Will the Vicious Credit Virus Affect the Real Economy?

In today’s volatile market, the focus is, yet again, on the Fed. Will they continue to cut? By how much? And if they do – will it even have any effect on the economy? Dr. Marc Faber explores…

Will rate cuts be of much help to the asset markets and the economy? I believe we are in a war between two major adversaries. On the one side we have the Fed (and other central banks) pumping liquidity into the system in a desperate attempt to support the asset markets and the economy. On the other side we have the private sector, which, as Hatzius explained, is being forced to curtail lending due to heavy losses in the credit market and to fight the Fed’s reflation efforts by widening credit spreads. Complicating matters is the fact that both adversaries have powerful allies.

The Fed has the Treasury and the government, as well as the Wall Street elite, as allies. The government could implement massive tax cuts in order to stimulate economic activity; the Treasury could bail out financial institutions, which in reality should be punished by bankruptcy; and the monied Wall Street elite will ensure that politicians and the Fed make it possible for them to continue their con-game. The private sector has allies in the form of inflation, a weak dollar, and a dissatisfied public (declining consumer confidence and lack of trust in government, which is reflected by the strong showing of Ron Paul), all of which form a powerful phalanx when battling the Fed’s reflation attacks. Inflation is a powerful ally for the private sector because it squeezes corporate profits and curbs personal consumption.

According to David Rosenberg, with 90% of companies reporting, third quarter operating EPS fell 8.5% year-on-year; while reported earnings, which include charge-offs, fell 28% year-on-year! Rosenberg also notes that "at $15.29 reported EPS for the S&P 500 in the third quarter of 2007, the P/E multiple on this basis is a lofty 23x – not the 18x ‘cheap’ multiple (or 14x on forward estimates) that is constantly being bandied about in the media." He adds dryly: "[T]he current $15.29 estimate for reported EPS is the lowest level of earnings since the fourth quarter of 2004. And where was the S&P 500 trading at that time? Answer: It averaged about 1,162 that quarter – just in case you were thinking of buying this dip." (I can’t wait to hear the Goldilocks’ crowd’s positive spin on these dismal earnings.)

The war between the Fed and the private sector will, in my opinion, be very protracted. The Fed will win some battles, which – along with much brouhaha in the media – will see Pyrrhic victories such as the stock market rally of August to early October, which led in dollar terms to new highs but failed to do so in Euro and gold terms, and was followed in Euro terms by renewed severe weakness. (Just for the record, as of this writing, the S&P 500 is down 9% year-to-date in Euro terms, having peaked out in June.)

Other battles will be won by the private sector, which through its contraction (recession) amidst inflation will lead to sharp downward movements in equity prices.

I am well aware that the Bureau of Labor Statistics and the Bureau of Economic Analysis will continue to use bogus figures when reporting inflation, and hence real GDP growth, but they won’t be able to hide the squeeze on corporate profits and the consumer from rising prices. I am writing this report at Thanksgiving, an opportune time to point out that the American Farm Bureau Federation has calculated that the cost to feed ten people dinner in 2007 is US$42.26, up 10.9% from last year and the biggest year-on-year increase in over ten years (David Rosenberg has compiled a Thanksgiving cost-of-giving index, which amalgamates the prices of turkey, sweet potatoes, cranberries and gifts, as well as travel expenses: it rose this year by 7.9%.) I don’t suppose these indexes took into account the rise in heating and electricity costs for the festivities, or the cost of a nice Bordeaux wine and bottle of Cognac, due to the weakness of the dollar. (I might add that in Switzerland it wouldn’t be possible for ten people to be served Christmas dinner for that amount.)

But the point is simply this: cost-of-living increases vastly exceed the reported inflation figures and are squeezing the consumer, which leads to revenue pressure for the corporate sector. (According to the Kaiser Family Foundation, health insurance premiums have risen 78% since 2001, while wages have gained only 19% and "the government’s inflation measure during that stretch was 17%".) At the same time, corporations are faced with a squeeze on margins due to rising costs.

