The Recession of 2007

John Mauldin | Thoughts from the Frontline
December 1, 2006

One of my favorite cartoons of all time is that of a very scrawny mouse caught out in an open field with a rather large hawk swooping down on it. There is no place to run, no place to hide. All the mouse can do is face the hawk and give him the bird, so to speak. The caption runs something like, "In the face of total disaster the only appropriate response is utter defiance."

And while the economic data is not a total disaster, it has not been good this week. Yet the response of investors everywhere is defiance, or at the very least serious nonchalance.

Recession possibilities? "What recession? I spit on your talk of recession." They continue to assume that things will turn out much better than merely OK. All manner of investments are priced for perfection, perfection being defined as growth slowing enough to take out inflation risk yet not enough to hurt the ever upward rise of corporate profits. Goldilocks is the name of the game.

The stock market did close down somewhat today, yet as trading came to the end of the session, it rose over 100 points from its low of the previous few hours. All you can do is just marvel at the amazing capacity of investors to embrace risk in the face of this week's economic data, which we will look at in some detail today.

And after we dissect the parade of bad news, I will tell you why it is not all that bad. I continue to believe we will see a recession next year, but not a major one. Let's jump into the data.

Housing: The Roof Leak Gets Worse

Let's start with the outlook for housing. This week we had the housing data for October. Permits and actual starts were down 28% and 27.4% (respectively) from one year ago. New home sales fell for the first time in three months, down 3.2% from the previous month, which the first chart below clearly shows. Anecdotal evidence suggests that November will be even worse.

We are seeing inventories of homes for sale rise. And it could get worse, as foreclosures in sub-prime loans are rising. The mortgage bond market is showing some signs of strain. About 3.3% of sub-prime mortgages made THIS YEAR are now delinquent by more then two months. Think about that for a second. Borrowers or lenders could not see (or did not care about) problems coming even a few months in advance.

While traditional mortgage defaults are not a problem as yet, delinquencies in ARMs (adjustable rate mortgages) are becoming an issue. Yields on these issues are rising even as overall mortgage rates are flat to down, because investors are demanding higher returns to offset the higher risks that are now becoming increasingly obvious.

Late payments are accelerating, after lenders began to require less documentation for loans and financed more homes without down payments, New York-based Bear Stearns & Co. analyst Gyan Sinha said in a Nov. 14 report.

About 38% of the most common sub-prime mortgages this year were for the full value of the home, up from 31% in 2005 and 21 percent in 2004, according to Bear Stearns. Sinha said 45.5% of the loans this year required "low documentation" of borrower income and net worth, up from 44.5% in 2005 and 40.1% in 2004. The data reflect "common methods of allowing first-time homebuyers to borrow more than they can afford," Sinha said. (Bloomberg)

Putting even more pressure on sub-prime loans is the notice by Moody's and Fitch that they are considering downgrading certain sub-prime bonds. (More on the risk in reaching for yield below.)

Look at the rise in total homes for sale. The trend is not good. Paul Kasriel of Northern Trust tells us that "Total construction outlays fell 1.0% in October, after a downwardly revised 0.8% drop in the prior month. The 1.9% drop in residential construction spending in October is the seventh consecutive monthly decline. The main message is that the housing market recession's bottom is not here yet."

When residential fixed investment drops 10%, we have had a recession in the US. The chart below does not reflect this week's data, which will only make it look worse. RFI is down by more than 10%.

Housing market recessions generally take years to work out, not months. This one is going to get worse before it gets better, with a bottom probably not coming until the middle of 2007. And as housing construction slows down, the 15% of the growth in the US economy that has been related to housing is going to disappear. While many market commentators, looking for good news a few months ago, cited nonresidential construction as performing well and adding to growth, we have seen that sector drop for the last two consecutive months by over 1%. Things will not grind to a halt, but they are going to slow down even more.

