Three BIG Words: Revision, Recession, and Intervention

Three BIG Words: Revision, Recession, and Intervention
Three words can best describe today’s markets: revision, recession, and intervention. The morning began with the government’s report on GDP for Q2 and the revisions for years 1999-2001. First a look at the Q2 numbers which show the economy has weakened considerably from the first quarter. The rate of economic growth slowed down to only 1.2% versus economists’ estimates of 2.4%. In addition to the slump in economic growth, another report by the Chicago Purchasing Managers Index for July showed a sharp drop in manufacturing activity. The Chicago CPM Index fell to 51.5% from June’s 58.2%. A reading below 50 indicates the economy is contracting. Like the GDP numbers, which fell short of expectations, the CPM Index came in far lower than expected.

In addition to these numbers, the Fed’s periodic Beige Book report showed the economy expanding modestly and unevenly across the country. The Fed used words such as "stable," "steady," "modest," or "moderate" to describe economic conditions. Four of the Fed’s districts in New York, Boston, Atlanta and Dallas show that economic activity is tapering off. Six other districts reported marginal growth; while only two regions of the country, Cleveland and St. Louis, showed signs of growth. Retail sales are mixed, and in most regions of the country there are visible signs that consumers are starting to retrench on their spending plans. Labor markets are weak and real estate was mixed.

Back To The Past?
It appears from the above reports that the economy is likely heading back toward a recession. This is worrisome for most analysts and economists who have been consistently wrong in forecasting a second half recovery. They were predicting 3.5% to 4% economic growth along with Wall Street. The widely held view is that we get strong economic growth in the second half of the year and this strong economic growth will help fuel corporate profits. Wall Street has some very hefty earnings growth figures for the third and final quarter of the year. The prediction is that pro forma earnings will grow at a 30% rate in the third quarter and a 40% rate during the fourth quarter, even though these projections aren’t real numbers. There is nothing on the horizon, either, in the economy or in the business world that would indicate these projections are even close to becoming a reality. This could be a big shock for the financial markets this fall, which have been counting on a big boost to earnings. Those projections for economic growth and miraculous earnings are looking more like a fantasy at this point.

GDP Revisions Ominous
More ominous for the economy and the financial markets is today’s government revisions of the economic numbers for the years 1999-2001. The major revisions show an economy that was much weaker than originally reported. GDP growth for the first quarter was revised down from the original 6.1% growth rate to 5%. What is more telling is the revisions of 2001 GDP, which show only a rise of 0.3%. Instead of one quarter of negative economic growth, we actually had three consecutive quarters of economic decline. Economic growth actually peaked in the fourth quarter of 1999 and slowed substantially during all of 2000. During 2000, the economy was already heading toward recession with the first quarter of recession beginning in the first quarter of last year. Previous reports had shown the economy had been strong throughout 2000, when in fact it had been weakening all along. A summary of other revisions are listed below:

The Bureau of Economic Analysis (US Commerce Department) issued their GDP report today. A link to the report is listed here for those who want to delve into the statistical data and form your own conclusions. Suffice to say this report is one more nail in the coffin of the new paradigm economy of the 1990’s. Like so many of the corporate revisions we have witnessed -- with more to come in the future -- the 1990’s "New Era Economy" has turned out to be more fiction than reality. As corporations come clean with their books, the government is coming clean with its own revisions as well.

Pinpointing The Truth
What these economic restatements reveal, and what so many other corporate revisions show, is the economy and corporate profits have been much weaker than expected. They point to one of the worst profit recessions in decades and an economy that is plagued by many imbalances. It also points to a day of reckoning that will be ominous when it occurs. The economy is heavily dependent on foreign capital to finance burgeoning trade and current account deficits. The US is taking in and consuming about 75% of the world’s savings. Between US foreign investment outflows and trade and current account deficits, the US needs to take in capital inflows of around $900-$1,000 billion per year. The trade and current account deficits require about $450 billion. Add to it the outflows of US capital, and it isn’t too hard to conclude a dollar crisis of a magnitude never seen before lies directly in front of us.

