We Haven't Seen the Worst Yet
11.10.08, 12:00 AM ET
The economy hasn't hit bottom yet. Neither, in all likelihood, have stocks.
Where is the economy headed now? Don't be misled by the global stock market rally that flared up after governments in Europe and then the U.S. announced their direct purchases of bank shares. Instead, consider the Bronx cheer that greeted the $700 billion bailout law. That market meltdown was caused by shareholders finally anticipating the economic pain I forecast two years ago (in my June 19, 2006 column, "Implosion"). The overarching reality is that both households and financial institutions are unwinding the immense leverage they built up over three decades. That deleveraging is far from complete.
Sadly, Washington policymakers are only partly cognizant of this new reality. Instead, they react ad hoc to each new crisis. The heads of banks and insurance companies are taking writedown after writedown, almost comically declaring after each that they've removed all the cancer and no further trips to the operating room will be necessary. Investors are treating each bailout as the last that will be needed, oblivious to further problems that continue the market's sawtooth pattern along a steeply declining trend.
The deleveraging is occurring in four phases. The first, the collapse in housing, started early last year when the subprime slime, as I dubbed it, came out into the open. Phase two, Wall Street's woes, began in mid-2007, when the demise of two Bear Stearns hedge funds revealed that financial firms were hugely leveraged and invested in overpriced assets of unknown and probably unknowable value.
These two phases are continuing. Housing prices are down 18% and will drop 23% from where they are now to reach the 37% total peak-to-trough falloff I foresee (see chart). Excess inventory, the mortal enemy of prices, now amounts to 1.8 million homes, which is a huge number relative to the net demand (new families minus departures to death and nursing homes), which is only 1.5 million a year. Meanwhile, the shared confidence that glues financial markets together has deteriorated to the point where banks don't want to lend to one another, much less to anyone else. The demise or rescue of Bear Stearns,
Until recently the goods and services side of the economy was holding up. Real gross domestic product fell slightly in the fourth quarter of 2007 but rose in the first two quarters of this year. Most economists, who are paid to be optimists, are only now coming around to the view that the economy is in a recession. I put less stock in raw GDP figures and peg the recession as having started late last year. In any event, the severe damage to the financial structure simply has to drag down the goods and services side. That fact is what persuaded politicians to commit to spending $700 billion to bail out the banks even though their constituents think Wall Street is run by overpaid crooks.
Phase three of the recession, the nosedive in consumer spending, will probably be the deepest since the 1930s. Consumers have relied on their home equity to fund spending well beyond their wages, salaries and other income, and that equity is fading fast, especially for those with mortgages (see chart). The collapse in house prices will, I expect, leave 25 million homeowners stuck with homes collectively worth $1 trillion less than their mortgages. Even including the 24 million who own their houses free and clear, one-third of homeowners will ultimately be underwater.
With little room to borrow, consumers are retrenching, and they're slashing their discretionary purchases, as I explained in my Sept. 29 column ("Worse Is Yet to Come"). That means forgoing not only cars and ocean cruises but also smaller items like dinner out and Christmas gifts. Also, consumers are beginning to regard payments on home equity, credit card, auto and other loans as discretionary outlays. When the choice is between making the credit card payment and putting bread on the table, financial integrity loses out. JPMorgan Chase recently reported it was charging off credit card debt owed it at a 5% annual rate. Charge-off rates will get a lot worse than that.
The combined $4.6 trillion in those four loan categories (second mortgage, credit card, auto and other) makes the $700 billion in subprime debt look like chicken feed (see chart). Financial institutions own a lot of those loans, directly or through securitizations, and they may suffer even bigger woes than from the subprime slime.
Unlike housing, commercial real estate wasn't overbuilt in recent years, but prices were bid up. Commercial real estate is backed by $3.5 trillion of debt, again heavily owned by financial institutions. In today's climate, declining demand may be devastating. Malls will suffer and tenants fold as consumers retrench. Warehouses will stand empty as consumers cut spending on both domestic and imported goods. Hotel occupancy will continue to slide. Layoffs will hurt the office space market, and those still employed will occupy less space as the partitions are moved in. Hospitals will have trouble covering their mortgages, as pressed consumers forgo elective procedures.
The recession will probably be the deepest since the 1930s, especially as it spreads globally in its fourth phase. Weak consumer spending in Japan and Europe, housing collapses in Ireland, Spain and the U.K. and the spreading financial crisis are already hobbling exporters in China and India. Think about the bankruptcy of Iceland and the stock markets collapsing around the globe, particularly in Russia, where the oligarchs are getting knocked down by big margin calls. Think about the bailouts of HBOS, Bradford & Bingley and the
Moreover, commodity prices are collapsing as global demand falls and as those who thought commodities were a legitimate investment rush out even faster than they charged in. The dollar is rallying as everyone flees to Treasury bills.
The profits of nonfinancial U.S. corporations are extremely vulnerable as domestic and foreign sales plunge, credit markets remain chaotic and the transfer of foreign earnings into dollars turns from a buoy into a millstone. That will help sink the $2.6 trillion in leveraged loans and $1.1 billion in junk bonds out there and push many investment-grade companies into junk status.
Getting out of this financial mess will require the elimination of excess housing inventories, completion of the writedowns and recapitalizations at financial institutions and the subsidization of underwater homeowners' mortgages. That could all take years and cost--who knows?--$3 trillion. On top of that, the likely disasters with consumer loans, commercial real estate and junk securities will take time and money, too.
If you're an equity investor with a long-only portfolio, it's not too late to take some money off the table. Remember 777--not the airliner but the low that the Standard & Poor's 500 hit in 2002. That's 21% beneath where we are today, but if it's breached, then all the stock rise of the last six years will have been but a bear market rally, and the bear market that started in March 2000 will still be with us.