Nine Roadblocks for the Rally

By Steve Christ
Thursday, July 30th, 2009

Before the bulls break out the champagne here, I would warn them not to get too far ahead of themselves.

After all, euphoria is a dangerous emotion that can lead to big losses — in this market, or in any other, for that matter.

And as for Dennis Kneale’s breathless prediction that the “recession is now over,” the picture on that score is about as clear as mud. . . the U.S. Economic Outlook is murky, to say the least.

What is crystal clear, however, is that our problems are actually getting worse, not better. Fundamentally, is as bad as it has ever been — even though the bulls have broken out the party hats, insisting that somehow the markets really can grow to the sky.

Of course, we know otherwise. If only it were so. . .

Instead, I’m firmly in the camp that believes a “new normal” has begun, and it’s based more upon frugality more than frivolity.

That’s because as unemployment surges, home prices continue to drop, and more wealth evaporates, consumers are more likely to try a least to live within their means. . . no matter how hard that may be.

As a result, without an uptick in jobs and a boost in income, a repeat of the debt-financed binge we just lived through simply isn’t going to happen.

It can’t be recreated either — even though the Fed is trying its best to do just that.

So, what we’re essentially left with is a classic case of a reluctance to borrow or consume: a big problem, since that is what the lion share of the U.S. Economy has been based on since 1982.

As a result, we have too many cars, we have too many houses, and we have too many debt holders teetering on the brink.

What we don’t have — or what we have a lot less of — are people with the cash flow to support it all. Sure, money still exists and there is lots of it, but it has very little velocity when a nation of “Good Time Charlies” suddenly turns frugal.

That being said, I thought we would play a game of connect the dots today as we view the current rally not only with awe, but also a deep-seeded suspicion.

Here are nine reasons why the champagne will have to stay on ice for the time being. . .

9 Hurdles to the U.S Economic Outlook

1. The Wealth Effect in Reverse

During the heydays, rising asset prices were all it took to get consumers to spend themselves into deeper into debt. However, these days the reverse is actually true.

Because according to the Federal Reserve, U.S. household net worth fell by $1.3 trillion in the first quarter, proving that green shoots are something of a fairy tale —  at least for the American consumer.

In fact, since its peak in the third quarter of 2007, household wealth has decreased by 21.6%, or more than a fifth. That is the most dramatic fall in the series since reporting began more than 50 years ago.

Yet somehow, the bulls keep pounding the table, saying there is light at the end of the tunnel, even though consumer spending is over 70% of the U.S. GDP. The truth is when taking huge losses, belts usually get tightened, not loosened.

2. The Heavy Chains of Debt

Meanwhile, consumer debt is still off the charts. In fact, household debt as a proportion of disposable income hit 133% as the recession began. Since then it has eased a bit to 128%, but its still way too high — not to mention unsustainable. At minimum, consumer debt should be 100%, and even that is a slippery slope.

By comparison, the consumer debt level coming off of the tech bubble in 2003 was around 85%, which tells you where all that “growth” came from: Households levered up. This time that’s impossible — for a whole host of reasons. So the while the FED has cut this rate to zero, it hasn’t done much to get people to the mall this go-round. . .

So just looking at it from a balance sheet perspective, either wages have rise quite a bit or debts have to be reduced dramatically. Otherwise the numbers for the average consumer just won’t add up.

3. Rising Unemployment

On a day when the stock market shot up by more than 250 points two weeks ago, the Fed minutes from June were quite a bit more sobering. Unemployment, according to the Fed, will top 10% this year. . . while most Fed policy makers said it could take “five or six years” for the economy and the labor market to get back on a path of full health in the long term.

So it looks like 2015 will be the year to look forward to. At best, the recovery will be jobless — which makes you wonder how it could be called a recovery at all.

Here’s betting unemployment tops 11%.

Meanwhile, 7.2 million people have lost their jobs since December 2008, making this the only recession since the Great Depression to wipe out all of the job growth from prior periods of expansion:

By the way, the real unemployment rate, or U-6, is 16.5% It accounts for those poor folks who are unemployed but are so discouraged that they have stopped looking.

4. Tax Revenues are Plummeting

Calfornia’s fiscal woes are only the tip of the iceberg. Falling tax revenues in 45 of the 50 states have left all of them facing fresh budget shortfalls.

In fact, according to a recent report from the Rockefeller Institute of Government, tax collections dropped by 11.7 % the first quarter — the largest fall on record. Meanwhile, early figures for April and May show an overall decline of nearly 20 per cent for total taxes. That will undoubtedly reduce demand and slow down the recovery, since government spending acccounts for 18% of U.S. GDP:

As for the Federal government, there has been a 22% drop in individual tax receipts so far this year, along with a 57% drop in corporate taxes.