Manufacturing: The Gears Get Jammed

The ISM manufacturing survey came in with a much lower than expected 49.5. When the index is below 50 that means that manufacturing is slowing. This breaks a string of 42 straight months of expansion. There is a fairly strong connection between the ISM index and GDP, and we could expect a slower GDP this quarter and next. And if the ISM continues to show contraction, we would typically expect a recession to follow. How likely is the ISM to show more contraction?

Norbert J. Ore, chairman of the Institute's manufacturing survey committee, said the index will probably stay below 50 "for several months" as the housing and auto industries bottom. It may then rise above 50, he said on a conference call with reporters. And the data was down in many areas. New orders, production, employment, order backlogs, and inventories were down. Prices were up.

Notice that last three-word sentence in the above paragraph: Prices were up. October ISM data showed prices paid for raw materials down to the lowest level since February of 2002, which had many economists telling us that this showed inflation was getting under control. Economists expected November prices to again be lower. They not only rose, but went from 47 last month to 53.5 this month.

Bernanke and a gaggle of Fed governors warned this week that inflation is still an issue. They are jawboning the markets with a constant barrage of speeches suggesting they are not as likely to cut rates as quickly as the market now thinks. Futures markets disagree and are now pricing in a 64% chance that the Fed funds rate will be cut in March. Please remember that the futures market does not get a vote in the Fed Open Market Committee.

This week we were also told that the third quarter was not as bad as the first GDP data released last month suggested. GDP was revised upwards to 2.2% from 1.6%. This was mainly due to inventory buildup and rising imports being revised higher. But higher inventories mean that manufacturers will slow production in the future, which is just what the ISM numbers show. The market reaction was to embrace the positive in the upward revision, which is that things are not as bad as they seem, while ignoring the source of the revision, which is not as positive. Recession? I spit on your recession.

Retail: It's All On Sale

Wal-Mart sales were down by 1%, with the company downgrading forecasts for December. Tiffany sales and profits were up 23%. Barry Ritholtz did a 30-store survey of discounting and sales and found that sales prices and promotions are quite high. He tells us, "The most recent review of price cutting is that they are both deep and broad. Our quick survey of both brick and mortar coupons and online savings codes shows that discounting is ramping up dramatically. This will likely pressure Q4 profit margins."

You can see his list at http://bigpicture.typepad.com/comments/files/discount_coupons.pdf.

As readers know, I have seven kids, and that means Christmas is not cheap. It is a lot of fun, but definitely not cheap. Normally I just go to stores and buy what I want toward the end of the season. I can tell you that this year I am going to make an actual list of the items I want and have my assistant look for the coupons and discounts. Every 10-20% helps.

Last week I wrote about the dollar dropping, and this week we watch it continue to fall, with further deterioration coming with the weaker ISM numbers, as investors think that the Fed will cut rates and make the dollar less attractive. But not everyone is worried about a falling dollar.

This week, while staying at the Helmsley in New York (and sleeping on one of the most uncomfortable mattresses I have experienced in years), I walked into the bar on Sunday night to get a drink before going to bed. Looking around, I noted there were 34 mostly middle-aged ladies in the bar and no men. Thinking this was somewhat odd, I asked one of them if there was some sort of convention. The pleasant accent that came back was from Ireland. It turns out that much of the hotel was occupied by ladies from Great Britain and Ireland on a shopping holiday.

They were positively giddy about the prices. "Everything is half what we would pay in London or Dublin." They were hiring limos to go shopping so they would have enough room for their packages on the way back.

And this does bring up a positive point. US companies which do business overseas are getting a boost in sales and potential profits, although the costs of doing business (and especially traveling) overseas are rising. In my own case, I work with my London partners (Absolute Return Partners) to help European investors find alternative investment portfolios. As is normal, we typically get a percentage of assets under management. Almost all of the money is either in pounds or euros. That means that my part of those fees is actually rising in dollar terms (by an admittedly small percentage, as the dollar is down only about 5% over the past few weeks), although the costs of staying in London and Europe are rising as well, and by what seems like more than 5%. The pound is back to where it was when George Soros famously decided to break the Bank of England back in 1992. It is almost to $2.

