A Topsy-Turvy Economy

Let me get this straight! I am sixty nine years old. I was brought up: 1) to save money; 2)to purchase a home only when I could afford one because home ownership is a privilege not an entitlement; and 3)if a person overextends by taking on excessive debt, that person should suffer the consequence of bankruptcy or foreclosure on his home. Now I find that my savings, largely in Treasury bills, are yielding 2%, far below the prevailing inflation rate; and, as a result of the government's intervention to save Fanny and Freddie, I am going to be taxed in order to bail out the profligates! What is wrong with this picture?

The stock market may have experienced some sort of distorted selling climax last week, with a washout of the financial stocks under very heavy volume on Tuesday and a sharp rally on Wednesday. In the distant past, a selling climax involved the ENTIRE MARKET'S cratering on very heavy volume in early trading and recovering to break even or better, all WITHIN THE SAME DAY. Tuesday probably marked the low in the financials for this cycle. The question is whether Tuesday's low was an interim bottom or THE BEAR MARKET BOTTOM for the S&P 500 Index?

At the low on Tuesday, the S&P 500 Index flirted with 1200. Often the market bounces off such round numbers. Moreover, bear market rallies can be seductive.

To review, I purchased a half position when: 1) the percentage bears reached the previous bear market high; and 2)the S&P 500 reached 1270, a 3/8 retracement of the previous bull market. I have been awaiting the next Fibonacci 1/2 retracement at 1170 and a level of 60% bears. The percentage bears is now at roughly 50.

So far, I have not acted. Even if 1200 marks the low, there is usually a successful test of that low within a few months. My style of investing requires patience and discipline, but, on the other hand, also the flexibility to change my mind if the market tells me to. Tune in!

High End Manhattan Coops Always Appreciate--NOT

In my last posting, I discussed the tragedy of Bear Stearns and concluded that even the high end of Manhattan property will probably fall 20-25% in price after years of a "seller's market". (This conclusion also pertains to the high end of related locations such as the Hamptons.)

The transition from a "seller's market" to a "buyer's market" usually involves an intermediate phase, when sellers price at the recent peak; but buyers, sensing the prospect of lower prices, hang tough with their bids. The result is a stalemate, characterized by a reduced number of transactions and a buildup in inventory for sale. The Manhattan market entered this phase during the first quarter of 2008. The number of transactions declined by 34% and inventories rose 20%, much higher than the normal 8%.

The next phase is the beginning of a buyer's market. Those sellers who must sell start to close the gap between bid and asked by reducing their asked price. This starts a downward trend. Given the extent of the property appreciation during the last ten to twenty years, which I would characterize as reaching "bubble" levels, a 20-25% decline seems modest. Afterall, an asset that has sextupled in price could easily correct a Fibonacci 3/8 of the appreciation, which would be a decline of 31%.

Manhattan high end property values are primarily a function of Wall Street's net hirings or firings and the level of bonuses paid out at the end of the year. Most of the prestigious and largest firms pay modest salaries with bonuses accounting for a huge percentage of total income during good years. It has already been announced that employment at Bear Stearns will perhaps be cut in half. The other major investment banks will probably reduce their staffs to some extent. Even if they don't, 2008 earnings for these firms will probably decline significantly. (The first quarter earnings were down sharply.) Yearend bonuses will follow suit.

Most real estate agents tend to appear optimistic most of the time. Afterall, their compensation is a function of activity. They point out that the weak dollar is propping up property values at the high end as foreign buyers with stronger currencies swoop in. That has had some positive impact; but in my opinion, that will eventually be overwhelmed by the developing negative Wall Street situation.

If I am right about this, at some point a great buying opportunity will occur. But when? Historically, it takes roughly a year after a bear stock market ends to clear out all of the excess real estate inventory. Even if the stock market bottomed in the first quarter of 2008, one would have until the first quarter of 2009 to buy.

I would strongly urge any buyer to be a tough negotiator. That involves an initial bid much lower than the offering price. I would also suggest that you, as a buyer, not show that you are enamored with the property.