What must be keeping Fed officials up at night is they are seeing their credit bubble turn into their own worst nightmare. The economic numbers show an economy that is once more heading back into recession and a credit crunch that is developing in the credit markets. The Fed however, is caught in a Catch-22 of its own making. If it lowers interest rates again to combat a weakening economy and flood the financial system with money to combat a credit crunch, it risks losing its credibility. Lower rates could send a signal to the markets that the Fed is losing control. On the other side is the plunging US dollar, which may require raising interest rates to keep foreign money invested, which in turn could damage the economy. Moreover, raising interest rates would pop the Fed’s latest bubble in the housing market. Rising interest rates would abruptly end the consumer-refinancing boom that is helping to prop up consumption as homeowners extract more equity out of their homes. Once the housing bubble bursts, there will be nothing left to prop up the economy besides deficit spending by the government, which has taken on a new dimension.

Cornered, With No Way Out
The 1990’s Clinton/Greenspan credit bubble leaves the Fed no attractive options. In every direction it looks, the Fed finds itself backed into a corner with "no way out." Once realization comes that the economy and the markets aren’t coming back, there is going to be a very severe reaction in the financial markets. The one area to watch is the dollar. Foreigners now own $9 trillion of US financial assets. Those assets are taking a beating with falling financial markets and a plunging US dollar. When some of that money decides to leave our shores, the day of reckoning will be upon us. The excesses of the 90’s will be dealt a severe retribution in the financial markets. There is also the $3 trillion in US equity funds. Up until this time, most investors have been in a state of denial, preferring not to look at their financial statements. At some point when the Fed can’t control the financial markets through intervention and spin, I suspect that John Q. Public and his neighbors are going to be heading for the exit gates at the same time. Trading curbs could be a daily feature of the financial markets if they don’t lock up.

I’m not sure that Fed indirect intervention in the markets will be able to contain the rush towards the exit gates. It is becoming more apparent by the day that intervention is holding up the markets. These miraculous last hour recoveries are becoming more obvious. The one-day wonders when the markets jump up by 4-6% defy rational explanation. Stories that the markets rallied on news of the Rigas family being taken off to jail on July 24^th, or the story for Monday’s rally due to investor optimism over the rescue of miners over this weekend are shallow and insulting to one's intellect. Intervention was able to turn the markets from the abyss to a minor gain in the Dow and the S&P 500, but they couldn’t save the Nasdaq.

A Brief Window of Opportunity
What investors may have to understand at this point is they have been afforded one more opportunity to get out of stocks. The predicted second half recovery, or the miraculous earnings recovery, will not take place for the third consecutive year. The cleansing process of the 90’s excess credit boom is about to take a turn for the worst. It could begin as soon as August or at least by this fall. The markets and the public are going to need something to distract them and perhaps a war will do just that. The miracle earnings predicted for the last three years are not going to appear. The economy is going back into recession. And if the dollar plunges, the Fed may be forced by foreigners to raise interest rates at a time it doesn’t want to with severe consequences for the housing market, the economy and the financial markets. If the Fed believes in miracles, it better hope that the $9 trillion of foreign money in our financial markets doesn’t decide to head for the exit gates. If it doesn’t, that will be a miracle worth praying for because there will be no miracle in earnings.

Heads Up Everyone
Watch the dollar and the US bond market -- they are the keys to what is going to happen going forward. Watch the gold market. It is currently reacting to the derivative markets as James Sinclair and Harry Schultz have explained in their essays on this site. Also watch the gold and silver equities markets reacting in a leveraged way to the price action of bullion. We are now in a corrective process that is taking some of the froth out of the gold markets from second quarter. Once these excesses have been taken out, and gold has been transferred from weak to stronger hands, the stage is set for the next advance of what I believe will be a decade-long bull market. At the moment, gold and silver are climbing a wall of disbelief by both bulls and bears. By fall, and finally by winter, much of this disbelief will turn to conviction. There is nothing like a strong price move to new highs to create new converts. A spike in prices is going to depend, to some extent, on what happens to the dollar and Treasuries. If they both plunge, which I suspect they will, then you are going to see some very large gaps in the price of gold and silver. When that happens, the precious metals stocks will go parabolic. The reason they rise so quickly and dramatically is because of their scarcity. It is similar to the Internet stocks. The floats are small -- even for some of the majors. So when demand hits these stocks, the prices fly.

