Hitting The Skids

The Daily Reckoning PRESENTS: What will be the event that sends our economy into a down spiral in 2006? According to Gary Shilling, the bursting of the housing bubble will start a chain of events that won’t be pretty for anyone…

HITTING THE SKIDS

A year ago, I believed three investment themes would work in 2005: a rallying of the dollar, spreading deflationary expectations and a flattening of the yield curve. Three more might commence in 2005 but could start later: a bursting of the U.S. housing bubble, falling American stock prices and a hard economic landing in China.

So what happened? The dollar did rally. Deflationary expectations spread beyond autos and into appliance stores, department stores, computers and recreational vehicles. The yield curve flattened and, late in December 2005, inverted. While the housing bubble didn’t burst, that market has definitely cooled. U.S. stocks didn’t decline like they did in the 2000-2002 bear market, but major stock indices last year registered only tepid gains, if at all. And China’s efforts to cool her overheated economy ran into difficulties.

What’s ahead for stocks and the economy in 2006? Setting aside unknown elements like major terrorist attacks, natural disasters or a bird flu pandemic, I believe six phenomena are shaping the investment climate this year. The world is awash in financial liquidity mainly due to rising house values, the negative U.S. corporate financing gap and the American balance of payments deficit. Inflation remains low despite higher energy prices. As a result, investment returns are low. Speculation remains rampant despite the earlier bear market. So, investors are accepting more risks to achieve expected returns. And then there’s the insatiable U.S. consumer, who, thanks to the booming housing market, continues to spend freely.

In this climate, I foresee 10 investment themes, seven of which are likely to unfold in 2006, while three will probably work – but maybe not until next year:

1. The housing bubble will burst this year. This once red-hot market is already cooling, with sales declining and inventories rising. The boom has largely been driven by investors’ zeal for high returns, ample cheap mortgage money and lax lending standards. Unlike earlier U.S. housing booms and busts that were driven by local business cycles such as the rise and fall of the oil patch along with oil prices in the 1970s and 1980s, this one is national and, indeed, global.

Since houses are much more widely owned than stocks, the bubble’s likely demise will shake the economy more than the earlier bear market in stocks. And if house prices collapse, that could change the good deflation of excess supply I foresee to the bad deflation of deficient demand.

2. The Federal Reserve will tighten until the housing bubble bursts, and seriously invert the yield curve in the process. An inverted yield curve, which occurred in late December 2005, foretells recessions much as the fact that Federal Reserve rate-raising campaigns usually end in recessions. Such a campaign started in June 2004, and continues.

I’m betting that the bursting of the housing bubble beats the Fed to the recessionary punch, but if not, the central bank will, as usual, do the job. Once housing is in a shambles, either falling from its own weight as I expect or due to central bank action, the Fed, of course, will do its patriotic duty and ease as the economy hits the skids.

3. U.S. stock prices will fall this year, perhaps below their October 2002 lows, in the midst of a major recession. A major decline in housing prices and activity will almost surely precipitate a full-blown recession. That, in turn, will send corporate profits down. Without robust corporate profits, stocks are vulnerable. And note that they’ve have muted gains for the past two years, even in the face of exploding corporate earnings.

4. China will suffer a hard landing due to domestic cooling measures and the U.S. recession. China is attempting to cool her white-hot economy, but is having difficulty. Her economy is more and more market-driven, but still is state-controlled in many aspects. Therefore, her policymakers lack the sophisticated tools to effect an economic soft landing. After all, if the Federal Reserve, with all of its skills and operating in a largely market-drievn U.S. economy, has only pulled off one clear-cut soft landing in 11 tries in the post-World War II era, why would the Chinese somehow succeed? Their futile efforts – coupled with a U.S. recession that will reduce Chinese exports as Americans buy less of everything – spell certain trouble for China’s economy this year and for China’s other trading partners.

Of course, a Chinese business slump this year doesn’t mean an actual decline in real GDP there. A cut from the current 9%-10% growth rates to 4% or 5% would be severe since more than those growth rates are needed to employ the hordes that continue to stream in from the hinterland to the coastal cities in search of better jobs and incomes.

5. The weakness in United States and China will spread globally, dragging down stocks universally. China’s economy is closely linked to the United States, so an American recession combined with Chinese domestic economic restraint measures insure a global downturn. Other major economies – in Asia and Europe – simply can’t pick up the slack.

Japan won’t be able to do the job. While her stock market has been celebrating Japan’s emergence from 15 years of deflationary depression as banks are being cleaned up and Prime Minister Koizumi institutes various free market-enhancing changes, it’s still unclear whether businesses and consumers can be coaxed into borrowing and spending.

And I’m not looking to the Eurozone to take up the slack either. The Continent remains export-led, with exports accounting for its meager growth in recent years while domestic economies stagnate.

6. Treasury bonds will rally. The yield on long-term Treasuries is now about 4.5% and I expect it to decline this year and reach 3% when deflation becomes irrefutably established, as I’ll discuss later. Downward pressure on Treasury yields will also result when the Fed reverses gears and eases once housing is clearly in retreat and a recession is evident.

