This post originally appeared in Doug Kass' blog on RealMoney Silver on Sept. 24 at 9:40 a.m. EDT.
The bearish case for stocks is predicated on the notion that the massive creation and accumulation of debt -- particularly the consumer sector -- contributed to a large portion of the domestic economic (and stock market) gains experienced since 2000.
This added liquidity from nontraditional lenders dulled the effect of the
and served to buoy the low credit markets, allowing companies that should have failed to have access to large sums of equity and bonds. This created the feeling that all was well with the business world as stock markets rallied around the world and corporate default rates hit all-time lows by early 2007.
But that was an illusion.
Today, the nontraditional (and creative) credit originators are in intensive care and will not fuel growth anywhere near the degree to which they have in the past. The binge of mindless mortgage (and other forms of) borrowing abetted by generous strangers and central bankers abroad, by legions of unscrupulous mortgage lenders in the U.S. who fed the machine of packagers of credit on Wall Street and, most importantly, by a too easy Federal Reserve -- is
. The credit unwind in the upcoming years can be expected to have a profoundly negative impact in the current down cycle of economic activity -- possibly for years to come.
- Lower Business Spending Based on a Weakening Domestic Economy: In the coming months, the credit market's unwind will most likely be felt by a reduction in hirings and delays in business fixed investment. Last week's ISI Group surveys -- trucking and shipping, U.S. CFO Diffusion Index (Fuqua), U.S. Small Business Optimism Index, the North America Business Confidence Index, U.S. CFO Employment Expectations (Fuqua), U.S. CFO Capital Spending Expectations (Fuqua) and U.S. Small Business Trends (NFIB) Capex Plans -- all point to multiyear lows in confidence and are supportive of a marked slowdown in business spending.
- The Industrialized Nations' Economies are Beginning to Weaken: The same poor domestic trends are being seen in surveys in Europe and Japan. The latter is particularly discouraging as the Japan Consumer Confidence Index (ESRI) and Japan Business Confidence Index (ESRI) were the most negative in almost three years in light of "declining wages and financial market turmoil" and a much-weaker- than-expected second quarter 2007. Supporting this notion, semiconductor equipment shipments in August fell dramatically and well more than forecast. Importantly, the U.S. does not have a concession on poor mortgage lending practices -- investing/trading in housing and heavy mortgage equity withdrawals have spurred housing speculation and consumption binges in Europe . Indeed the resort areas of Europe (like Costa Del Sol, Spain) are no different than the Miami, Fla., market a year ago -- dotted with construction cranes and now with an excess of unsalable housing inventory.
- The Emerging Growth Markets Will Not Be Insulated from the Industrialized Economies' Deceleration: Despite the Bulls' marginalization of a weakening U.S. economy -- BRIC remains the catalyst for growth -- the industrialized nations (Germany, England, Japan, etc.) are turning more sluggish. That weakness coupled with our domestic weakness could finally impact even the high-growth regions of the world.
- Housing Is Replacing Technology as the Achilles Heel of Future Growth: The parallels between the excesses of technology in the late 1990s (daytraders goosing share prices, overpriced IPOs delivered by Wall Street, zero cost of capital leading to capacity increases and unrealistic expectations of a new paradigm of uninterrupted growth) and the residential real estate market in the early 2000s (daytraders (investors/speculators) in homes goosing home prices, a too-easy Fed that delivered generational-low mortgage rates and a Wall Street community that demanded and packaged products of nondocumented subprime mortages) are clear. Following the stock market bubble in the late 1990s, it was tech that was dreck (and plagued by excess capacity). In the most recent cycle, it was the housing sector that bubbled up and is now plagued with excess capacity. In my debate last week, economist Brian Wesbury was a devout economic bull, citing that housing represented only about 6 percent of GDP. From my perch, bears are not overstating the multiplier effect of a sustained housing downturn (homeowners have only just begun to acquiesce to a deteriorating market) nor the negative wealth effect of a decline in housing prices. (A 20% drop in home prices equates to over $4 trillion of lost consumer wealth.) Supportive of a 20%-plus drop in home prices was last week's CME extension of the futures market of the S&P Case-Shiller Home Price Index to five years from only one year. Click here for examples of the market participants' 2011 home price expectations in major regions in the home futures market. If these home-price declines are anywhere close to reality, the subprime crisis is only in the second inning.
