Economic & Market Update
By Richard Morey

March 2, 2010

THE ECONOMY

As I began writing this report, I thought it might be interesting to see how I would try to prove that the economy and stock market are now on solid ground, and that all the major risks have indeed passed. Recent data on manufacturing, consumer spending, consumer confidence, the profits from financial companies, and unemployment all show at least some signs of stabilization if not outright growth. Normally, they paint a picture that could lead to positive outcomes for our economy and markets. However, there are still four challenges we face. While the economy always faces challenges, the problems we still face are unique in the fact that they are huge problems. If one or more occurs, the stock market will go down, most likely dramatically and very quickly. It would take an entire book to begin to fully explain       

Problem #1: Sovereign Debt Defaults

Sovereign debt refers to the bonds issued by governments. When governments want to spend more money than they are taking in through taxes, they borrow it by issuing sovereign debt. Now government bonds are normally considered the safest types of bonds. Since governments can print money, it is assumed that they will always be able to pay back the money they borrow. However, the European Union does not allow individual countries to print more Euros at will. As a result, when European nations need to pay off current debts, they may or may not be able to come up with the money needed, i.e. they may default on their debts.

As we speak, five European countries are on the verge of defaulting on their debt. These are Greece, Italy, Ireland, Portugal and Spain. Great Britain isn’t far behind, though they are more likely to avoid default than the others (they also are not in the Euro-zone, which helps). Worries that Greece won’t be able to pay back its debts led our stock market down over 6% the first five weeks of this year.

Why should we worry if Greece can’t pay its debts? Because that debt is held by large European banks, and a Greek default might topple one or more major banks. This would likely lead European banks to stop lending to the other countries whose debts are far too large. If those countries then defaulted, the European banking system would crash once again. Our financial institutions and markets would follow.

Now the Greek economy is not very large compared to some in Europe. It is small enough that Germany – the largest and most economically stable European country – could easily bail them out. Not surprisingly, German taxpayers are not too keen on this idea. Greece got into trouble because they borrowed huge amounts to subsidize a relatively easy lifestyle for its citizens. Asking the German taxpayers to bail them out so the Greeks can continue to live beyond their means is not an easy sale.

In this report I’m not going to go into all the details on the different ways being proposed to bail Greece out. Suffice it to say, none of them are pretty – particularly for the Greek economy and society. But at the end of the day, the European financial system should be able to withstand a Greek debt default and/or bailout. Spain, on the other hand, is an entirely different matter. If we hear that Spain is contemplating defaulting on their debts, we should all be very, very afraid. While Greece is a relatively small economy, Spain is one of the larger in Europe. If Spain were to default on its debts, there is a 100% certainly it will spark a financial crisis in Europe. (Similar though somewhat smaller concerns exist around Italy, Portugal and Ireland. Great Britain would of course be the biggest shock, though the least likely to occur.) Will Spain default? I recently read in-depth reports on this by two of the leading Spanish economists. One is sure they won’t while the other is sure they will. After reading both, I wasn’t convinced either way, as both made very good arguments.

I never expected to face the prospect of entire European nations going bankrupt. This is obviously a big issue. After reading numerous reports by respected European economists, all  we can say is that there is certainly a real chance we will have one or more sovereign defaults in Europe. If that occurs, there is a 100% chance stock markets around the world – including the U.S. market – will plummet.

(Hearing about debt leading to sovereign defaults, many clients have asked me if the United States is in a similar situation. Not yet is the short answer. While our Government debts are large and expanding quickly, they still are not as high compared to the size of our economy as those of the countries discussed above. Our debts will inevitably continue to grow this year and next year. And even if we add another $1-2 trillion in debt this year and next year, we still won’t be beyond the “point of no return.” However, 2012-2013  are likely to be key years for us. If our federal budget in 2012 – 2013 at the     latest – isn’t focused on getting our debt under control, our economy will most likely suffer the same fate Greece is now staring at. This means higher taxes, serious cuts in important programs (like Medicare), high inflation, and a severe, prolonged recession.)

Problem #2: U.S. Mortgage Defaults


We have discussed this topic many times over the last year or so. In the summer and fall of 2008, over $30 billion of mortgages had their first “reset” each month, which is when a mortgage that had a very low initial rate first resets to a higher rate. When this happens, on average the monthly payment increases 40%. As we now know, approximately 40% of those mortgages went into delinquency and were followed by a foreclosure. Last year this number went down to approximately $15 billion per month. This month it goes up to approximately $20 billion, in May it goes to $25 billion, and by August it reaches $30 billion once again. Near the end of this year it retreats to $20 billion before jumping back to $30 billion or more from next March through the end of 2011. It then drops very quickly in 2012 to $5 billion a month.

Assuming that approximately 40% of these homeowners default, this means our banks are looking at well over $200 billion in additional losses by the end of next year. It is worth noting that these losses occur even if the loans are restructured to keep the homeowners in their houses. When a loan is restructured such that the principal is reduced, this means the bank immediately books a loss on the difference. This is why banks continue to be very slow in restructuring any loans. They want to push off all losses as far into the future as possible. But this does not mean the losses disappear. Add in the huge losses banks are incurring in commercial real estate and we see a fragile banking system facing hundreds of billions of dollars of new losses – losses that are nearly guaranteed to occur.


What will happen as these losses mount for our banks? There are three possibilities:


1.    Financial Collapse & Panic. In order to attempt to predict the outcome of this next wave of      foreclosures, earlier in the year I read a book entitled Too Big to Fail by Andrew Ross Sorkin. Mr. Sorkin is a financial reporter who has been closely associated with the top executives from the largest investment banks in the country for many years. As a result, they gave him access to their activities during the financial crisis.