7. The dollar will remain strong since the United States is a global safe haven. The buck rallied strongly in 2005 after having been all but written off as dead. The United States is the world’s growth leader, which should benefit her currency. In addition, America lacks the language barriers, labor immobilities and productivity-robbing socialistic tendencies that hinder Euroland economies. I expect the dollar to remain strong this year primarily because in times of trouble, the United States is a safe haven. America, with all her speculative excesses to be corrected, will probably remain the best of a bad lot.

8. Global and chronic deflation may commence in 2006. With a global recession collapsing commodity prices and the robust deflationary forces already at work, major goods and services price indices in the U.S. and abroad, such as the CPI, will no doubt fall this year. But that doesn’t guarantee chronic deflation. Inflation usually recedes in recessions, so it’s the action in the following recovery in 2007 that will tell the tale. If price indices continue to fall then, true deflation will have arrived.

I foresee the good deflation of excess supply, driven by new tech productivity and excess capacity, as in the late 1800s and in the 1920s, not the demand-deficient deflation of the 1930s. Still, the transition to good deflation may be rough since few are prepared for it and have oversized debts that need to be drastically reduced. Unlike inflationary periods, when the real value of debt falls, it rises in deflation. Furthermore, a very severe collapse in the housing boom, which is found in many countries throughout the world, could destroy enough net worth to spawn bad deflation.

9. U.S. consumers could start a long-run saving spree this year, reversing their 25-year borrowing and spending binge. Consumers have no intentions of becoming big savers. Spending money at malls has become the national pastime, and as long as they have assets against which to borrow and eager lenders here and abroad, they’ll keep shopping. Few have the perspective to quit while they’re ahead – or at least have some remaining borrowing power – but will play till they lose, and lose big.

A renewed bear market in stocks and a collapse in house prices will eliminate the two major sources of consumers’ buying power. The fall in house prices, especially, will rob U.S. consumers of borrowing power. Incomes won’t support robust spending since they’re likely to remain subdued.

10. Deflationary expectations may surge and spread widely in 2006. Deflationary expectations spread and intensified in 2005 as consumers waited for lower prices for cars, airline tickets, telecom fees, even general merchandise before buying. That leaves producers with excess capacity and inventories that force them to cut prices. Those cuts only fulfill consumer expectations and encourage them to wait for even lower prices. These deflationary expectations make discounts – such as in the auto industry – difficult to end.

Regards,

Gary Shilling
for The Daily Reckoning
January 12, 2006

Dr. Gary Shilling is president of A. Gary Shilling & Co. Inc., an investment advisory and economic consulting firm and publisher of the monthly INSIGHT newsletter.

Prescience has empowered Dr. Shilling to beat the stock market by a wide margin over many years while providing consistently accurate forecasts to his subscribers. Twice ranked as Wall Street’s top economist by polls in Institutional Investor, Dr. Shilling was also named the country’s No. 1 commodity trader adviser by Futures Magazine. And in 2004, MoneySense ranked him as the third best stock market forecaster, right behind Warren Buffett.

A regular columnist for Forbes magazine, Gary Shilling appears frequently on radio and television business shows and has written six books, including Is Inflation Ending? Are You Ready? In 1983 and, more recently, two books detailing his forecast for the new world order and its consequences for your wallet. For his very latest research, see:

INSIGHT

“House Prices Seen Slowing,” says the LA Times.

And more news from Contra Costa, also in the Golden State:

Christopher Thornberg, senior economist with the UCLA Anderson Forecast, told a business group that he believes a drastic deceleration in home sales is coming. “You are starting to see a slowdown in housing market activity, and that says loud and clear that things are starting to break,” Thornberg said.

Thornberg believes house prices are about 30 percent to 40 percent overvalued. But a return to normal is not an easy matter, he explained. “If you have a big decline in unit sales, you’ll have mortgage brokers and real estate agents and construction workers all losing jobs. And what’s driving the California job market right now? Construction, finance and real estate jobs. Those will go away…all that wonderful money is going to disappear. Suddenly, the house isn’t going to be able to pay for the kids’ education, it’s not going to pay for your retirement in Bermuda and it’s not going to pay for that face-lift at age 74.”

Thornberg adds, “…we have peaked. And beyond that is a downhill run.”

We have wondered about that. Everywhere we look, there is so much “wonderful money.” On our street in London there is a Ferrari dealer and a Lamborghini dealer. It seems as though every other car is a Porsche or a Mercedes. And, looking around this past weekend, we saw an ordinary house for sale – three bedrooms, three baths, parking space. It was ordinary in every sense but one: it is priced at about $9 million. A pretty far run downhill for someone.