If you are new to investing in gold, you must understand that this is a volatile sector. It moves on emotion and fear as well as fundamentals. You must also understand that like the metals themselves, it is scarce. Very strong hands also hold it. Those who are strong believers aren’t parting with it. So when it rises, it moves quickly because there isn’t enough supply. This is why you may want to consider adding to your position on weakness, buying at support levels for the metals or the equities. Finally, avoid the hedgers. They have done poorly when prices rise because they aren’t as leveraged to the price of gold and silver because they have sold their production forward. So when prices rise, they don’t benefit to the same extent as the unhedged companies. You can see this difference reflected in the price run up of the HUI versus the XAU.

Today's Markets
Volume was high coming in at 1.92 billion on the NYSE and 1.64 on the Nasdaq. Advancing issues outpaced declines by a narrow margin on the NYSE while losers beat out winners on the Nasdaq by 20-14. The only green light on the board occurred in oil, drug and bank stocks.

Overseas Market
European stocks climbed as companies including Unilever, Allied Irish Banks and Sanpaolo IMI said earnings will be better than forecast or topped estimates. The Dow Jones Stoxx 50 Index was 0.9% higher at 2744.83 at 5:45 p.m. London time. Five of the eight major European markets were up during today’s trading. Japanese stocks fell, led by exporters such as Kyocera Corp., after a drop in a U.S. consumer confidence index stoked concern that spending will slow in the nation's biggest trading partner. The Nikkei 225 stock average lost 1.3% to 9877.94 as of 3 p.m.

Treasury Market
Treasuries reacted positively to the day's weaker-than-anticipated data, which fully support the notion of a sidelined Fed for the foreseeable future. But Treasury investors also had to contend with a large refunding package. The government will auction $22 billion in five-year notes and $18 billion in 10-year notes next week. The 10-year Treasury note rallied 1 point to yield 4.46% while the 30-year government bond gained 1 10/32 to yield 5.305%.

The Fed's Beige Book report on economic conditions revealed that growth expanded moderately across sectors and regions. The Fed also indicted that retail sales were mixed and that manufacturing was improving while labor markets remained stable. Thursday will see the release of another slew of reports: weekly initial claims, June construction spending, expected to have risen 0.3%, and the July Institute of Supply Management Index, which is seen posting

Housing market is completely uneven throughout the country and appears to be totally locally-based. There are areas with NO housing price growth at all (see, Dayton Ohio). There are others---Silicon Valley---where middle class people are just priced out of homes, pure and simple.

I challenge you to find me stats that show that the AVERAGE price of a house in the U.S. has significantly appreciated in the last two years, nationwide.

First, a 200% increase over 20 years (10 % per year) is about average for the American housing market. In the 1970s, housing in many markets was rising at a rate of 10% per year, or higher.

Second, Richard, "location, location, location." Note that NY, MAINE, DEL (dying population states, NY with rent control) had very high housing price increases; but GROWING states (AZ, ID, NM, TX, and so on) have very modest price increases. This is a case of people moving OUT of the "rust belt" and the high taxes, etc., discourage new housing construction, thus driving up the prices.

Now, I agree that ANYONE will tell you that right now your home is your best investment. Is there any serious economist who thinks that housing prices increases are "inflationary?" Nope.

Richard, you are trying to have it both ways: homes are a source of INVESTMENT for most people now, and especially when the market hiccups, people put money into their homes. It's a tangeable asset. So if people are taking on more mortgage debt, IN PART (and I agree, ONLY in part) it reflects the view that homes are investments, not merely "shelter."

Now, I will be the first to admit that it APPEARS that home prices for new middle-class housing have risen so far that NEW middle-class houses are becoming "unaffordable." So why is it that the ONLY homes I see being constructted---either here in Ohio or in AZ where I just visited---are homes in the $175,000-$200,000 range? I keep hearing stories that people "can't afford to furnish these," but this is apparently an urban legend. They are not going EMPTY. People are buying them. So where are the "middle class/working class" living? More than ever, it appears they are going back to what they used to do all the time: starting off in trailers, then going to older 1950s-1960s era housing, then moving up.

I submit it was a false expectation that young marrieds, even with two incomes, would jump into a $200,000 home. When I was growing up, virtually EVERYONE began in a trailer or "older" home, and gradually worked their way up.

BTW, this will amuse you: I had dinner with an old friend. He is a beer truck driver for Bud. BEER TRUCK DRIVER. He sent his kid through expensive private schools, then to U of A---a state (but not cheap) school---has taken vacations to Europe and Asia, has a boat and a "third" sports car. Maybe you are in the wrong profession?

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