Saturday, November 17, 2007


Remember irrational exuberance, the creator of asset bubbles? Well, we may now have irrational pessimism, the creator of panic selling in the credit markets. We know this because many of the assets being written off, or sold at a discount by banks and hedge funds, are AAA-rated. It is the highest credit rating possible—the rating of Treasury bonds as well.

This belies the underlying strength of the economy. Consumers are still buying—with retail sales up 5.2 percent annually in the latest October survey. So the credit crunch is not yet affecting overall consumer spending, just what they are buying. Inflation is up slightly, but not what one would expect with soaring oil prices.

A famous 2001 research paper on “Herd Behavior in Financial Markets” stated that “Intuitively, an individual can be said to herd if she would have made an investment without knowing other investors’ decisions, but does not make that investment when she finds that others have decided not to do so. Alternatively, she herds when knowledge that others are investing changes her decision from not investing to making the investment.”

Much of it is generated by media pundits, who love to dramatize the adversity without doing the hard work of actually analyzing the numbers. And it sells ads. Human nature is controlled in large part by emotions, and during crises the motivating emotion can be fear. It magnifies all events. The glass is then half empty instead of being half full, in a word.

One example is predictions that banks may suffer upwards of $250 billion in writedowns before the dust has settled. Yet the top 5 banks’ revenues—banks such as Citicorp, JP Morgan/Chase, Wachovia, and Bank of America that are writing off those losses—have had record-breaking revenues this year. Business Week reports that their revenues could be up 7 percent from last year’s high of $127 billion.

The S&L crisis cost banks and taxpayers some $160 billion in the early 1990s, and helped to cause the 1991 recession. But this was when total Gross Domestic Product was 44 percent of what it is today. Banks were also not in the greatest shape then, with much lower capital and loan loss reserve requirements. Add to this the worldwide glut of savings that has poured into our stock and credit markets, and we see that this credit crunch may mostly be motivated by fear, rather than fundamentals.

And so in the words of a famous radio commentator, we should be looking at “the rest of the story”. What is it? Labor productivity jumped a huge 4.9 percent in Q3, mainly because the business investment that brings new technologies is up almost 8 percent. This will boost incomes while counteracting the high energy prices.

PPI/CPI—Overall wholesale inflation (PPI) rose just 0.1 percent in October, and retail prices (CPI) rose 0.3 percent. But PPI/CPI prices are up 3.5 percent and 6.1 percent, respectively, in 12 months. Still, with oil prices over $90 per barrel and gas above $3 per gallon, this is remarkable.

PENDING HOME SALES—This is signed contracts only, and attempts to predict existing-home sales that will close. The Pending Home Sales Index (PSHI), a forward-looking indicator based on contracts signed in September, rose 0.2 percent to a reading of 85.7 from an index of 85.5 in August, according to the National Association of Realtors. This was the first rise in one year, even though it was 20.4 percent lower than the September 2006 level of 107.6. “Even with relatively low fourth quarter sales, 2007 will be the fifth highest year on record for existing-home sales. The median existing-home price in 2007 will have fallen by less than 2 percent from an all-time high set in 2006,” said the NAR’s chief economist Lawrence Yun.

We know that the concept of irrational exuberance was first trumpeted by Fed Chairman Alan Greenspan in 1996. It wasn’t until 2000 that the stock market bubble burst. Now we are hearing dire predictions that are more due to the herd behavior of media pundits than economic fundamentals. Most of it is based on unfounded fears. This is no substitute for a better understanding of the complex factors that determine economic growth.

Copyright © 2007

WEEK OF October 29, 2007—Third Quarter Growth Robust

The U.S. economy is booming, in spite of the credit crunch. The ‘Advance’ estimate of third quarter GDP growth came in at 3.9 percent, higher even than Q2’s 3.8 percent and the best performance in the past 6 quarters. The Federal Reserve dropped its fed funds and discount rates another 0.25 percent on the same day, so that the Prime Rate is now 7.5 percent.

In spite of the good growth rate, the Fed’s quarter percent rate drop was far too timid for the job at hand. Third quarter foreclosures are up 40 percent over the second quarter in California alone, according to DataQuick Information Services. So interest rates have to come down further to ease the credit problems caused by the Fed’s rate increases of the past 2 years.

The Fed’s press release said that “economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction.”

Yet the FOMC release added that the upside risks to inflation “roughly” balanced the downside risks to growth. Such wording usually means the Fed is done with any more rate reductions for the present. This is even though the Congressional Budget Office estimates that a possible 2,000,000 subprime loan holders may lose their homes nationwide through 2008!