Also in yesterday’s news, Bloomberg reports that Wall Street will hand out $21.5 billion in bonuses. All that wonderful money! Where does it come from? What does Wall Street do to earn it? The masters of the universe on Wall Street tell us that they “allocate capital efficiently.” They must be doing a heckuva job allocating capital. We’re surprised that there is so much money to be made in “allocating capital.” But we’re suspicious. We don’t even know what allocating capital is. How is it different from helping the fool part company with his money? Is it what you do when you entice speculators into Google at 117 times sales and 350 times earnings?

Well, get it while you can. And enjoy it as long as it lasts. These bonuses will probably disappear, too, along with all that other wonderful money from the housing bubble.

Meanwhile, our old friend, Marc Faber tells Bloomberg that the best place for your money now is in Asian property: “When you look at asset classes, given the demographics in Asia and urbanization in the long run, I’m quite sure property prices will rise.” The Bloomberg Asia Pacific Real Estate Index, which includes stocks of homebuilders from Japan to Singapore, rose 26 percent in 2005. That’s compared with a 35 percent gain in the Bloomberg U.S. Real Estate Index.

“There is a speculative element to everything in the present time. We live in a world of inflated assets.”

Yes, we do. Realtors in California, stockbrokers in New York, car dealers in London – a lot of very nice people have made their fortunes as assets took on air. Shame it has to disappear some day.

People who have been walking on water are going to have to learn to swim.

[Ed. Note: Americans owe $7 trillion on their homes – twice as much as 10 years ago. But our incomes – our ability to pay – have gone up by a fraction of that amount. It’s painfully clear a lot of that $7 trillion will never be paid back. Find out what you can do to protect yourself when the biggest lenders on the planet are taken down.

More news from our team at The Rude Awakening…

Bill Bonner, back in Paris with more thoughts…

*** Argentina is the world’s second-largest corn exporter after the United States, and the third-largest soybean exporter. And if Argentina stays in this drought pattern they have been in, explains our commodities expert, Kevin Kerr, a rally in the grains is likely, just on fear.

“Rains may have been insufficient to prevent South American crops from being severely affected,” continues Kevin. “Some experts estimate that the growing regions in Argentina received only about a quarter of normal rainfall over the previous three months.”

“Argentina is forecast to produce 17.3 million metric tons of corn this marketing year. That’s down 11%, according to a report from Bloomberg.

“My sources in the pits in Chicago are turning more and more bullish. And they say hedge fund managers and large speculators have become more bullish on corn, too. As I have mentioned many times before to my Resource Trader Alert subscribers, one factor that is fairly new on the scene for demand is corn-based ethanol. Corn-based ethanol futures on the Chicago Board of Trade have risen 69% since their launch in March.

[Ed. Note: Kevin assures us he’ll be keeping a close eye on the weather down in Argentina and this possible rally in grains will certainly give him some good fodder for the presentation he’ll be making at Investment University’s upcoming conference.

Kevin, along with other investment experts, such as Karim Rahemtulla, Mark Skousen and Sala Kannan will be speaking at the 8th Annual Investment University Conference in Delray Beach, Florida on March 15-19…you won’t want to miss this. And you can still get in on the early bird discount if purchase your tickets before this Monday, January 16…

*** We got rid of our apartment in Paris. It made no sense to continue paying rent in one city when we live in another one. So, instead of going home, last night we stayed in a little rental unit down in the heart of the Latin Quarter.

How we would have loved to have this place 20 years or 30 years ago! If only we could have afforded it then. The apartment is only a few paces from the Pont des Arts. On the other side of the river is the Louvre. It is the kind of romantic pied a terre people dream about, with beams on the ceiling and an antique stone fireplace. We dreamt of it ourselves…of cafes and brasseries…and walks along the Seine…

But now, the romance seems to have gone out of it. We notice the paint that needs to be touched up, the plumbing that needs attention, and the stains on the carpet. “We should get rid of this place,” we tell Elizabeth.

Last weekend, we walked around in London and came upon a Harley Davidson dealer on Fulham Road. We were drawn over to the gleaming chrome like a kitten to a bowl of milk. Many years ago, we road a motorcycle – a BSA. Most readers will not recognize the name. BSA, a British-made motorcycle must have gone out of business decades ago. And so many years, say between the age of 19 and 39, we dreamed of buying a Harley, but we could never afford it. We liked the idea of cruising around on a big bike, the wind in our hair, bugs in our teeth.

Now, we could buy any motorcycle in the shop. But the thrill has gone out of it. We think of the cold weather…the wet seat…and the foolish drivers. And wind in our hair? If only we had hair!

We remembered our poor Aunt Jacqueline. All her life she dreamed of living in France, the country of her ancestors. Sitting on the porch of our house in Maryland, looking out over the tobacco fields, she would tell us about her visits to France…about the cafes…the artists…the museums…and about our French forebears. She loved the place from afar. But when we finally took her to live with us she was already 80 years old. It was too late. She had forgotten why she liked the place so much. The thrill had gone out of it.

We don’t know what lesson to take from this. These were just our thoughts this morning, while walking down the Rue Mazarine.