Pressure on revenues and cost increases contributed to the dismal performance of earnings in the third quarter of 2007. For example, Starbucks (SBUX) increased prices by an average of 9 cents a cup in July. However, customer visits to US stores fell 1% for the quarter ended September 30. Starbucks’ CFO noted that a "similar decline may occur in the fourth quarter although they will be positive for the full year". (This would seem to indicate that the economy slowed down considerably in the second half.) According to him, "unbeknownst to us, we saw economic headwinds that quite frankly came up probably stronger than I thought." Earlier, Starbucks’ CEO had remarked: "The consumer is being faced with rising costs in every sector of their lives, and so part of that is reflecting on us." An informed friend of ours suggested that declining traffic at Starbucks stores in the US is of particular concern, since Starbucks serves all income levels.

Therefore, declining traffic is not just a "sub-prime problem"! I should now like to reiterate what I have explained on a number of previous occasions. Rather than paying too much attention to the media and to analysts’ positive spins, it will pay to watch the market action of equities as a forecaster of business prospects. Starbucks’ stock made a double top between May 2005 and November 2006. After that its shares went downhill, although the stock market continued to rise to its final peak in mid-October 2007. This should have been a warning sign that Starbucks fundamentals were deteriorating.

Similarly, the fact that retail stocks failed to better the July high in the recent August 16 to October 11 rally, which led to a new all-time high for the S&P 500 in dollar terms (but not, as we have shown, in Euro terms), isn’t a good omen for retail sales, consumption, and the economy. I am not the only person who questions the economic statistics published by the US government: writing recently for Kate Welling (welling.weedenco.com), Lee Quaintance and Paul Brodsky of QB Partners observed:

"…the credit markets finally clogged towards the end of Q2 2007, closing the major private sector artery policymakers had been using to synthesize domestic output (expressed in nominal dollar terms through nominal GDP growth). True to form, they began creating U.S. dollars out of thin air at an accelerated rate in Q3 2007 (14.7% annualized). The Bureau of Economic Analysis (BEA) published nominal U.S. GDP growth at an annualized rate of 4.7% in Q3 2007. Taking the BEA’s figure at face value and subtracting the annualized rate of monetary inflation, we believe inflation-adjusted U.S. GDP contracted at about a 10% annual rate in Q3 2007. This rate of economic contraction would seem to be consistent with the analysis of the corporate profit slump discussed above, and with the observations made in earlier reports that the US economy is already in recession.


Marc Faber
for The Daily Reckoning
December 19, 2007

P.S. You can read the conclusion to this essay in tomorrow’s issue. Be sure to tune in…

No big news from the markets yesterday. Inflation and deflation fought to a draw…and then called it a day.

The Dow fell 65 points – and we noticed that copper was down about 25% from its high. Copper, as you no-doubt know, dear reader, is regarded as the metal with a Ph.D. in economics. When it goes down, the economy tends to go down with it.

You don’t have to be a genius to figure out why. Copper is used in making machines and houses. When demand for copper goes down, so does business activity.

After landing those blows, deflation followed up with a nice combination of jabs. Building permits were reported at a 14-year low. And in Southern California, house sales sank to a 20-year low.

Wiring new houses takes a lot of copper; so when there are fewer new houses, there is also less demand for copper. And less demand for financing – which is a good thing, since financing is less available anyway. Financial stocks have already lost $74 billion of value this year. Moody’s is down 50%. Merrill (NYSE:MER) is down almost 50%. KKR Financial has dropped from 27 down to 14.

And when housing and finance go down…it shouldn’t be long before the entire economy follows.

"The bottom line," writes David Rosenberg of Merrill, "is that housing and consumer spending were joined at the hip…and now that hip is going in for replacement."

Consumers can’t make money from rising house prices. And they can’t borrow money either. All they can do is to spend the money they earn. Ouch. Ouch. And in an economy that relies on consumer spending for 70% of its GDP, a falloff in consumer spending is very bad news.

Yes, dear reader…a recession is probably on the way. Maybe it is here already. And it will probably be a real recession this time, not just a phony recession such as we had in 2001. This time the consumer will actually have to cut back on his spending. This time, consumer credit will actually go down. In short, this will be a recession worth having.