- The Salutary Inflation Environment of the Last Decade is In the Process of Being Reversed: The (previous) benefits of globalization, productivity and technology gains -- which served to reduce inflation over the last decade -- will be losing their effect in the cycle ahead. Inflation, understated as it might have been over the last several years, will begin to accelerate as emerging markets continue to produce a demand pull. Based on continued strength in the emerging markets, the recent commodity cost pressures (oil and food), a sharply lower U.S. dollar placing upside pressure on import prices, and, more importantly, a projected rise in the Owners Equivalent Rent (the irony is that currently tight rental markets -- the consumer can't readily access the mortgage market and home prices remain high -- should produce a 4%-plus rise in the housing component (31%) of the CPI) it is reasonable to expect an alarming rise in the CPI over the next few months. Gold is rocketing and TIPS (Treasury inflation-protected securities) spreads are already widening. (Higher inflation is the inference of Greenspan in his recent book in which he candidly admits that his own efforts at containing inflation were helped by "the potent disinflationary force" of "globalization's vast economic migration" of cheap labor into competitive markets. In the next two decades, Greenspan relates, the benefits will be played out and will be replaced by inflationary influences.
- The Democratic Tsunami Bodes Poorly for Stocks: As the schism between the haves and have nots grow, the political tide is turning ever further towards populism -- RealClear Politics' Head to Head polls point to a Democratic presidential victory in 2008. And with that likely success will be rising trade protectionism and higher corporate and individual tax rates. Again, as Brian wrote in the WSJ. "Populism is in the air these days, and the threat from tax hikes, trade protectionism and more government involvement in the economy is rising." (To select a candidate that is most aligned with your views, take this quiz!.
- Slowing Top-Line Growth, Cost Pressures and Higher Corporate Tax Rates Augur Poorly for Profit Margins: The outlook for corporate profit growth for the last half of 2007 and 2008 remains too optimistic and, as a result, P/E ratios are higher than the bulls contend. Already, the nonexport domestic economy is slowing. (Domestic nonfinancial profits and cash flow were down 1.4% and 1.8%, respectively, in the second quarter of 2007).
- Pushing on a String: Pushing on a string means that the positive impact of lower interest rates is overwhelmed by the reduction in credit availability and the desire to borrow as lenders try to improve the quality of their loan book and borrowers, at the same time, repairing their balance sheets. In all likelihood, the Federal Reserve's loosening of the monetary reins will not only hasten the depreciation of our currency -- it will do little to bring the housing market back into balance. Tuesday's 50-basis-point reduction in the discount rate and the federal funds rate is like treating a patient wracked with cancer with antibiotics. When the injections of antibiotics wear off, the patient's body is still disease-ridden. That body of stressed and stretched individual mortgage holders, a consumer levered far greater than in prior cycles, the quickening pace of mortgage resets in 2007-08, crippled (capital weak) nontraditional lenders and a record inventory of unsold homes will act as a weight against economic recovery.
- Strangers Might No Longer Be Kind Enough to Underwrite our Consumption and Growth: Faced with the prospects for an unsteady and perhaps precipitous drop in the U.S. dollar, the nations that underwrite our consumption binge in the last decade will diversify away from the U.S. dollar -- denominated assets into more sound currencies, serving to raise the cost of financing our country's economic growth.
- Bullish Sentiment Is Elevated: Forget the negativity bubble -- investors are getting downright giddy. Short interest fell a whopping 5% last month on the NYSE. Moreover, the Investors Intelligence survey indicated that nearly 54% of respondents were bullish (up from 40% a few weeks ago) while bears slumped by 10 percentage points to 27%. (Not surprisingly, many technical analysts -- who often counted short interest and the II survey in their bullish repertoire -- have ignored these technically bearish signs.)
- The History of Market Performance Following Rate Cuts When the Markets are Near 52-Week Highs Is Uninspiring: The virtuous cycle of 2002-07 is over.
The equity markets are currently moving on the fumes of that past cycle.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.