While the secular trend in the prices of Manhattan high end coops is definitely up, there have been periods of sharp decline. An example is the 1973-74 period. Then a virulent bear stock market, high interest rates, and some risk that New York City was in deep financial trouble created a perfect storm to drive down coop prices. What a great opportunity to buy a coop in one of the premier buildings in New York City! I have a friend who did purchase a seven room tower apartment in one of the great coops in Manhattan during this time. The by-laws of this building allowed the tenant shareholder to sell his shares back to the corporation for nothing in order to relieve the shareholder from having to pay maintenance. (Technically, if other shareholders were bankrupt, the remaining solvent shareholders would have to foot the total maintenance bill. That is why the "put" option was written in.) My friend thought about offering to buy the shares from the seller for nothing, but took a good look at him and realized the seller was much bigger and could probably outrun my friend. He then bought the shares for $125,000. They were, at the recent peak, worth roughly $13,000,000, an unleveraged compound annual 15% return over 33 years. (The National Association of Realtors says that home prices have appreciated at the rate of inflation plus 1.7 percentage points, which amounts to roughly 5% annual appreciation since 1926.) My friend's $125,000 investment would be worth only $625,000 today if it only compounded at 5% a year. What a fabulous investment he made! Not that I expect THAT bad a real estate market this time around. However, this story does demonstrate how important an entry point can be in any asset purchased for investment.

We all own Bear Stearns stock

Over this weekend, J.P.Morgan acquired Bear Stearns for $2 a share. Those of us who didn't DIRECTLY own Bear Stearns equity should not breathe a sigh of relief. INDIRECTLY, we who live in or near Manhattan own Bear stearns stock. Forget the impact in the near term on our common stock portfolios or the long term impact of the Fed's recent intervention on the nation's budget deficit. For those of us who own coop apartments, condos, and homes in the New York area, the major impact will be the substantial decrease, perhaps on the order of 20 to 25%, in property values, even at the "high end" of the spectrum. The deleveraging of our nation's economy will cause employment on Wall Street to shrink; and when that happens, property values will shrink as well.
As far as the stock market is concerned, we are entering the "puking" stage, or, for those more refined, the "throw in the towel" stage. This may be necessary to reach a durable bear market bottom. The final so-called selling climax is accompanied by a very rapid descent in stock prices on very heavy volume. Here is where Fibonacci numbers are helpful. The next such number, a 1/2 retracement of the bull market over the last five years, is 1170 in the Standard & Poors 500 Index. The last Fibonacci number, a 5/8 retracement, is 1070.

Bottom Fishing

The sentiment reading from Investors Intelligence, which is published weekly on Wednesdays, indicates today that 43.3% of investment advisors are now bearish, a very significant figure because that was the level at the last bear market bottom. That, coupled with the 3/8 retracement of the last bull market, a Fibonacci number, fulfills the two necessary conditions for a bottom mentioned in previous blogs. Accordingly, I am now investing one half of my financial assets allocated to equities. That money will go into the T. Rowe Price Standard and Poors Index Fund.

I am only investing half because past bear markets have ended with the percentage of bears rising to well over 60%. Furthermore, the deleveraging of the macroeconomic balance sheet is just beginning and may last for many more months. The period of economic malaise may prove to be longer than average.

Close, But No Cigar

Most U.S. families have most of their net worth in two asset classes, their homes and their common stocks. At this point, the prices of homes have declined 6-7% from their peaks on a nationwide basis, an event unprecedented since the Depression of the 1930s. As I explained in a recent posting, there is probably more decline to come. The impact of this has already hurt consumer spending, as evidenced by the poor retail sales during the Christmas season. The stock market, reflecting the probable onset of a recession, has entered a bear market. I am 68 years old. During my adult life, I have never experienced a time when both asset classes were in decline nationwide. (We did have that circumstance in New York City during the 1973-74 period, which is the subject of a future posting.)
While the outlook is bleak, the stock market is a discounting mechanism and will bottom long before the clouds lift. Right now, as one wag quipped, "My 401K is rapidly becoming my 301K!"
In earlier postings, I said that the two necessary conditions for buying in a bear
market are 1)a level of at least 43 to 60 percent bears in Investor Intelligence's weekly survey of investment advisors, and 2) A 3/8 minimum retracement of the previous bull market, which is a Fibonacci number. Yesterday and today, the down market has retraced 3/8 of the bull move from 2002 to 2007. However, unfortunately, this week's percentage bears rose to only 31.5%, well below the threshold buy level of a minimum 43%. While it is safe to say that the percentage bears will rise next week, it probably won't yet reach 43%. So, at this juncture, I have not yet entered the equity market. Close, but no cigar!

