WEEK OF NOVEMBER 12, 2007—TOO MUCH IRRATIONAL PESSIMISM

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.

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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

WEEK OF October 22, 2007—HOUSING A SYMPTOM, NOT THE CAUSE OF A RECESSION

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

WEEK OF OCTOBER 15, 2007—WHO ARE NOBEL ECONOMISTS?

The 2007 Nobel Prize in the Economic Sciences was just awarded to three U.S. economists, all mathematicians, in what is part of a watershed movement to bring back economics that benefits public institutions, as well as private individuals. Their research into “mechanical design theory” has made financial markets more workable for the many, rather than leave them to the devices of the “invisible hand” of Adam Smith, our first free market economist.

Also, major banks have agreed to set up a $200B fund to increase liquidity in non-subprime commercial paper markets. Why? The credit crunch is caused by mortgage lenders unable to sell their non-conforming, jumbo loans into the secondary market. And so by providing liquidity to the short end of the secondary market (i.e., 90-day commercial paper has the cheapest rate.) that buys shorter-term consumer loans, it should ease the credit crunch and make more money available.

What is the real cause of the credit crunch? Fed Chairman Bernanke claimed in his most recent speech it was the fault of sloppy underwriting of subprime loans: “The rate of serious delinquencies has risen notably for subprime mortgages with adjustable rates, reaching nearly 16 percent in August, roughly triple the recent low in mid-2005. Subprime mortgages originated in late 2005 and 2006 have performed especially poorly, in part because of a deterioration in underwriting standards.”

Yet the Fed has raised short-term interest rates 4.25 percent over that time in chasing the phantom of inflation. This in fact has doubled mortgage payments in many cases; something that no borrower (or maybe lender) could have anticipated—whether prime or subprime loan. Therefore, the Fed should be shouldering much of the blame. It created the problem, not faulty underwriting.

The economics prize Nobel press release stated that “Whether one considers auctions, elections or the taxes we pay, our lives are governed by mechanisms which make collective decisions, while attempting to take account of individual preferences. Such mechanisms are designed to deliver the greatest social good despite the fact that individual participants may act for their own gain, rather than for the general well-being of society.”

This is bringing us back to a form of Keynesian economics that sees a role for government and regulation. The latest research is moving economics away from libertarian or so-called supply-side economics, in a word, which had enshrined unregulated, free markets that tended to cause greater income inequality.

What is the research? It is a branch of Game Theory (remember the film, “A Beautiful Mind”?) that helps to determine the best market outcomes for the “general well-being of society”, in the words of the Nobel committee.

Markets do not do this automatically. For example, those with insider information tend to profit more from market information that is not readily accessible to all. So government regulation does not have to be a bad thing. That is why we have the Federal Reserve, whose charge is to regulate banks and the money supply. Without the Fed, recessions would be deeper and inflation swings more volatile. Hence one of its mandates is to “manage” inflation.

Copyright © 2007

WEEK OF October 8, 2007—(SOME) INFLATION IS GOOD

We know that third quarter economic growth will be good to very good, in spite of the credit crunch. Why? Prices are still rising at a healthy rate. And some inflation is good for economic growth, contrary to what the Federal Reserve may say.

The September Producer Price index for wholesale goods and services rose 1.1 percent, but most of the increase was in food and energy—no surprise in a growing economy. The so-called core rate without food and energy prices rose just 0.1 percent and is up just 2 percent in 12 months. This means that the extreme fluctuations in energy and food prices (due to seasonal demand factors) are not being passed on to other goods and services. What would happen if prices actually began to fall? That is one of the official definitions of a recession!

Here are some reasons we will see good growth for the rest of this year. The September employment report showed 110,000 jobs added to private and government payrolls, while another 118,000 jobs were added in revisions to prior months’ estimated job growth by the Labor Dept. The 4.7 percent unemployment rate means the U.S. economy is still at full employment.

Then retail sales, the main indicator of consumer spending, continue to be healthy. Overall consumer spending is averaging 3 percent and retail sales, its main component, soared 5 percent annualized in September, the strongest showing in at least 2 years. The biggest spending was in health care, as well as catalogs and online sales, each up 1 percent.

In spite of this, growth could be slowing in Q4. Third quarter job growth was half that of 2006, and private sector payrolls are growing at slowest pace in three and one-half years. This alone should keep another interest rate cut on the table at the Fed’s October meeting, says CBS Marketwatch economist Irwin Kellner.

Interest rates have barely budged since the Fed’s September rate cut. ARM indexes, such as the Cost of Funds, or Treasury, or LIBOR indexes are still hovering around 5 percent, which means it could be months before holders of adjustable rate mortgage will see any payment relief. Why? Investors are asking for higher returns until the extent of ARM defaults is known. Most of the negatively amortized Option ARMs were issued in the past 2 years, and so they won’t reach their full payment for at least another year. It is that uncertainty that is keeping short-term interest rates high.

How do we know when property valuations return to more normal levels? A measure of housing value used by economist Robert Shiller of Irrational Exuberance fame, is the growth of median incomes. Housing prices over the long term tend to approximate the average increase in household incomes. No surprise, since that is what determines affordability.

Household incomes have increased 5.6 percent per year over the past 35 years.

Yet average home prices have risen more than 50 percent just over the past 6 years, according to the National Association of Realtors. This means housing values have risen 15-20 percent over the historical norm in those years, and so must fall by that amount to return to the historical norms.

Copyright © 2007

WEEK OF October 1, 2007—CONSUMERS ARE RECOVERING

The key to a recovery from the subprime debacle is the health of consumers. And so consumer spending is the most closely watched indicator at present, with the Federal Reserve now waiting to see whether its one-half percent rate cut will keep consumers, and so the economy, humming. Surprise, surprise. August consumer spending is the highest in 2 years; probably because the labor market is still creating jobs.