When the dotcoms went down, it affected no more than about 10% of the economy – at the most. When residential housing goes down, the damage will be much more widespread, long-lasting and deeper.

Even the art market is beginning to get hammered. A report in the International Herald Tribune tells us that while prices have held fairly steady, it has come at a large cost in sales. At Christie’s, for example, 19% of the stuff for sale at a recent auction "hit the dust," meaning – it didn’t sell. At Sotheby’s the total rose to 27%; lots at a recent auction didn’t make the minimum prices set by sellers. In other words, prices weren’t allowed to get to a market-clearing level. Result: no sales. And no information. We don’t know how low prices would have gone if they had been allowed to fully express themselves.

Turns out, the auction houses are giving sellers ‘guarantees’ that effectively stop the market-clearing process. If the price drops below the guarantee, the object is simply removed from the sale. In art, as in houses, it will take a long time to discover where what things are really worth.

But if we were a judge, we’d still have to give the day to inflation – on points. For while copper is getting knocked down, platinum never looked stronger. It’s at a record high and punching hard.

A headliner item on the inflation side was the price of wheat, which also rose to an all-time high.

"Grocery bills keep growing," says an article in the Dallas Morning News. And the U.N. goes further, with a report saying that not only are prices rising – the world’s food supply is shrinking.

Shrinking? How could the world’s food supply be going down when the world’s population is growing so rapidly? How could farmers produce less food when they have so much more technology to work with? How could food production decline when so many marginal properties are being put into production? We don’t know. But if it is true that farm output has peaked out, prices of agricultural commodities should rise even more steeply in the years ahead.

Meanwhile, the American Farm Bureau tells us that it costs more than 10% more to feed people this year than it did a year ago – up to $42.26 for a group of ten. Not in Switzerland, says our old friend Marc Faber. Only in America could you feed 10 people on so little money. But the key point is that prices are rising sharply. Remember, inflation packs a wallop – especially among the marginal middle and lower classes, where food is a large percentage of the family budget.

Then again, as they have to pay more for food and fuel…they will have less left over. Which, of course, means less consumer spending…recession…falling demand…and…what?…falling prices! Go figure…

We don’t have time to figure…we’ve got to run and catch another plane…


*** We’re in the air again…this time down to sunny Florida.

As long term Daily Reckoning sufferers might recall, we were moving to Florida in order to save taxes. Well, we weren’t really moving to Florida. We do not live in the United States at all. But if we weren’t going to live in the United States it seemed like an extravagance to not live in a high-tax state like Maryland. We’ve been paying taxes to the state of Maryland for the last 12 years – all the while barely setting foot in the Old Line State.

Along came a tax attorney with some good advice: move. Specifically, move to Florida; the Sunshine State doesn’t have an income tax.

So here we are, setting up non-residence.

"Wait a minute," said an attorney yesterday. "Why do you need to be a resident of any state…since you don’t really live in the United States?"

It was a good question. Too bad we didn’t have a good answer. Because it now looks as though we’ve been paying taxes for nothing. Of course, all taxpayers pay taxes for nothing…or next to nothing. But we didn’t have to pay Maryland after all. We’re going to ask for our money back.

*** Where would you rather live, dear reader, Paris, France, or Paris, Texas?

In Paris, France, you have art, culture, food, architecture, theatre, films, restaurants, cafés, bistros and museums. But Paris, Texas, has its charms too.

Actually, we can’t think of any. But in Paris, France, you will pay $1 million or so for a 1,400 sq. ft. apartment with nothing in it. In Paris, Texas, on the other hand, for only $84,000 you can buy a 3-bedroom house, 1,352 sq. ft., with a laundry room, garage and patio.

We saw a photo of it in today’s USA Today. Ugly as sin. Still, what do you expect for $84,000?

More to come…on the humbug of modern American win-win capitalism…on vernacular architecture…on the Wow Factor…and more!

Until then,

Bill Bonner
The Daily Reckoning