No Economy For Old Men

When I heard the Bush/Paulson measures to alleviate the mortgage mess and the ensuing proposals of the leading Democratic presidential candidates, I yearned for another time -- a time when notions such as caveat emptor, moral hazard, and sanctity of contract meant something. Unfortunately, these are becoming anachronisms and are being supplanted by the notion of "too big to fail". While government interference with the free market will, no doubt, moderate the incidence of foreclosures and the level of lender writedowns in the short run, it will, in the long run, encourage excessive borrowing in an already heavily leveraged economy and have negative implications for the U.S. dollar.

Paulson classifies the subprime mortgagees into: 1)those who would be in default even if the teaser rates were not reset, 2) those who would likely remain current on their mortgages if the teaser rates were frozen for five years but couldn't survive an immediate reset, and 3)those who are able to remain current on their payments even after the scheduled resets. He would allow the middle group to have their payments frozen for five years and then reset in hopes that the incomes of the mortgagees would have risen during that time to a level that would avoid default even at the reset rates. The Clinton approach would freeze at the teaser rate the mortgages of both the Paulson-designated group AND those who can afford all payments. I, on the other hand, would divide the universe of those who can't make their payments into two groups, those who were defrauded when they took out their loans, and those who were not. The first group should be made whole; the second should suffer the consequences of their decisions.

When a person mortgages his home, he is responsible for knowing the terms of the mortgage contract -- "caveat emptor" or "buyer beware." Ignorance of the terms of the mortgage is no reason to allow the mortgagee out of his contract unless the terms of the mortgage were not fully disclosed. If a mortgagee bets that when the interest rate is to be reset, he will either be able to sell his home for a profit or reset the mortgage at a low rate; and it turns out he is wrong, he should suffer the negative consequences of his decision -- "moral hazard." In the Clinton initiative, even those who can manage the mortgage payments after scheduled resets are entitled to a period of frozen teaser rates. If I were the mortgage lender I would expect no change in the terms. Otherwise, it would be an abrogation of the notion of "sanctity of contract". Why are these notions being suspended? Because the aggregate impact on the economy if they were strictly adhered to would be disastrous? We have seen how the notion of "too big to fail" has been invoked to "rescue" Donald Trump and Long Term Capital Management. Now subprime mortgagees can be added to this list.

How bad would the impact on the economy be if the subprime mortgagees are allowed to fail? Very bad indeed! There would be hundreds of thousands, perhaps millions, of foreclosures and forced sales of property. No one wants a foreclosure sale in his neighborhood. The negative impact on home prices and consumer confidence would be significant. A friend of mine, a highly respected economist, estimates that the historical relationship between the aggregate market value of U.S. homes and U.S. GDP has hovered around 100%, plus or minus 10%, in most years since 1950. In 2006, that relationship was 160%. An immediate regression to the norm would involve more than a 30% drop in home prices.

For purposes of illustration, let us assume that home prices nationwide decline 15% peak to trough during this cycle--a rare event indeed. The total market value of U.S. homes has been estimated at $21 trillion. The total debt against that asset is $11 trillion. A 15% hit to home prices would reduce owner equity from $10 trillion to $6.85 trillion, a decline of 31.5%. However, roughly $7 trillion of home value is in unmortgaged homes. Calculating solely for mortgaged homes, a 15% home value decline translates into a 70% reduction in equity. To put this into perspective, out of a total of 75 million U.S. homes, 50 million are mortgaged. If the owners of 50 million homes experience a 70% decline in equity, consumer confidence would plummet, which would start a vicious cycle of lower spending, layoffs, even lower confidence, etc. The probability of recession, now put at 50% by the most pessimistic Wall Street economists, would be close to a certainty, in my opinion.