(And since I complained about the Helmsley mattress, just so that you know I am not entirely negative, the recent upgrades in mattresses and pillows by Marriott is fantastic. Would that all hotels would follow their example.)

The Inverted Yield Curve Gets Steeper

The yield on the 10-year bond dropped to 4.43% as of the close of the markets today, although it touched 4.4% right after the release of the ISM data. The bond market is clearly expecting a slowdown, and the yield curve is signaling an increasing chance of a recession. Look at the curve and bond rates below. Notice that 3-month T-bills are 23 basis points lower than the Fed fund rate.

The Recession of 2007

An inverted yield curve is the best indicator of a recession coming within at least four quarters. When we saw the yield curve invert in September of 2000, we had a recession about 7 months later. Look at where the yield curve was in 2000 as compared to today:

If we had the same timing, that would suggest a recession beginning in the second quarter of 2007. If the data is all that bad, I can hear you asking, why will it take so long?

Because it takes time for things to slow down enough to actually put the US economy into a recession. For instance, new home construction is slowing, but builders must finish what they started. Real estate construction employment is down but is nowhere near the bottom.

As I think this is a housing-led recession, we should realize that homeowners are initially reluctant to drop prices. That takes some time. Further, it will take some time for lower home prices to really register on consumers and thus on consumer spending.

Corporate profits are slow to turn down, but they eventually do. As noted above, there could be considerable pressure on profit margins this quarter, which will mean more negative earnings surprises in the next quarter. And finally, manufacturing and housing are significant parts of the economy, but consumer spending is still the big dog. Consumer spending takes a while to actually slow.

But that is why I think the recession will be relatively shallow, as much of the economy is now in services, which are more resilient than manufacturing or housing. Nonetheless, previous experience suggests it will have a psychological impact.

We should be glad these things take time. We do not want to see markets or economies drop precipitously.

But if I am right, the stock market is going to be under considerable pressure next year. The average drop of the markets is about 40% before and in a recession. There are reasons to think it will not drop that much this time, but it is hard to imagine it not dropping by some significant amount. Dow 9,000 is a real possibility, if not probability. Yet the market is unconcerned, with volatility as measured by the VIX at close to all-time lows.

Further, credit spreads, the difference between government bonds and riskier investments, are at levels that really cannot get much lower. Any pronounced trouble and we could see some serious problems develop in the bond markets in a flight to quality. I would not want to be long high-yield bonds or other riskier bonds today without a serious and quick exit possibility if your "stops" are hit.

Investors, in my mind, are not getting paid for the risks they are taking. But that is because they do not think they are taking risks. They thought that in the fall of 1999 and then again in the fall of 2000 as well. We would be wise to pay attention.

Switzerland, Dubai, Denmark and Chile

As noted above, I was in New York earlier this week, meeting with some of my international partners. Long-time reader Jerome Schonbachler of EFG (the third-largest private bank in Switzerland) came over from Geneva. He and his team are going to work with investors in Switzerland, the Middle East, and most of Asia. I agreed to go to Switzerland and Dubai next year, although not sure when. I am already going to Denmark in late August and South Africa next month, and the partners at EFG which handle Latin America committed me to go to Santiago sometime as well. The relatively slow traveling year I have been having is about to change.

For those readers in the above-mentioned countries who have written to subscribe to my Accredited Investor E-letter, I apologize for taking so long to finalize the details so we can work with you. But we are (finally!) there.

If you are in the US, Europe, or almost anywhere in the world, and would like to get my Accredited Investor Letter, you can subscribe at www.accreditedinvestor.ws. I work with partner firms around the world to help accredited investors find alternative investments like hedge funds, commodity funds, and other alternative investments. If you would like to know more, please feel free to sign up and/or write me. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC. Member NASD.)

It is time to hit the send button, as the Maverick's game starts in about an hour and I want to get there in time for the tip-off if I can, as well as see my #2 daughter and her boyfriend a little. Have yourself a great week.

Your wondering how this will all play out analyst,

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