Factors Aligning Against the Boom Cycle

As growth now fades, many investors foresee a soft landing and a quick rebound. I do not. I believe that profit growth will continue to fall well below expectations, while the economy faces a long, lumpy road ahead before healthy growth emerges once again. Here are some reasons why.

1. An Absence of Wealth Generators

The wealth effect of rising stock prices in 1996 to 2000 was followed by a near-vertical climb in housing prices in 2001 to 2006. This provided consumers a dramatic and unprecedented rise in net worth. Unfortunately, there is no asset class that is likely to provide a similar degree of direct or indirect stimuli over the next several years.

• Housing is not likely to be a stimulus:
  Despite the quantum leap in home prices from 2000 to 2006, refinancing cash-outs have increased the American consumer's leverage to real estate as the ratio of mortgage debt to home values has never been higher. Therefore, opportunities to fund consumption by leveraging the housing stock further are more limited than in past economic cycles.
• Equities are not likely to be a stimulus:
  Stocks have provided an unprecedented boost to consumers over the last 25- and 10-year periods. Looking ahead, a repeat performance is unlikely. Instead, I believe a period of lumpy and uneven economic growth is likely. This is especially true given the prospects for modest top-line sales growth and rising cost pressures. In fact, I believe that corporate profit margins remain quite vulnerable. Slow economic growth and shrinking margins are not a recipe for expanding price earnings multiples or rising share prices.

2. Mortgage Lending Isn't Likely to Get More Creative

Unconventional and aggressive mortgages already have stretched the limit of lenders and the patience of policymakers. (Aggressive mortgages include ARMs, unusual teasers, high loan-to-value ratios, interest-only loans, reverse amortizations, etc.) Where can you go when you've gone too far? When mortgage lenders lend at 110%-120% of home value, what uncharted credit territory still awaits exploitation? Other debt markets were also creative and liberal in their extension of credit. The automobile industry, for example, has liberalized terms as far as it probably can. Indeed, manufacturers have helped create a tapped-out consumer by offering teaser loans and creative financing. Yet there is little top-line progress to show for it.

3. Businesses and Households Have Locked In Much Lower Interest Rates

David Rosenberg of Merrill Lynch did an excellent job recently of chronicling this interest rate cycle. In short, rates during 2003-06 were already quite low, so the Fed has little room to maneuver.

In the last cycle when the prime lending rate was pushed up to 9.5% at the peak, the average of the prior three years (1998-2000) was 8.5%. So when the Fed eased and the prime rate hit its low of 4%, there was very substantial stimulus, because everyone rolled out of high average rates to a very low rate.

But look at the current backdrop: In the past three years, prime has averaged 5.35%. The prime rate now is 8.25%. So say the Fed eases 200 basis points after this tightening cycle is done. Who cares? That would still leave prime at 6.25% or 90 basis points higher than the "average rate" being carried by the household sector (averaging out the past three years). You see -- when the Fed eased 200 basis points from January to April 2001, it had successfully taken rates 100 basis points below what the average was and, hence, provided real stimulus for the consumer.

We can carry the same analogy to mortgage rates, especially adjustables, which averaged 6.2% to ultimately scale into a cost that was almost 300 basis points lower. Now that is called rate stimulus. But the average ARM rate from 2004-06 has been 4.5%, so even if the Fed eases enough to take the yield back down to 3.4%, the amount of stimulus based on the mathematics will fall nearly 200 basis points shy of providing the thrust it did in the last cycle.

4. The Lack of Savings Is an Economic Headwind

A 50-year low in the personal savings rate leaves the consumer exposed and illiquid. Simply put, there is no margin of error for the consumer. The decline in savings has dropped to dangerously low levels, so the stimulus of lower interest rates will have a lessened impact on retail activity than it has had in the past.