Kurt Brouwer July 18th, 2008
Source: Calculated Risk
See also Real Estate — Is A Bottom In Sight?. The terms Composite 10 and Composite 20 refer to real estate prices for a group of 10 cities or 20 cities, respectively.
For more on the Case-Schiller index, see an earlier post we did on it, Major Turning Point? — Robert Schiller.
Kurt Brouwer July 17th, 2008
Source: Carpe Diem
As we can see from this chart, current subprime loan originations have fallen from the high levels of the bubble years (2004-2006) and now they are well below the pre-bubble period (2001-2002). Eventually, subprime loans will come back a bit, but at a sustainable level. The data on subprime mortgage loans is from a Harvard study on the state of nation’s housing market.
Kurt Brouwer July 16th, 2008
Larry Kudlow pointed to an interesting correlation in this post on his blog [emphasis added]. President Bush removed the executive order banning new oil drilling in the U.S. contintental shelf and oil price futures dropped. Coincidence? Or, causality?
Bravo For Bush (Kudlow’s Money Politic$, July 15, 2008, Larry Kudlow)
In a dramatic move yesterday President Bush removed the executive-branch moratorium on offshore drilling. Today, at a news conference, Bush repeated his new position, and slammed the Democratic Congress for not removing the congressional moratorium on the Outer Continental Shelf and elsewhere. Crude-oil futures for August delivery plunged $9.26, or 6.3 percent, almost immediately as Bush was speaking, bringing the barrel price down to $136.
Now isn’t this interesting?
Democrats keep saying that it will take 10 years or longer to produce oil from the offshore areas. And they say that oil prices won’t decline for at least that long. And they, along with Obama and McCain, bash so-called oil speculators. And today we had a real-world example as to why they are wrong. All of them. Reid, Pelosi, Obama, McCain — all of them.
Traders took a look at a feisty and aggressive George Bush and started selling the market well before a single new drop of oil has been lifted. What does this tell us? Well, if Congress moves to seal the deal, oil prices will probably keep on falling. That’s the way traders work. They discount the future. Psychology and expectations can turn on a dime.
The congressional ban on offshore drilling expires September 30, so that becomes a key date. A new report from Wall Street research house Sanford C. Bernstein says that California actually could start producing new oil within one year if the moratorium were lifted. The California oil is under shallow water and already has been explored. Drilling platforms have been in place since before the moratorium. They’re talking about 10 billion barrels worth off the coast of California…
The drop in the price of oil is probably a coincidence, but we do know that the price of oil is exceedingly high now primarily due to assumptions about the tight supply of oil worldwide. If the U.S. ends it ban on drilling, then a significant new supply of oil will begin coming on line in future years. Today’s price reflects assumptions about the future because oil producers around the world make a daily choice whether to produce oil or leave it in the ground.
The choice to leave it in the ground is based in part on the assumption that future prices will be higher than today’s price. As high prices reduce demand both here and abroad, that alone will impact the world price of oil. And, if oil producing countries believe the U.S. is finally serious about drilling more and also about aggressively developing other energy sources, then producers may begin producing more to take advantage of high prices today. And, that — more supply — would help reduce prices even further. For more on this, see 2 Trillion Barrels? — U.S. Oil Shale — Chart of the Day.
In the past couple of weeks, we have seen a sea change in attitudes here about drilling:
Source: Carpe Diem
We have also seen some viable new strategies for reducing our dependence on oil altogether, see A New Strategy for Energy Independence — T. Boone Pickens.
If you are having trouble understanding why gas prices are soaring, this post should help you understand the basic economics of supply and demand for daily necessities such as gaoline or food:
Kurt Brouwer July 16th, 2008
On Wall Street there is a phrase called the ‘kitchen sink’ earnings report. It works like this. A given publicly-traded company is struggling, they know a really bad quarterly earnings report is inevitable, and so they toss in everything negative they can find — up to, and including, the proverbial kitchen sink. That way, they get all the bad news out at once. Over the past few months, as investors, we have been living through a kitchen sink period in the financial markets as almost everything imaginable has been thrown at us:As you can imagine, all of these factors have contributed to widespread unease and a feeling of doubt about the future. A recent article from the Washington Post [emphasis added] points out how bleak the current mood is, but also tries to put our present economic environment in a historic context:
Why We’re Gloomier Than The Economy (Washington Post, June 18, 2008, Neil Irwin)
“Ask Americans how the economy is doing, and their answer is stark: It is not just bad, it is run-for-the-hills terrible. Consumer confidence is at its lowest level in almost 30 years. Only 12 percent of Americans think the economy is in good shape. On the Internet, comparisons to the Great Depression are widespread.
But the reality is different. According to most broad measures of how the economy is doing, it’s not all that grim.
