Context Barometer

Much like the villain in a bad horror movie, the global financial crisis just won’t go away. No one can breathe easily until the threat is eliminated, but when that will be accomplished remains to be seen.

We must nevertheless deal with the situation as it stands now. In this issue of the Context Barometer we will discuss the outlook for the economy in these trying times, paying particular attention to a few of the major asset classes—residential real estate, stocks, bonds, and gold.

Housing Still a Concern 

Many of our current problems are directly attributable to reckless lending and spending in the housing market. The number of foreclosures among sub-prime mortgage­–holders is continuing to rise. The rate is higher in some states than others. In Florida it is 48%, Nevada 45%, New York 39%, California 38%, and Arizona 36%. The national average is 33%.

Reasonable estimates indicate that as many as 6 million more homes are in jeopardy and will soon be on the market. Meanwhile, the number of potential buyers has been reduced to a level not seen since the mid-1990s. Job loss or fear of job loss as well as tightened lending standards is making home ownership more difficult for many.

About three-fourths of the outstanding mortgages are held by the Federal National Mortgage Association (Fannie Mae) and Federal Home Mortgage Corporation (Freddie Mac). Both of these government-sponsored enterprises were initially designed to assist lenders by allowing them to securitize mortgages for resale on the open market.

Mortgages that cannot be refinanced or modified by the banks in which they originated typically end up on Fannie Mae or Freddie Mac’s books. That includes mortgages on the verge of default and foreclosure. By paying the balance due, Fannie or Freddie takes possession of the collateral, which by now amounts to an inventory of approximately 160,000 homes.

To keep Fannie Mae and Freddie Mac in business, the Treasury Department has been providing much-needed funds and will continue to do so for at least three more years. This is essentially a back-door bailout of the nation’s banks. Many banks have thus been able to pay off their own loans from the government by selling their most risky mortgages to Fannie Mae and Freddie Mac for close to 100% on the dollar.

Since none of the foreclosed homes can be liquidated for anything close to their initial valuation, the losses escalate at taxpayers’ expense. So far, the program has cost $145 billion. Considering the sheer number of defaults and foreclosures expected, the total cost of the bailout could eventually be as much as $1 trillion.

Homeowners who’ve managed to pay their mortgages in a timely manner still have to contend with loss of equity. According to zillow.com, a website for current real estate information, nearly a fourth of the nation’s mortgage-holders owe more on their homes than their homes are worth. This so-called negative equity has repercussions beyond the obvious loss of assets and security. Many homeowners are postponing purchases of big-ticket items, reconsidering their decisions to retire or relocate or simply walking away from their housing obligation.

Consumer Confidence

The most recent data published by the Economic Cycle Research Institute indicate that our economy is now at a 45-week low, following the most precipitous slide in 50 years. Employment, auto sales, housing starts, factory orders, and consumer confidence are all showing weakness. The Consumer Metrics Institute, which tracks consumer retail sales, warns that we can expect a long period of contraction.

Even Walmart, the largest retail company in the world, had poor sales results last quarter. Tom Schoewe, Chief Financial Officer of the company, noted that more customers than ever are living paycheck to paycheck. Given that 70% of the gross domestic product (GDP) is attributable to consumer spending, any loss by the company known for family-friendly prices is a sure sign that other retailers are in worse shape.

Employment

Economic recovery is of course highly dependent on how many workers are gainfully employed. In the last three weeks alone, the number of people receiving unemployment benefits increased 64.1% on an annualized basis. The average length of unemployment is now 34.4 weeks. These figures do not begin to tell the real story, however. Many people have become so discouraged that they have stopped looking for full-time work or are no longer eligible for benefits. The total number of under- and unemployed workers exceeds the 16% rate reported by the Department of Labor­—by how much is unknown.

States in the Crossfire

The fewer people employed, the fewer retail sales and the less money collected in taxes. Since 2009, state revenues from all sources, but primarily sales taxes and personal and corporate income taxes, have declined an average of 11.8%. This is despite the $23.9 billion increase in state taxes levied this year.

California’s $1.8 trillion economy is larger than Russia’s, yet the state is sinking deeper into debt every day. To balance the budget, lawmakers must either sharply curb spending or come up with $19 billion in new monies. California is far from alone. Forty-six other states will also have to contend with a budget shortfall in the next fiscal year.

Overall, about 200,000 state jobs have already been cut. A report from the Economic Policy Institute in Washington predicts that 162,000 more workers stand to lose their jobs if Congress does not extend the program guaranteeing $24 billion in Medicaid payments to the states by the end of the year.

A Nation at Risk

On July 1^st, Alan Simpson, co-chair of President Obama’s Debt and Deficit Commission offered an ominous assessment of the nation’s fiscal future, calling budgetary trends a “cancer that will destroy the country from within unless checked by tough government action in Washington.” He went on to say that at the present time federal revenue is fully consumed by three programs: Social Security, Medicare, and Medicaid. Other obligations, including the entire budget for homeland security, military operations, veteran affairs, education, and culture, are being financed by China and other countries.