Six Southern California Counties had 13,314 foreclosures in July, August Sept., versus just 1,960 foreclosures in the third quarter of 2006. They are particularly pervasive in San Bernardino and Riverside counties, the working-class exurbs of Los Angeles and Orange County, and the fastest-growing counties in the state.

But overall, the surge in economic activity has easily outweighed the effects of the credit crunch to date. Business investments and exports led the way, growing 7.9 and 16.2 percent per year, respectively, in Q3. Disposable, or after tax, income grew a whopping 4.4 percent, which seems to be fuelling consumer spending. So-called real final sales—after inflation and inventory expansion are taken out—rose 3.5 percent. And yet inflation, via the GDP price index, rose just 1.6 percent, versus 3.8 percent in the second quarter.

Meanwhile, residential investment (ie, new-home construction) is “nowhere near a historic low”, according to the Economic Policy Institute—in fact, it remains close to the post-1979 average of 4.6 percent,. Though housing inventories are at historic highs, new-home construction would have to drop by another one-third—to 3 percent of GDP growth—to approach its historic low last reached in 1991. But new-home construction rose 4.8 percent in Sept., and inventories shrank to an 8.3-month supply.

The GDP price index assesses the costs of all goods and services produced domestically. So where is the inflation with the index so low, and why is the Fed so worried about it? That is the mystery, and why we believe they will in fact continue to lower rates come Dec. 11, the last meeting of the year.

Copyright © 2007


Dr. Edward Leamer, UCLA economist, gave what may be the best analysis of housing’s affect on the business cycle at this year’s Jackson Hole economic symposium. Housings’ effect is negligible on current business activity, in a word, though it may be a predictor of future activity. And so we believe that economic growth will continue to increase at or near its current 3 percent rate into next year, before slowing down in late 2008.U.S. Gross Domestic Product has grown a very robust 3.1 percent since 1970. Residential real estate contributed one of the smallest segments to that growth—4.2 percent of the total, or just 0.13 of the 3 percent average growth rate over that time—below even equipment and software sales, according to Dr. Leamer.

In fact, housing's share of the economy is too small to cause a recession without other factors coming into play, such as the S&L banking crisis of 1989, or bursting of the stock market bubble in 2000. As a predictor of future growth, housing’s wildest swings tend to come just before a downturn, but housing also recovered before the rest of the economy in 8 of the last 10 postwar recessions, says Dr. Leamer. And though residential sales continue to decline, they have not reached levels that affect overall activity, since overall activity is powered by other sectors.

Real estate activity would have to subtract approximately 1 percent from GDP growth, and it is now subtracting approximately three-quarters percent from the GDP growth rate. The housing industry employs a lot of workers, from construction to insurance, to banking, to of course sales. And when sales decline, so does the employment of those workers. Conversely those workers are the first to be hired during the recovery cycle.

Right now, the most important housing statistics to watch are housing starts (construction) and existing home sales. Starts fell 10 percent in September, while existing sales dropped 8 percent. Overall starts are down to 1.19 million units, from its 2005 high of 2 million, a 40 percent drop. Existing-sales are down to 5 million from 7 million units in 2005, a 29 percent drop.

Yet we are seeing very little effect of the housing downturn on employment, which has dropped from 4.5 to a 4.7 percent rate. This is because the service sector of our economy continues to generate the most activity, followed by exports, durable and nondurable goods, and equipment and software. They cumulatively have averaged 3.36 percent growth from 1985 through 2006. (Imports, which subtract from domestic sales, contributed a negative -0.81 percent to growth over that time.)

Business investment and commercial real estate investment are two sectors still growing robustly, as well. And consumer spending has increased 3 percent since 2005. Exports, meanwhile, are supporting the manufacturing sector, thanks to robust growth in the rest of the world. In fact the IMF says that global economic growth was a huge 5.2 percent this year, and will be 4.8 percent next year.

So, as much as real estate is contributing to the credit crunch, we do not believe that it will bring down the rest of the economy. In fact, it is because overall growth is so strong that we see sales stabilizing by the end of this year. Real estate prices are notoriously “sticky”, according to Dr. Leamer, meaning sellers are reluctant to drop prices to levels that buyers can afford.

In fact, new-home sales are stabilizing, as builders have been cutting back on production. Sept. sales increased 4.8 percent, while inventories fell to an 8.3-month supply. The median price also rose 5 percent to $238,000. It goes to show that reducing inventories is the key to restoring stability to the real estate market.

Copyright © 2007