Soft? You betcha. In recession? Quite possibly. And a crisis in the financial markets has rattled nerves for months now. But so far, the economy is holding up better than it did during the last two recessions in 1990 and 2001. Employers haven’t shed as many jobs, the unemployment rate is still relatively low, and gross domestic product has kept rising. Things are nowhere near as bad as they were in the Great Depression, or even during the severe recession of 1982-83. The last time consumers were this miserable, in May 1980, the jobless rate was 7.5 percent and inflation was 14.4 percent. Now those numbers are 5.5 percent and 4.2 percent respectively…”
Objectively, conditions are not bad compared to 1980, so why is the mood so dark? We believe that there are two factors at work today. The first factor is that the economy and the financial markets are definitely struggling. Coupled with that is the sharp decline in home prices - something we have not seen since 1991. In addition, we are reminded daily of higher prices for food and fuel when we stop for gas or go to the grocery store. All of these factors hurt our confidence.
We also believe that Americans are in doubt about major institutions in our country. We know that President Bush’s approval rating is around 23%, which means that only 23% believe he is doing a good job. However, Congress’s ratings are far worse and only 12% of Americans believe Congress is doing a good job. In short, we are facing a crisis of confidence in our government as well as our economy. Over the past 30 years, consumer sentiment slumps the most when we lose confidence in both the economy and in our government. And, that may be why consumer confidence is almost as low now as it was in 1980.
Index of Consumer Sentiment Nears 30-Year Low
Source: St. Louis Federal Reserve Bank
This chart from the St. Louis Federal Reserve Bank shows the Index of Consumer Sentiment going back in time to January 1978. It is hard to believe, but consumers are now gloomier than they have been in the past 30 years, with one exception - 1980. That year we faced very difficult economic conditions during a contentious presidential campaign (Carter vs. Reagan).
We certainly have problems these days, but having lived through the early 1980s, I have a difficult time equating the difficulties we have now with the horrendous economic environment we had in 1980-82:
Double Digits in 1980-82: Inflation, Unemployment & Mortgage Rates
In the late 1970s and early 1980s we had sky-high inflation, unemployment and mortgages rates. At that time, the Federal Reserve’s Chairman, Paul Volcker, had to raise interest rates to unheard-of levels. These rate hikes led to a prolonged economic contraction that was the worst since the Great Depression of the 1930s. This description from Wikipedia gives a sense of how severe the reaction was [emphasis added]:
“…However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker’s Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street and blockading the Eccles Building…”
The image of farmers blockading Washington D.C. with tractors is hard to imagine now, but those were tough times. The reason Volcker raised interest rates so aggressively was that inflation went wild in the late 1970s. For example, inflation hit 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981 before Volcker’s harsh medicine began to kick in and inflation moderated to 6.2% in 1982.
As inflation ratcheted higher, so did home mortgages rates. Thirty-year fixed rate mortgages went up to nearly 13% in November 1979 and did not fall under 12% again until November 1985. The peak rate for mortgages was 18.45% in October 1981. 18.45%!
But, even though high interest rates began knocking down inflation, soaring rates also led to sharply higher unemployment. The unemployment rate peaked at 10.8% in December 1982. However, it had been soaring for years and it remained at 8% or higher until January of 1984. Given all this, it is not surprising that investors and consumers were very negative in that time period 1980-82.
A Decade of Above-Average Returns Followed a Decade of Below-Average Returns
As you can see from the chart below, when consumer sentiment hit bottom in 1980, we had just been through a terrible decade for stocks. In fact, the decade of the 1970s had negative real (adjusted for inflation) returns for stocks. However, the decade of the 1980s was excellent for stocks.
Source: Brouwer & Janachowski, LLC
As you saw in the first chart above, in 1990, consumers again turned very negative due to a difficult real estate market, the onset of the first Gulf War in August 1990 and a slowing economy and impending recession in 1991. Yet, again, the plunge in consumer confidence in 1990 came just before an excellent decade for the stock market.
Now, we are going through another difficult time for stocks, very similar to what happened in the 1970s. In fact, stock market returns since 2000 have also been negative, adjusted for inflation.
As we saw in the chart above, returns from the stock market are cyclical. Good times follow bad times. Now, I cannot tell you that this plunge in consumer sentiment unquestionably presages a turning point for investments. However, I can state with confidence that such extreme negativity in consumer sentiment is rare. In fact, the index has only been lower once in 30 years. I believe the current level of pessimism is overdone and that, ultimately, the country’s bleak mood will change.
As the Washington Post article referenced above concluded:
“…But now, coming off two decades of prosperity and low inflation, Americans have come to treat low unemployment and inflation as givens. We have gotten so used to things being good, in other words, that even when conditions become somewhat bad, it feels terrible.”