There is roughly $1.76 trillion of subprime mortgage debt against roughly $1.96 trillion of home value. A 15% drop in home value would reduce equity from $200 billion to a minus $94 billion; so lenders would be on the hook for around $100 billion in writeoffs. Of course, a nationwide 15% decline in home value would result in a far greater decline in the value of homes used as collateral for subprime mortgages due to the impact of foreclosures. In this example, the total writedowns by lenders would be in the hundreds of billions, not just $100 billion.

Given this illustration, it is no wonder that the U.S. government is intervening in the free market process to try to stem the impact of falling home prices. I read that a large commercial bank has subprime mortgages at face value totaling 285% of equity. A fifteen percent writeoff of those mortgages would reduce equity by 42%. Two "venerable" financial institutions, Citicorp and Morgan Stanley, have had to shore up their capital by raising funds from Abu Dhabi and China respectively. The terms of the Citicorp deal, an 11% preferred stock convertible close to the market price of Citicorp common as of the date of issue, are those of a company in trouble. Deterioration in bank equity would mean less ability to lend unless further equity infusions were then available.

By the way, the S&P 500 Index is only off around 7% from its highs. Given the seriousness of the housing crises, I am surprised at such a limited response so far.

Why am I opposed to government intervention here? Am I a free market purist? I believe that the economy in the long run is better off when down cycles cleanse the excesses of the previous up cycles; and the housing bubble is a whopper of excess. Recessions are not pleasant; but U.S. citizens have weathered them in the past. If the U.S.intervenes and continues to bail out those who have made bad investment decisions, it will continue to have a deleterious effect on the U.S. dollar in the long run. It would encourage excesses in the future and indicate to the world that we are permissive and soft. We should remember that a significant portion of U.S. Treasury debt lies in foreign hands. A weak dollar means higher inflation and interest rates in the long run.

Liklihood of a bear market

Since the high in the S&P 500 Index (The "Index") of 1553 mentioned in a previous posting, the Index reached a slightly higher high of roughly 1562 recently. However, the new high was unconvincing because it occurred with unimpressive breadth and volume. The recent weakness from that high can be attributable to the confluence of a number of possible causes:

1. The problems in the financial system resulting from the mortgage mess. The ensuing writeoffs by major financial institutions may not be complete.

2. The weakening dollar, while a spur to export growth, is beginning to accelerate on the downside; and global holders of dollar assets are getting nervous. Since the Federal Reserve is worried about recession, it stands ready to continue its easing to avoid one, which would exacerbate dollar weakness. The Fed's best tactic to buoy the dollar would be to RAISE interest rates, hardly likely at this juncture. In short, the Fed is in a bind.

3. While careers have ended on Wall Street in the past due to predictions of the consumers' folding, which rarely happens, one can make a case for recession. Oil prices at close to $100 a barrel, home prices on the decline which restricts borrowing against home values to bolster consumption, and the rapid drop in financial equities could reduce consumer confidence so much that the Christmas season is a bust. That would set off a vicious cycle of lower employment, still lower consumer confidence, leading to lower employment, etc.

4. During this economic up cycle, profit margins have reached 13%, versus a historic norm of 8%. There is plenty of room for Index earnings to decline in the event of a recession.

5. If the leading contender for the Democratic Party's nominee for the Presidency, Hillary Clinton, beats the drum for protectionism loudly; and the financial markets sense that she means it rather than just trying to generate votes, the stock market could take a serious hit.

It is always difficult to identify a bear market in its early stage. After all, the stock market goes up more than 80% of the time. Bull markets die hard! However, for the above reasons, there is more than a de minimus probablity that a bear has already started.

If the recent Index high of 1562 is not exceeded before a bear market occurs, then possible Fibonacci buy points in the Index would be 1261, 1168, 1076. Tune in!