My purpose in reading this book was to try to determine if the next wave of losses is likely to lead to another financial collapse. My conclusion is that we are highly unlikely to see a repeat of 2008. There are many reasons for this confidence. First, the weakest financial institutions already went out of business. Secondly, those that remain were better at controlling risk from the beginning, and they have had over two years now to prepare for the losses they know are coming. Finally, the Treasury Department and Federal Reserve Board have also learned a great deal about how to prevent a financial crisis due to massive mortgage losses.

 
2.    Large Stock Market Losses. The primary factor that has driven the stock market higher since last March is the profits the banks have shown. The first quarter those profits are replaced by very large losses, expect the stock market to go down sharply. In fact, most likely the stock market will go down before the official losses are reported. As soon as the market figures out the losses are definitely coming, the stock market should drop quickly.
 
In a sensible world, this possibility is the one that would prevail, and it is indeed the most likely outcome. As the bank losses mount, the stock market goes down in recognition of the fact that the financial system remains troubled. Then, over time, the banks weather the storm and get back to sustained profitability, and our economy gets back on track. However, there is one other alternative, and it is the most disturbing.

3.    Zombie Banks. Yes, this is a real economic term. A dictionary definition is as follows: “A zombie bank is a financial institution that has an economic net worth less than zero but continues to operate because its ability to repay its debts is shored up by implicit or explicit government credit support.” The term is typically used when referring to Japanese banks. In the late 1980s Japanese real estate soared. That bubble popped in spectacular fashion in 1990, with Japanese real estate losing two-thirds of its value. All the major Japanese banks became insolvent, but the Japanese government refused to allow them to fail. Instead, they propped these banks up, keeping them alive even though they were dead beyond any hope of recovery (hence the term “zombie banks”). This led to what is called the “lost decade” in Japan, for without a properly functioning banking system the Japanese economy ceased to grow throughout the entire decade of the 90s. Even today, more than 20 years later, the Japanese economy remains stagnant at best.

To summarize this section, I believe it is highly unlikely we will have another round of financial crisis and panic. Most likely the mortgage losses will bring the stock market down again for some time, but as the losses are cleared from the banks’ books we will end up with a more sound financial system. If this is combined with some absolutely necessary regulatory reform, in the not-too-distant future our financial infrastructure should then be back to normal.

Problem #3: High Stock Prices


Valuing the stock market is always a complicated process, and every day there are some analysts who say the stock market is undervalued and others who say it is overvalued. Given the complexities of answering this question, I usually rely on the one economist who has turned out to be correct over every market cycle for the last 15 years, Dr. John Hussman. Dr. Hussman believes the stock market is destined to go down substantially due to the mortgage problems. However, he says that he would be just as concerned if there were no mortgage problems, due to how overpriced the stock market has become. In a recent report, he said, “… I am doubly concerned here because on the basis of an ensemble of fundamental measures (normalized earnings, revenues, book values, dividends), the only points between the pre-Depression period and the late-1990's when the market has been so richly valued were November-December 1972 (before a 2-year market loss of about 50%), and August-September 1987.” So the only other times when the stock market was this overvalued over a 50+ year time period resulted in a 50% loss in the first instance cited and a 22% loss in one day in the second (October 19, 1987).


As we discussed in a previous update, the stock market is fairly valued today only if corporate earnings immediately grow at the rate they were growing in 2006. But in 2006 nearly 40% of the stock market’s profits were from financial companies. As we know now, those profits were a mirage. And while the economy will most likely show some growth over the next few quarters, I would say it is absolutely impossible for us to return to 2006. Those days are (fortunately) gone forever.


Unlike the mortgage resets that we know for sure are coming each month, stock market losses based on stocks being severely overpriced are difficult if not impossible to accurately time. Stock markets have been known to stay overpriced for far longer than one might expect. But sooner or later, stocks that are overpriced come down.


We have the same concerns for asset prices in China – only larger. The Chinese stock and real estate markets are not just overpriced but are full-blown bubbles (particularly their real estate market). This will end, and given the inherent volatility of Chinese markets, when it does their losses are going to be severe. (This should then present a great buying opportunity.) Even if our markets were doing nothing new on their own, the moment Chinese asset prices pop, our markets will suffer large losses.

 

Problem #4: History

 
Over the last two years I have read several in-depth studies of all the financial collapses since stock markets were involved. Perhaps the best was a book entitled: This Time Is Different:
Eight Centuries of Financial Folly by Carmen M. Reinhart & Kenneth S. Rogoff. This book represents the largest analysis done to date on financial crises and their impact upon economies and stock markets. My summary would be:

 

Ø       Financial crises have some common features, and they are all very bad for an economy.

Ø       The economies directly affected usually take many years to recover.

Ø       The stock markets directly affected also go through some common stages:

Ø                  They go way down initially.

Ø                  Then at some point the collapsing phase ends.

Ø                  The stock market then goes up dramatically.

Ø                  However, the crisis damages the economy such that it remains weak for another two or more years.

Ø                  The stock market goes down again, on average 28%, when the exuberance from not collapsing wears off and the market realizes the economy remains unusually weak.


Conclusion

Despite the optimism being expressed by most stock market analysts, we continue to face large, serious economic and market risks. While it is possible, we think it is highly unlikely that one or more of these risks will not materialize this year. This comes as no surprise to anyone who studies economic history. And as the old saying goes, those who ignore history are bound to repeat it. In this case, this means a repeat of significant losses in their accounts, something we intend to avoid at Secure Retirement.