Saturday, January 26, 2008


America, the "Vanilla Sky" economy.

Whether or not we are in a recession depends on who you talk to. If you are a consumer reeling from the loss of value in your home, no longer able to lower payments by refinancing your mortgage, or someone in residential real estate, construction or the mortgage industry, the answer is certainly YES. On the other hand, if you are in a more traditional industry such as pharmaceutical, transportation, food, energy, or a large technology firm, things are probably OK.

While experts continue debating, the economy is still chugging along. The unemployment rate is at 5.5%, up from a low of 4.5% a year ago, but far from the 8% to 10% levels seen in the early 90’s. But while the economy grew at a healthy 2% last year, profits have been declining, with earnings for S&P500 companies down in both third and fourth quarters of 2007. This is why I call it the “Vanilla Sky” economy, like the creepy 2001 movie where after a car crash Tom Cruise cannot figure out whether he is dead, alive, living a dream, or where reality lies. Business is growing but not profitably, and evidence of a slowdown is all around us. We are hanging on to our jobs but not getting raises because employers are making less money. We pay our bills but feel poor. The real estate downturn and market turmoil have caused our networths to decline. The banking crisis is making it near impossible to refinance our houses, get more cash and lower payments. Gone are the days of cashing lucrative stock options, flipping IPO's, day trading, or getting cash out of the house to pay bills and finance our life style.

So are we in a recession? And why is it so difficult to figure out?

The answer is we just went through a bubble. America has a history of bubbles: the energy crisis in the late 80’s, the busts in early 2000’s, and now real estate. All have the same root cause, too much money thrown at a sector for too long.

In the late 80’s government tax shelters caused enormous inflows into energy. You could put money into an oil and gas trust and immediately get a full return on your taxes, without a need for the venture to ever make a single profit, the equivalent of free money. It ended when the government changed the tax laws, causing a glut and an energy recession that lasted well into the 90’s. In the mid to late 90’s it was VC’s chasing the Internet gold rush, virtually throwing money at any high tech start-up with a pulse. The industry eventually went bust in 2001 and didn’t fully recover until four years later. And this century witnessed financial services firms in a heating frenzy to throw money at any consumer dead or alive, using growing home appreciation as collateral, in the belief they would never go down in value.

These trends start with decent business value propositions but eventually morph into the equivalent of a pyramid scheme as they gain too much momentum. And like pyramid schemes, they work for a while but end up badly, especially if you are the one holding the cards at the end. We always recover, but it takes several years. This bubble will be no different.

So again, are we or are we not in a recession and why can’t the experts agree on one or the other? The answer lies in the way our economy works. Just like a car, it is made of many parts, some functioning, some not. This economy feels like a car that works well for the most part, with the exception of the gear box which is frozen in third gear. It is moving but cannot accelerate, and at the same time it is not coming to a screeching halt. Our economy's "gear box" is of course the banking system, virtually frozen for six months, since the sub-prime crisis hit full course. The fed keeps greasing it, lowering interest rates and adding money into the financial system, hoping it will eventually crank itself out and work smoothly again. But the bankers, just now emerging from huge sub-prime mud piles after taking very large write-offs’s, are still a bit gun shy about jumping right back in.

Smart money is betting we are not in a recession, but that it will take some time for the financial system to clean itself and work smoothly again. A good barometer is Warren Buffet. He recently took sizeable positions into basic American industry, railroads, manufacturing and consumer staples. But he is staying clear of the financial sector, thinking there will be better opportunities ahead. If he thought we were heading into a recession, he would hold on to his cash and wait for a better time.

My predictions for 2008:

1. Economy recovers slowly in the second half of the year.
2. Banking system returns to normal by summer, as lending is simply too large a source of income for banks to ignore.
3. Fed reduces rates to 2.5%, mortgages decline below 5%.
4. Dollar peaks at €1.50 and gradually goes down to €1.25 by year end.
5. Oil ends 2008 in the $60’s. While demand for oil doubled in the past five years, the price quintupled. The slowdown in the economy will help synchronize supply and demand to a more rational level.
6. Residential housing continues to depreciate; reaches bottom some time in 2009, flat lines for a few years, and starts appreciating significantly in 2013.
7. Countrywide CEO Angelo Mozilo replaces Donald Trump on The Apprentice, who resigns from the show when he announces his candidacy for President of the United States.
8. Stock market recovers from mid year lows with the S&P500 reaching the 1600’s by end of year.
9. Google reaches $900.
10. Large cap stocks outperform.
11. Consumer staples, property and casualty insurance, energy and utilities, pharmaceutical and healthcare, selected growth large cap technology, and Japan outperform the market.
12. Financial services, home builders, small caps, and China underperform.


Anonymous said...

I'll blame it all on the Bush Administration. They have been toying with both the US and the global economy for way too long.

The war in Iraq devalued the Dollar (can't keep spending money that is created out of thin air for ever)which in turn increased the cost of imported goods and increased US exports. The increase in exports resulted in a bigger demand for oil, combined with FUD over the politically troubled oil producing countries, resulting in a knee-jerck reaction sending both Oil and Gold to all time rediculous highs!

Who benefited more from these high oil prices? Arab countries (producers) or Texas based oil companies (with all-time highs for corporate earnings)? Where is George Bush from? Yes indeed - Texas! So it is not such a bad outcome after all!

Which companies or industries benefited most from the War? Defense, oil & gas, homeland Security, and yes mortgage companies!

Mortgage companies?? so what is the relationship between mortgage companies and the war you ask?

How do you think the Bush Administration finances the budget defecit?? YES ... it lowers the interest rates!! This encouges the consumer to refinance, and in many cases to upgrade, their homes. This leads to taking on more debt, spending more money on mortgages and consumer goods (like iPhones). The x-Chairman of the Fed would call it "irrational exuberrance".

The Mortgage companies had their hey days and will continue to do well even in a down economy. The ones that will end up "holding the bag" are the individual investors (or the consumer) who have invested their borrowed money in REIT's and other funds that were backing up these "bad loans" that are financing the inflated real estate properties. This also happened when the "Dot Com" bubble bursted a few years ago, the inidividual investors ultimately paid the price!

The new Real Estate bubble is getting bigger, as Rene says, and it eventually has to burst. We are witnessing the realtity of 10 years of irresponsible governance and are going to start to pay for it!

Yes Rene ... we are just starting another 5 years of recession. Tighten your belt and get ready for a very bumpy ride ahead!

Robert I.

bzliteyear said...

Nice post.
I agree with many of what you wrote, though not always in agreement on the timing. Also, I would never bet against the US consumer. They may take some lumps, but they're very resilient. In fact, US consumers now include international visitors who are buying US exports and/or real estate because everything is so cheap.
Btw, all the people who are predicting how long it takes to recover from a bubble and that we'll be in a real estate funk due to the bubble, etc...I think this recovery could happen faster than people realize. Remember how quickly the dotcom recovered, how quickly the PC boom/bust recovered in the early 80's, etc... Technology will continue to change the world and drive growth.