It is a pleasant surprise, given all the bad news in August. It means the Fed has room to cut rates further at its October 31 FOMC meeting should real estate sales continue to decline. August new and existing-home sales dropped 8.3 and 4.3 percent, respectively, and for sale inventories are up to a 10-month supply. Another surprise is that median prices are still holding, as higher-end homes continue to sell.

The drop in the Prime Rate that determines most credit card rates could also spur more consumer spending over the holidays. August credit card debt rose a whopping 8.1 percent, or $6.1 billion, according to the Federal Reserve.

September’s unemployment report also generated optimism. Though the jobless rate rose from 4.6 to 4.7 percent, 110,000 new payroll jobs were created and past months’ employment was revised upward. Health care and food services are responsible for one-half of all payroll jobs created this year, according to the Labor Department. Mortgage lending, its related services, and construction continue to lose jobs, however.

The good jobs picture is encouraging consumers to continue to shop. Real consumer spending increased a large 0.6 percent, while the inflation rate is back down to early 2004 levels. The Personal Consumption Expenditure index, the major inflation indicator, is up just 1.8 percent in 12 months. Average hourly earnings are rising 4.1 percent—double the inflation rate. The fact that incomes are rising faster than inflation has to make consumers feel more secure.

"Consumers -- so far -- are taking the recent financial turbulence in stride," said economists for Credit Suisse in their weekly outlook. They look for a 0.4 percent increase in September sales, boosted by moderate growth in general merchandise sales, and sales growth in restaurants, building materials and apparel.

But others think the retail numbers won't be so rosy. "Sluggish chain-store suggest that September was a disappointing month for retailers," wrote economists for Global Insight, who expect only a 0.1 percent gain in sales. "Consumers have become more cautious and resistant to outlays on big-ticket items," such as building materials and durable household goods.

For the third quarter as a whole, consumer spending increased at a 3 percent annual rate, double the growth recorded in the second quarter, economists said. This could mean that third quarter economic growth will exceed 3 percent, following the 3.8 percent Q2 final estimate of GDP growth, since consumer spending accounts for two-thirds of economic growth.

Copyright 2007

WEEK OF September 10, 2007--BERNANKE'S 9/11 SPEECH ATTACKS TRADE DEFICIT, BUT NOT FED BUDGET DEFICIT

It is perhaps fitting that Fed Chairman Ben Bernanke on the anniversary of 9/11 should be making a speech in Berlin that attempts to clarify why we have run up such a trade deficit—of approximately $1 trillion last year alone.

Chairman Bernanke made the speech on the 9/11 anniversary for several reasons. It is consumer spending and borrowing since 9/11—fueled by record low interest rates—that enabled the huge trade deficit, and the trade deficit in turn has enabled the huge federal budget deficit—up to $8 trillion at this writing.

Those twin deficits are a major headache for Bernanke. They happen at the same time that “the U.S. has already reached the leading edge of major demographic changes that will result in an older population and more slowly growing workforce,” said Bernanke in his speech.

This explains why the Fed has been reluctant to drop consumers’ interest rates as it finally did for its banks last month. It wants to discourage consumer spending and encourage more savings, which would reduce the twin deficits.

There is also a second reason behind the Fed’s reluctance. Too much money in consumers’ pockets tends to cause higher inflation. Bernanke and many other Fed Governors, apparently, believe that part of their mission is to discourage consumers from any inflationary tendencies. I.e., if consumers believe the Fed is hawkish and vigilant concerning any inflation, then consumers might shop more carefully. It is only if consumers believe the Fed is serious about controlling prices, in other words, that consumers will control their spending.

In fact, a famous speech Bernanke made when the Fed’s Vice Chairman in 2001 outlined this philosophy. He claimed it was the Fed’s anti-inflation vigilance in the 1980s that caused a period he called the “Great Moderation”, when inflation was subdued. Inflation began to moderate in the 1980s after such draconian Fed measures as raising their fed funds rate to 19 percent in 1981. This caused 2 recessions within 3 years, needless to say.

However, Bernanke is only giving us part of the story. Consumers are over indebted not only due to the Fed’s very accommodative credit easing, but the federal tax cuts of 2001 and 2003 put a huge amount of money back into consumers’ pockets. This encouraged the borrowing binge, and caused the dollar’s value to fall to a 15 year low. It has also caused the price of imported oil—which is paid in dollars, let us not forget—to rise to $80 per crude barrel of devalued dollars at this writing.

The influx of foreign savings also had a hand in the double-digit housing price rises of the past several years. For it is foreign savings that have been the main cause of lower long-term interest rates (i.e., bonds), at the same time the Fed was raising short-term interest rates. This became a disconnect that could not last. It is the rise of short-term, adjustable rates that has fueled the huge number of defaults, hence the current credit-crunch.

The latest news continues to be mixed. Retail sales are still growing at a 3.9 percent annual clip, but only because of deep discounts on last year’s models in August. Industrial production fell, while the U. of Michigan’s preliminary Sept. survey of sentiment edged up slightly, and inflation expectations declined. That is a good sign. There certainly is not yet a credit squeeze on credit cards or car loans. But there’s the rub, to borrow from Shakespeare. If and when the Fed does begin to drop consumers’ short-term rates, this will encourage more borrowing and spending, not more savings.

Consumers tend to save more when interest rates are higher, in other words—such as in the 1980s. But that hurts economic growth. A much better way to cure the twin deficits is to raise taxes on the wealthiest, those making more than $200,000 per year, as was done during the 1990s. Cutting taxes neither cuts deficits nor helps retirees’ benefits, period.

Copyright © 2007