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Since housing peaked in early 2006, I haven't had a nice thing to say in my fund's quarterly letters about the economic outlook. Though I did not predict the degree of financial Armageddon we got, I consistently predicted that the housing bubble would end badly both for housing and the economy. Still, for the first time since housing and the economy peaked, I believe I can see the end. Getting there requires painful adjustments and, I suspect, a lower stock market. However, we will get there, and a recovery will follow in spite of what the most bearish analysts suggest.

In the short term, my focus remains capital preservation. However, even though I remain bearish, looking beyond the current gloom is as important to me now as it was to look through the housing bubble as it inflated. I know that approach generated better returns for my investors since the market peaked, and I believe it will enable them to profit more after the market troughs. With that in mind, in my most recent quarterly letter I shared with my investors my checklist for a turn; what follows is a slightly expanded version of that list.

Item 1: We Must Learn the New Spending Run-Rate of the U.S. Consumer

Consumer retrenchment, a trend that will be exacerbated by rising unemployment and rising savings, is now a fact of life. Until we discover the new spending run-rate of the U.S. consumer, it will be impossible to properly estimate earnings for consumer discretionary companies.

However, a second terrible holiday spending season will help get us there. Not only will it shed light on how much less the consumer will spend, it will also expose further and potentially significant deleveraging of fixed costs that could push earnings down further.

I suspect that by sometime in the first half of 2009, enough of the bad information will be out to allow analysts to lower estimates for consumer companies for 2009 and 2010 to levels they may actually be able to beat. Such an event is even more likely if unemployment peaks by mid-2009. In the meantime, retailers already have inventories at levels that match demand and are downsizing operations, both by streamlining headquarters and closing stores, though these trends will accelerate. These steps, when complete, will maximize earnings when consumer trends stabilize.

Item 2: We Must Discount a Worldwide Slowdown

Emerging markets, it will turn out, are linked to the developed world and will slow; as they do, the reduced demand for capital goods will have an obvious impact on earnings of industrial companies. Everyone knows this, but what I think gets less focus is that most of the decline in demand for industrial goods still emanates from North America and Europe. Frankly, Asia and Latin America are hanging in, and only recently has demand from Eastern Europe and Russia begun to fall.

Earnings estimates for industrials thus still have far to fall. (Most estimates for industrials still assume up or at least flat year-over-year earnings; much too rosy.) However, when industrial estimates fall, they will be reduced further and faster than was the case for retail and financial companies. Analysts understand that industrial production slows quickly (unlike personal consumption, which slows slowly). By the first half of next year, emerging markets should deliver the fundamental disappointment required to let this process play out.

In addition, the emerging-market consumer will be no savior, not for the developed world nor for his own economy. Real estate sales have been slowing for most of the year and now auto sales are dropping, too. Real estate and durables go first (sound familiar?) and then the rest of the consumer spending dominos follow.

Item 3: Assets Must Be Deleveraged and Valuations Deflated

Deleveraging and asset deflation make this downturn ugly. While all real assets are destined to deflate, housing remains the key. When housing ceases to plummet, consumer and bank balance sheets will stabilize. It won't be a picnic getting there -- in fact, it will be ugly -- but nonetheless my analysis suggests this will occur by the middle of next year.

After spring, housing will still decline but will do so slowly, and the system can handle that. Commercial real estate will have its own nasty cycle that adds a whole new layer to the problem and will take longer, but as it occurs the government will simply increase the size and scope of the bank bailout to insure it does not become a systemic problem.

Also by spring, government intervention will likely move to direct deleveraging of the consumer via permanent and material mortgage forbearance. This action, as sickening as it will be to those who borrowed and spent responsibly though the debt bubble, will be necessary to lower the debt level of the consumer balance sheet to a level low enough to jump-start personal spending and the economy in turn.

Honestly, as much as I detest this final bailout, I doubt we're going anywhere without it. Understandably, there will be lots of kicking and screaming about this final bailout (including from me!). This means we won't do it until the need for it reaches a crisis pitch. At that moment, everyone will be too busy watching the skies (and seeing their retirement funds wither) to be opposed.

Item 4: The Banks, Once Saved, Must Lend More Freely

By the time U.S. housing -- the deflating asset that drives the story -- stops crashing in the spring, the banking system will be stronger. The government has begun the process of taking out weak players and putting their deposits in the hands of the (relatively) strong. The process has focused on large banks, but will move quickly to the small.

Of course, even with a bailout, it's now back to your regularly scheduled credit cycle. Until banks get a better picture of what their coming loan losses look like in credit cards, business loans and commercial real estate (which includes residential and commercial developers), credit will stay tight. Unfortunately, the vast majority underwrote these loans just as poorly as the mortgage loans.

However, by mid-2009, even though banks may not have seen the absolute peak of their nonperforming loans, they should begin to get confidence in modeling the losses. Once they know what their REO (and soon-to-be-REO) is worth, they will trust their balance sheets enough to lend more freely. Moreover, as they begin to see real estate stabilize and see their losses peak, they'll also be among the first to understand that the economy is stabilizing if not improving. With that knowledge, they can begin to loosen credit standards. They won't go back to the lending-like-drunken-sailors days of yore, but any amount of looser will be better.

Items 1 and 2 are necessary so that earnings, at least of early-cycle companies, stop going down. Markets don't go down if earnings estimates are not going down, too ... that is, unless balance sheets are in danger. That's why Items 3 and 4 are necessary. They stabilize the balance sheets of both companies and consumers. It is possible these events converge sometime in the first half of 2009. It all works, assuming the current bank bailout succeeds. (For the record, if the system crumbles, my checklist goes in the shredder.)

Companies are already moving fast to right-size and retool their operations to profit in a leaner world. Laggard companies will follow their lead. In this environment, a small uptick in the top line will drive significant bottom-line profits and, in turn, stock market gains. You know what? I could easily be wrong about the timing of a turn, so give me a little grace on that measure. However, I'm certain these events are the right events upon which to focus, and that's exactly what I will be doing as we move forward from here.
Geoff Johnson, CFA, is founder of Catamount Capital Management, a registered investment adviser and manager of a value-oriented hedge fund. Prior to investing, he was founder and president of Direct Response, an advertising agency specializing in political and corporate public image campaigns. Johnson earned his master's of business administration at The Wharton School at the University of Pennsylvania, and holds a bachelor's in political science and a master's in public opinion research, both from the University of Connecticut.

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