When you hear politicians and pundits opine that this is the worst crisis since the Depression, just mentally compare current conditions to those of the late 1970s and early 1980s. Back then, we had double digit inflation, unemployment and home mortgage rates. Today, inflation is around 4%, unemployment is 5.5% and 30-year fixed mortgages are about 6.25%. In other words, we are not remotely close to anything like double digits on any one of these factors, much less all three.
Summing It All Up
I believe that as the bad news gets absorbed and financial conditions moderate, the most likely outcome is that consumer sentiment - and the financial markets - will turn more positive. Several developments are now helping create the underpinnings for revitalized economic and market conditions.
At this point, I do not know if “everything, but the kitchen sink” has been thrown at us. Nonetheless, I believe the U.S. economy and our financial markets are fundamentally strong and resilient and that they will survive this downturn and begin growing again.
In the early 1980s, the stock market took time to regain positive momentum in the face of the many negatives, but patient investors were rewarded with a strong and prolonged turnaround in the markets. I believe the same is true now. Patient investors will again be rewarded as conditions improve. And, when it does come, the turnaround in the stock market could be dramatic - on the upside.
Kurt Brouwer July 15th, 2008
One great thing about the financial markets is that they force us to evaluate trends objectively. The declining dollar is a case in point. It is clear that the dollar is falling against major currencies. That is undeniable. And, from a financial perspective, the declining dollar is neither good nor bad, because all trends have winners and losers.
When the dollar falls against the euro or the British pound or the Japanese yen, investors in those currencies or stocks or bonds denominated in those currencies will gain. And, U.S. companies that export goods will find their products are more competively-priced against rival products sold in the hot currencies. On the other hand, if you’re buying something that is imported or going on a vacation in London, well…that outrageously-priced cup of coffee just got more expensive.
Why is the dollar falling? There are many theories, but the most obvious one is short-term interest rates. Short-term rates are going up overseas and they’re not going up here, so very large institutional investors such as big banks, securities firms, central banks and so on are moving cash to other currencies. This is normal and not particularly significant. However, if the dollar kept falling, there is a point at which the U.S. Treasury and the Federal Reserve would have to take some steps to bolster the dollar. We are not at that point yet, in my opinion, but we should be. I think the Treasury and the Fed should begin working with other central banks in order to stabilize the dollar, which has fallen steadily versus the Euro. This chart shows how many dollars it takes to buy one Euro. The Euro fell for several years versus the dollar and begin moving up in late 2001:
Source: St. Louis Federal Reserve Bank
David Gaffen at the Wall Street Journal’s MarketBeat Blog (daily reading for me by the way) gives a bit of background on why the mood seems so dour right now [emphasis in the original]:
Pity the Dollar (WSJ/MarketBeat Blog, July 15, 2008, David Gaffen)
…The U.S. currency hit a new record low against the euro Tuesday, three-month lows against the British pound and is nearly at parity with the Australian dollar, of all things, as global investors question the value of U.S. assets and the quality of the entire U.S. balance sheet, so to speak.
“Markets are fearing another major crisis, and they’re doubting that the Fed or U.S. Treasury will do anything near-term to alleviate the situation,” says Kathy Lien, chief strategist at DailyFX.com. “They’re skeptical about the efforts of the government.”
Of late, the euro traded at $1.5969, down from a record of $1.6038 reached earlier in the day. Global markets dropped sharply in the wake of the middling showing by U.S. markets Monday after a Fannie Mae/Freddie Mac rescue was announced.
…The dollar has continued to come under pressure as investors believe U.S. assets do not offer enough return for the risks being taken. Bond yields are low when compared with other major global economies, and the Fed is in a bind – it cannot raise rates while the economic malaise continues, but it fears worsening inflation if it lowers rates.
“The deteriorating market and economic conditions in the U.S. continue to be the chief causes of the broad decline in the U.S. currency,” writes Ashraf Laidi, chief currency strategist at CMC Markets. “As long as these continue, the dollar will deteriorate regardless of any jawboning by policy makers, which would be perceived as bluffing rather than communicating real policy intentions.”
…In part, the dollar’s decline mirrors the fall in U.S. equities, which are reacting to Mr. Bernanke’s testimony. “What’s basically happening at the moment is that the dollar is following equity markets, and they’re going down, and the reason it’s all happening is the credit crunch which is based in the States,” says Chris Furness, head of currency strategy at 4Cast Ltd.
Yesterday, we reported that PIMCO and Bill Gross had turned positive on the dollar vs. the Euro (see Gross Likes Dollar vs. Euro For First Time). Obviously, the brain trust at PIMCO is responding to broad economic and financial trends so this should not be taken as a sign that the dollar will turn around right away. However, it is positive in that the folks at PIMCO believe that the Euro is overvalued.
In order for the turnaround to begin though, I believe the Fed and other central bankers are going to have to give the currency markets a strong signal that they are supporting the dollar. See also How Far Has the Dollar Fallen? And Why? — What’s Next?.