Last Week in Review

Last week in every market segment was down including energy, materials and utilities. Overall, it was a tough week with the S&P500 down 3.1%, Nasdaq fell 2% and the Dow Jones Industrial declined 3.8%. Year-to-date the S&P500 is now down 9.3%. Small caps continue to outperform large (less negative) and growth is trouncing value investing. Market jitters continue and the bears are winning.
Oil troubles continue with prices rising to new highs. Increasing energy prices have stoked inflation fears. The numbers of speculators in the commodity markets is growing rapidly only adding to the feeding frenzy. In addition, escalating tensions between Israel and Iran is adding instability to an already rocky oil market. The scuttlebutt is that Israel will bomb Iran with assistance from the U.S. in the next six months. Oil prices will soar to over $200 a barrel if Iran is attacked. Baring an attack, the energy markets look very frothy and should retrench from these lofty levels.
Problems in the financial sector persist. Banks have only written off one-third of their bad investments and the housing market is rapidly disintegrating. These problems will not be fixed overnight. Until the housing market begins to recover the economy and markets will stay in turmoil.
Inflationary forces continue in the developed and developing world is reaching the choking point. Many economists feel inflation is not that bad because it has not spread to workers. Rising unemployment is keeping wages down. So in economist-speak inflation is not so bad.
In the real world the problem is that the collapsing housing market in conjunction with rising food, energy and healthcare costs have taken the consumer out of the market. I know I write this all the time but two thirds of our Gross Domestic Product (GDP) is generated by consumer spending. Consumers aren’t spending (look at the recent performance of retailers and automobile manufacturers). Consumer lead recessions (vs. business lead recessions) are always deeper and take longer to recover. It takes more time to build up consumer sentiment and get consumers spending again. This is not going to be an easy and quick V-shaped recovery. It will probably resemble a very wobbly wide W-shape.
The Fed is talking hard ball and many of its members want to raise the Fed Funds Rate when they meet. It will be difficult for them to raise rates any time soon because it would bring this fragile economy to a screeching halt. Instead, they will have to keep rates where they are and if things get worse they may have to lower rates again.
In the short run, the market will remain choppy with equities swinging significantly down on bad news and moderately up on good news.
I will be in Chicago this week at the Morningstar Conference. I hope to meet with numerous portfolio managers of mutual funds. I will be reporting back my findings and interviews.

The Math: Economy Less Consumer Equals Recession

Without a doubt, investors will remember 2007 as the year that the housing market collapsed and triggered a credit crunch. The earnings of just about any company that was involved in homebuilding or lending were crushed, and resulting economic worries triggered stock declines for many consumer goods companies. Simultaneously, U.S. exports boomed, reaching an all-time high of 12.1% of GDP. Not surprisingly, companies with significant foreign-based earnings did well. Overseas stocks also delivered great returns, and as these economies continued to grow so did their demand for energy and raw materials commodities from China and other high-growth developing countries.
The last four months have been difficult for stocks as prices have declined substantially from their highs in October 2007. The markets have broken through many technical support levels -- this is true for every major index (Dow Jones, Russell, Nasdaq and S&P), which means that technical damage has been done.
The good news is that the Federal Reserve has finally woken up to the severity of the situation and is working diligently to respond to escalating economic concerns. On January 22, 2008, the Fed unexpectedly cut the fed funds rate by 75 basis points (0.75%) from 4.25% to 3.50% in advance of its policy meeting. The Fed has not cut rates in one stroke by such a large amount since 1982. In making the cut, the Fed cited the “weakening of the economic outlook and increasing downside risks to growth.” This move was desperately needed to ensure market stability and sooth investor fears. Sinc then, the Fed has continued to cut rates and has stated its willingness to cut rates further to shore up the markets.
It appears that the combined impact of the housing implosion and the fallout from the structured finance debacle has pushed the U.S. into recession - or at least whole sectors of the economy are now in recession. How protracted the economic weakness will be and what its full impact on the markets are the new questions to be answered.
The key to an economic turnaround is consumer spending because it accounts for 70% of our economy (Gross Domestic Product—GDP). The falling housing market and the resulting tightening of mortgage lending have hit consumers hard, causing them to spend significantly less. Consumers who are more and more worried about the overall economy have triggered stock declines for many consumer goods companies.
A volatile stock market does not help consumer sentiment either. When you add rising unemployment to the mix, it is obvious that the U.S. consumer isn’t going to go on a spending spree anytime soon. It will be tough to entice the consumer to start spending when it is difficult to borrow, and many are already heavily in debt. Until credit markets are repaired, the consumer won’t start spending enough to cause a recovery, and businesses will curtail spending. If consumers and businesses aren’t spending, that only leaves the federal government, a scary thought. Even the proposed fiscal stimulus plan by the President won’t be enough to turn the tide. When credit becomes this tight, a recession is almost inevitable.
How did credit get so tight? Why are funds more scarce and underwriting criteria toughening? It all started with the mortgage-backed securities and how they are packaged and sold through our unregulated shadow banking system.