In short, while the government is always out of money, it has never been close to this bad. Without the printing presses, we would already be bankrupt.

5. Rising Prime Mortgage Defaults

Remember when subprime mortgages began to blow up? Of course you do. . . that’s old hat at this point. Today, those defaults have moved right on up the value chain.

Delinquency rates on the least risky mortgages more than doubled in the first quarter from a year earlier, as prime mortgages 60 days or more past due climbed to 2.9 percent through March. Serious delinquencies on prime loans, which account for two-thirds of all U.S. mortgages, rose to 661,914 in the first quarter from 250,986 a year earlier. Meanwhile, mortgages 60 days or more past due rose 88 percent from last year.

The good news is this is the last of the mortgage dominos. After prime mortages, there’s nothing left to fail. Unfortunately, this is the biggest domino of them all.

6. Oh, but Wait. . . I Forgot about Option ARMs

As my pal Ian Copper has been writing for some time now, Option ARM resets will be tougher for the economy to handle than subprime and we will see greater numbers of bank failures, foreclosures, delinquencies, and economic hardships because of it.

What should concern you is that about $750 billion worth of option ARMs were issued between 2004 and 2007 and will begin resetting shortly. Worse, as of December 2008, about 28% of option ARMs were either delinquent or in foreclosure, according to reports.

But here’s the kicker: nearly 61% of option ARMs originated in 2007 will eventually default, according to a Goldman Sachs report. And due to the way these mortgage nightmares are structured, the rest of them won’t fare much better.

61%??? That’s enough to make a banker take a leap.

7. Next Up: The Credit Card Debacle

According to reports earlier this month, credit card losses are continuing to accelerate with Capital One reporting that write-offs have reached 9.4%. . . with no end in sight. Meanwhile, American Express Co., the largest U.S. credit card company by purchases, wrote off 10 percent of its own loans.

Simultaneously, revolving credit totaled $939.6 billion in March and the Federal Reserve reported that 6.5 percent of it was at least 30 days past due. That is the highest percentage since the Fed began tracking this number back in 1991.

What has evolved is an environment where banks are much less eager to hand out the plastic, since the business isn’t exactly what it used to be. And as a result, banks sent out only about 500 million credit card solicitations in the first quarter.  That is fewer than in any year since 2000, as overall available credit shrinks.

And when the credit card swamp finally gets drained, a “new normal” will be here to stay.

8. The Commercial Real Estate Crash

At this point in the cycle, most people recognize that commercial real estate is following the same exact path as the housing bubble — the exact same path!

And we all know how that one turned out.

In fact, losses on commercial loans could reach as high as $30 billion by the end of the year as property values plummet, rents decline, and defaults reach record levels. All of this is a recipe for disaster. . . and industry leaders have estimated that 200,000 businesses and 10 percent of the nation’s shopping malls will shut their doors over the next year.

That means that we’re maybe only in the second inning here as this crisis unfolds.

So, with roughly $530 billion in commercial mortgages coming due for refinancing in 2009-2011, and some estimates showing that as many as 68% of loans maturing during that time will FAIL TO QUALIFY for refinancing, you have to wonder how it will all get done.

The short answer is. . . it won’t.

In fact, as Federal Reserve Bank of Atlanta President Dennis Lockhart said earlier this year, the mortgage bonds due this year and next “are coming up against capital markets not active enough to deal with those maturities.”

When that happens. . . big companies go under.

9. The Ghost in the Machine

Here’s a chart that speaks for itself. It is a measure of U.S. Industrial capacity that shows almost one third of US industry is now sitting idle:

Enough said.

Now if there is a pony somewhere in all of that mess, I just can’t find it. And I haven’t even brought up the prospect of higher taxes through cap and trade, or what a massive health care package will do to small businesses.

Meanwhile, I think we are going to find out this fall that the government doesn’t have any of the answers after all.

Besides, violent bear market rallies are entirely commonplace. In fact, some of strongest occured after Black Monday in 1929.

Take a look:

So while the bulls have had their way here lately, the bigger picture lurks in the background.But to see it, you have to have the courage to connect the dots.

That means that now, more than ever, it’s a stock picker’s market — especially if you have a taste for champange.

Your bargain-hunting analyst,

Steve Christ, Investment Director

The Wealth Advisory

P.S. According to Moody’s, commercial real estate values around the country have dropped 35 percent from their peak in October 2007. But that’s just the beginning. . . the decline appears to be accelerating. In fact, values have dropped by more than 15 percent over April and May. To learn more about how to win big as commercial real estate crumbles, click here.