Recently, the national debt leapt $166 billion in a single day, the third largest one-day increase in history. It defies all logic to think that we can continue borrowing forever.

Either the government will print more money, which will decrease the value of the dollar, or the government will default on its loans. Hyperinflation needs to be a major concern.

Outlook for Major Markets

We encourage investors to read This Time is Different by Kenneth Rogoff (Harvard) and Carmen Reinhart (Univ. of Maryland). It is one of the best books on economic history to be published in a long time. The authors report the results of their study of “eight centuries of financial folly.” No matter which country or which century they looked at,

they found that notable financial events unfolded in a remarkably similar manner.

Banking crises, for example, are almost always followed by an extended period of economic contraction. This typically leads to a sharp decline in tax revenues and a significant increase in government spending. That in turn leads to an average 86% increase in government debt within three years.

Other trends are also of particular relevance in trying to discern what lies ahead. On average, after a banking crisis, housing prices decline for about six years, employment for about five years, and stock prices for 3.4 years. If we use the Bear Stearns collapse in March of 2008 to mark the beginning of the current banking debacle, these findings suggest that we won’t see a real economic recovery for some time.

U. S. Stocks: What happened to the shoots that were supposedly sprouting in 2009? Six of the 986 U.S. bank holding companies, which were deemed “too big to fail,” received government bailout money. When they did manage to earn a combined $51 billion by the end of the year, their stocks went soaring. Investors who deluded themselves into thinking that we were out of the woods failed to take into account the fact that the other 980 bank holding companies lost money.

Every bit of growth we have observed in the last year can be traced to government bailout or stimulus money. There has been zero growth due to private sector expansion. If the government had not intervened, we would be talking about one of the worst year over year economic growth rates in 50 years.

The S&P 500 is down 31% from its high in October of 2007. There have been a few signs of improvement along the way, but at the moment the S&P is down about 9% since April. Although many investors are convinced that the market bottomed out in March of last year, it would not be surprising to see an even lower dip before the end of 2010.

Bonds: For now, U.S. government bonds may provide good short term results, but they are unlikely to yield significant returns in the long run. The Federal Reserve Board is said to be discussing additional stimulus moves that could further increase the Fed’s balance sheet, from about $2.4 trillion to $5 trillion. If the debt remains unchecked, bondholders will surely take flight and yet another Ponzi scheme will have fallen under its own weight.

Gold:  The price of gold has been swinging wildly of late, leading many investors to fear that the gold is a bubble that is ready to burst. It is well to keep in mind, however, that as an investment, gold offers particular advantages:

Michael Cembalest, Chief Investment Officer at J. P. Morgan put together an informative chart showing that whereas gold represented 17% of global financial assets in 1982, it represented only 4% in 2009. Even though gold prices doubled from 1982 to 2009, a massive expansion of dollar-denominated assets in the same timeframe has tended to obscure gold’s true worth.

As we’ve discussed in previous issues of the Barometer, we think that gold will be selling for $1,650 an ounce in the next several months or so. From the end of 2009 until June of this year, the price rose from $1,095.20 to $1,242.30 an ounce, a respectable increase of 13.4%. Investors who bought at rock-bottom prices in October of 2008 have so far realized a gain of 82%. Since 2001, gold is up 380%.  

The more government bailouts are mandated, the more likely it is that the Fed will resort to measures that will weaken the dollar and drastically reduce its purchasing power. Under those circumstances, asset classes other than gold, including stocks, bonds, and real estate, will be worth less than face value. In our view, gold will not only retain its value but will be selling for $3,000-$5,000 an ounce sometime between 2015 and 2016 if not sooner.

Social Insecurity

We need to stay vigilant to stay solvent. The national debt is massive. Many columnists have lamented how unfair it is to pass this debt on to the next generation. They don’t seem to realize that government debt can never be repaid as it is too large. 

In 1776, the year we became a nation. Adam Smith made the following observation in his seminal book, The Wealth of Nation: “When national debts have once accumulated to a certain degree, there is scarce….a single instance of their having been fairly and completely paid.”

The current crisis is global. Spain, for example, has a total debt to GDP ratio of 250%, Germany and the U.K. 400%, the U.S. more than 500%, and Greece more than 800%.

Whenever a government is unable to fulfill its promises to another country, or to its own citizens, the situation is volatile. Right now we are in a twilight zone, extremely pessimistic about our currency and economy while fearing that we will become more pessimistic in due course. 

Clearly, we cannot expect to rely on old remedies. There is no Superman or leadership with fresh economic insights to save the day. Rogoff and Reinhart’s book title is intended to be ironic. How can this time be different if we go on repeating the same mistakes and getting the same outcome. Human behavior hasn’t changed, but this time some things are different. We’ve become a global society in which the financial mistakes that have been made are far more complex and will lead to far greater negative implications then in the past.

In future issues of this newsletter, we will endeavor to further explore Rogoff and Reinhart’s, as well as other historical information for clues on where we are heading. As always, we affirm our commitment to assisting you in making your own preparations for the future. Please let us know if you have any questions or comments.