What Happens When the Easy Money is Gone? Go Global!

Consumers can no longer tap their homes to support their lifestyle nor can they run up their credit cards forever (credit card debt is reaching a historic high). The subprime mortgage debacle has made it difficult for consumers to withdraw funds from their homes and caused housing prices to fall. Add in a falling stock market to this mix and the American consumer must be feeling less wealthy. Historically, a falling housing market has caused consumers to rein in their spending. As credit continues to dry up, the American consumer will have to begin living within their means. That could make things uncomfortable for a while and leave the U.S. economy in a bind.

In the past when the U.S. economy caught a cold, the contagion spread around the world. The world economy has been too dependent upon the U.S. consumer to buy its good but the world is becoming a different place. Hopefully, the global economy can slowly wean itself from the American consumer and become more dependent upon the emerging middle class in India, China, and South America.

The falling U.S. dollar will help this global shift by making imported goods more expensive. On the plus side, exported U.S. goods will become more affordable to the new world emerging middle class. This new demand for U.S. goods and a falling demand for imported goods to the U.S. could correct the trade imbalance caused by years of over spending by and over dependence upon the U.S. consumer. This scenario would allow the U.S. economy to grow albeit slowly and the world to grow apace.

Credit is drying up for the U.S. consumer making him played out as the engine for global growth. The U.S. consumer won’t be able to borrow and may have to begin to save. The easy money has dried up and we are about to find out what the world will look like without the U.S. consumer in the drivers seat. Hold onto your hat! The ride is going to be bumpy especially in the U.S.

In short, emphasizing global investments will be crucial if your portfolio is going to generate decent returns over the next few years. That means allocating half of your equity investments abroad which is a stark change from the past when the U.S. markets dominated the world.

Consumer Prices, Inflation, Unemployment, and Corporate Profits

Great News! U.S. consumer prices were flat in November. Most economists were expecting a small rise of 0.2% rise for the month. This could allay inflationary fears at the Federal Reserve. The market will now expect the Fed to focus on lowering interest rates towards the middle of 2007 and stop thinking about further rate hikes. Stocks and bonds will trade up on this news.

In other good news, the Labor Department reported that the number of Americans filing for unemployment benefits dropped for a second week. This will begin to allay another fear investors have had that the economy might cool quickly. A long gradual landing of this bull market is what investors are hoping for in 2007.

Robust quarterly profit reports keep rolling in, with Costco, Honeywell and Citigroup all reporting good news.

Consumer spending is now the worry. The economy is a three legged stool with spending by the government, businesses and the consumer. Government and Business spending is expected to be moderate. It is the consumer that has been driving economic growth. Will Americans decrease their spending as housing prices contract? Will a decrease in wealth (caused by falling housing prices) translate into consumption? Many economists and investors have been waiting for most of 2006 for consumers to feel this falling wealth effect and moderate their spending. It appears that the low unemployment rate could be bolstering consumer confidence because consumer spending has not abated. If the consumer stops shopping, then this bull market is probably over.