Altruistica

"Altruistica": Seeking a return to full financial disclosure and regulatory oversight. A financial market analysis blog for "entertainment purposes" only by an experienced CFA seeking new hedge fund engagements for investment writing and analysis. The author has experience investing internationally, running a hedge fund, making angel investments, and helping launch five startup companies. Investors should do their own due diligence.

15 January 2007

Shilling: A Dozen Reasons To Worry (For Non-worriers)

What’s ahead for stocks and the economy in 2007? Setting aside unknown elements like major terrorist attacks or natural disasters, (Shilling) believes seven phenomena are shaping the investment climate this year. A. Gary Shilling makes money for his subscribers by going against the grain--and he's usually right. He was out of tech stocks by 1999 and dumped the homebuilders last year. (Their promo, not mine). These points are excerpted from the December 2006 issue of Shilling's "Insight" investment advisory letter.

The world is awash in financial liquidity mainly due to appreciated house values, the negative U.S. corporate financing gap and the American balance of payments deficit. Inflation remains low despite higher energy prices. As a result, investment returns are low. Speculation remains rampant despite the 2000 to 2002 bear market. So, investors are accepting more risks to achieve expected returns. And then there’s the insatiable U.S. consumer, who, thanks to the booming housing market, continues to spend freely.

In this climate, I foresee 12 investment themes, seven of which are likely to unfold in 2007, while four will probably work but maybe not until next year:

-- Housing prices will collapse. The housing bubble is deflating as sales of new and existing homes slide, prices begin to drop and housing starts decline. A bigger price plummet may start soon as many speculators give up on appreciation dreams and throw their properties on the market, triggering a downward spiral. Alternatively, interest rates on the adjustable rate mortgages of many sub-prime borrowers will adjust up dramatically this year and force them into defaults and house sales. Unlike earlier U.S. housing booms and busts that were driven by local business cycles, such as the rise and fall of the oil patch along with oil prices in the 1970s and 1980s, this one is national and, indeed, global. And since houses are much more widely owned than stocks, the bubble’s likely demise will shake the economy more than the earlier bear market in stocks.

-- The Fed will ease when house prices collapse; meanwhile, the yield curve will remain inverted. Once the Fed embarks on an interest rate-raising campaign, it almost always keeps going until something big happens, and that something is normally a recession. This time, we’re betting that the bursting of the housing bubble beats the Fed to the punch. Once housing is in a shambles, either falling from its own weight as we expect or due to central bank action, the Fed, of course, will patriotically ease as the economy hits the skids. The yield curve inversion, the only meaningful effect of the Fed’s current campaign that we can find, rightfully worries many because they have preceded every recession since 1950 with only two fake signals.

-- U.S. stock prices will fall, perhaps below the 2002 lows, in the midst of a major recession. A major decline in housing prices and activity will almost surely precipitate a full-blown U.S. recession. That, in turn, will send corporate profits down after a spectacular advance over the last five years. Without this robust growth, stocks are vulnerable.

-- China will suffer a hard landing due to domestic cooling measures and U.S. recession. China is attempting to cool her white-hot economy, which grew at an estimated 10.5% rate last year, but is having difficulty. A major U.S. recession will shrink Chinese exports dramatically as U.S. consumers buy less of everything, especially imports. So between domestic economic cooling efforts and a U.S. recession, a Chinese business slump is in the cards for 2007.

-- Weakness in U.S. and China will spread globally, dragging down economies and stocks universally. The U.S. economy dominates the world, not only because of its size but also because America is the only major importer. Most other countries are running trade surpluses, and the U.S. is the buyer of first and last resort for their excess products. The Chinese economy is closely linked to America’s, and a U.S. recession, combined with Chinese domestic economic restraint measures, insures a global downturn. Other major economies in Japan and Europe simply can’t pick up the slack.

-- Treasury bonds will rally. Yields rose a bit over the last year, but surprisingly little in view of continued economic growth and further Fed tightening. Downward pressure on Treasury yields will result when the Fed reverses gears and eases once housing is clearly in retreat and a recession is evident. I expect the current yield on the 30-year bond to decline in 2007 and ultimately reach my long-held target of 3%.

-- The dollar will rally, but only after the recession becomes global. The greenback last year remained strong against the yen but not against the euro. The dollar may be weak early this year, but strength would come later in the year as U.S. consumers curtail spending, imports fall and, as a result, foreign economies become weaker than the U.S. Later this year, the dollar should gain against the euro and yen and also against the commodity currencies, the Canadian, Australian and New Zealand dollars, which will suffer as global recession slashes commodity demand and prices.

-- Commodity prices will nosedive. Commodity prices showed unusual strength in recent years and not just in the energy sector. Industrial metals prices have skyrocketed. So have livestock and grains of late. Even precious metals have reached prices not seen since inflation was raging in the late 1970s.

In the long run, we don’t see any constraints that will prevent the normal reaction to high commodity prices--increased supply that will depress prices. In energy, Hubbert’s Peak devotees believe the world is running out of crude oil so prices will skyrocket in the years ahead. But we’re convinced that human ingenuity will, as in the past, prevent a Malthusian outcome. The ongoing fall in U.S. home sales and likely collapse in prices will have very negative effects on building materials prices. Lumber and copper prices have already nosedived.

-- Maybe global and chronic deflation will commence in 2007. The global recession I foresee, coupled with deflationary forces already at work, will cause major price indices in the U.S. and elsewhere to fall this year. That alone doesn’t guarantee chronic deflation. Inflation usually declines in recession, so the proof will come in the recovery that follows in 2008.

-- Maybe U.S. consumers will start a saving spree, replacing their 25-year borrowing and spending binge. The money extracted from, first, stocks, and more recently, from houses are behind the drop in the U.S. consumer saving rate. With stocks likely to again fall significantly, a significant fall in house prices seems almost certain to precipitate a shift from a quarter century borrowing-and-spending binge to a saving spree, unless another source of money can bridge the gap between consumer incomes and outlays. But no other sources, such as inheritances or pension fund withdrawals, are likely to fill that gap.

-- Maybe deflationary expectations will become widespread and robust. Deflationary expectations spread and intensified in 2006 as consumers waited for lower prices for cars, airline tickets and telecom fees before buying. Christmas 2006 sales depended heavily on slashed electronic gear prices. Deflationary expectations may become widespread and robust when chronic deflation becomes established and consumers wait for lower prices before buying. Zeal for saving will augment this.

-- Speculative areas beyond housing may suffer in 2007. Housing is not the only area of heavy risk-taking. A great disconnect between the real economy and the speculative financial world has existed since the late 1990s, fed by mountains of liquidity sloshing around the world, expectations of and demands for oversized investment returns, and low volatility, all of which have encouraged risk taking. Anticipated stock volatility remains at rock bottom. Spreads between yields on junk bonds and Treasurys are tiny as ample financing and loose lending keep corporate defaults at record lows.

The huge gap between speculative financial markets and economic reality has persisted for a decade. It will probably be closed with many tears in the next recession, only adding to its depth.

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