to become disappointed when they find this doesn’t lead to the corporate earnings growth they are counting on.

2. Prices: Dr. John Hussman has the best track record of correctly analyzing stock prices of anyone we have found. Here is what he wrote yesterday on this topic: “What we do know is that stocks are overvalued even on the basis of normalized earnings, to an extent that exceeds nearly every pre-1995 level except 1929. Intermediate term conditions are strenuously overbought, investors (with advisory sentiment now down to 15.6% bearishness) are clearly overbullish, and interest rate trends are pushing higher. This situation does not always resolve itself into market declines, and indeed, given that market internals remain reasonably firm, we may continue to observe marginal new highs for some amount of time. But the statistical regularity from overvalued, overbought, overbullish, rising yield environments is one of steep, abrupt market losses generally within a period of about 10-12 weeks.” (bold italics mine)

So while we certainly cannot predict the future, particularly on a short-term basis, current market conditions have almost always led to large stock market declines in fairly short order.

Bond Market: The bond market is not nearly as treacherous as the stock market as we begin the New Year. While bond prices did go up substantially from the historic low levels to which they had dropped by the end of 2008, the yields on some types of bonds are still fairly high, and bargains can still be found in some areas. While we certainly do not expect to get nearly 20% in total returns from our bond funds in 2010 like we did in 2009, the best bond managers should be able to approach or exceed low double-digit gains this year.