Economic Realities

The Daily Reckoning PRESENTS: The question that’s on the tip of everyone’s tongue in January – what does the new year have in store for us? Well, our friend Gary Shilling sees twelve possible investment themes that could unfold in 2007. Read on…


What’s ahead for stocks and the economy in 2007? Setting aside unknown elements like major terrorist attacks or natural disasters, 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 2000-2002 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 12 investment themes, seven of which are likely to unfold in 2007 while four will probably work but maybe not until next year:

1. Housing prices will collapse. The housing bubble is deflating as sales of new and existing homes slide, prices begin to drop and housing starts decline. A bigger price plummet may start soon as many speculators give up on appreciation dreams and throw their properties on the market, triggering a downward spiral. Alternatively, interest rates on the Adjustable Rate Mortgages of many subprime borrowers will adjust up dramatically this year and force them into defaults and house sales.

Cheaper energy costs will not offset losses in house appreciation nor will non-residential construction growth. The Fed is unlikely to slash interest rates soon enough and big enough to save the day. Washington will be politically forced to bail out hapless homeowners, but as with the late 1980s-1990s S&L crisis, will probably arrive too late to prevent major damage.

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. And 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.

2. The Fed will ease when house prices collapse. Meanwhile, the yield curve will remain inverted. Once the Fed embarks on an interest rate-raising campaign, it almost always keeps going until something big happens, and that something is normally a recession. Such a campaign clearly started in June 2004. This time, we’re betting that the bursting of the housing bubble beats the Fed to the punch, but if not, the central bank will, as usual, do the recessionary deed. Once housing is in a shambles, either falling from its own weight as we expect or due to central bank action, the Fed, of course, will patriotically ease as the economy hits the skids.

The yield curve inversion, the only meaningful effect of the Fed’s current campaign that we can find, rightfully worry many because they have preceded every recession since 1950 with only two fake signals. Today’s rationalizations as to why long Treasury yields are artificially depressed appears no more valid than those in early 2000 as the yield curve neared inversion. The federal surplus at the time resulted in few new Treasury bond issues. That, the optimists believed, was depressing Treasury yields and causing a false recession-forecasting signal. But the 2001 recession followed the inversion, as usual.

3. U.S. stock prices will fall, perhaps below the 2002 lows, in the midst of a major recession. A major decline in housing prices and activity will almost surely precipitate a full-blown U.S. recession. That, in turn, will send corporate profits down after a spectacular advance over the last five years. Without this robust growth, stocks are vulnerable.

4. China will suffer a hard landing due to domestic cooling measures and U.S. recession. China is attempting to cool her white-hot economy, which grew at an estimated 10.5% rate last year, but is having difficulty. Fundamentally, China is experiencing a capital investment bubble, which is very misleading even in open market economies since is sends the wrong signals to participants. Since it takes capacity to build more capacity, what looks like strains and shortages are really symptoms of mammoth excess capacity problems that are only revealed when the boom subsides. That’s what happened in the U.S. new tech boom in the late 1990s, and now in China in less sophisticated industries. That excess capacity will, of course, drive even bigger exports.

A major U.S. recession will shrink Chinese exports dramatically as U.S. consumers buy less of everything, especially imports. Indeed, as U.S. manufacturing shifts to China, so does its inherent volatility and inventory cycles-and the long shipping time between China and the U.S. enhances those cycles’ violence. So between domestic economic cooling measures and a U.S. recession, a Chinese business slump is in the cards for 2007.

That, of course, doesn’t mean an actual decline in real GDP in China. A cut from the current 10% growth rates to 4% or 5% would be severe since more than that growth rate is needed to employ the hordes that continue to stream from the hinterland to the coastal cities in search of better jobs and lives.

5. Weakness in U.S. and China will spread globally, dragging down economies and stocks universally. The U.S. economy dominates the world, not only because of its size but also because America is the only major importer. Most other countries are running trade surpluses, and the U.S. is the buyer of first and last resort for their excess products. The Chinese economy is closely linked to America’s, as just discussed, and a U.S. recession combined with Chinese domestic economic restraint measures insure a global downturn. Other major economies in Japan and Europe simply can’t pick up the slack.

6. Treasury bonds will rally. Yields rose a bit over the last year, but surprisingly little in view of continued economic growth and further Fed tightening. This tells me that global deflationary forces are robust.

Downward pressure on Treasury yields will result when the Fed reverses gears and eases once housing is clearly in retreat and a recession is evident. I expect the current 4.7% yield on the 30-year bond to decline in 2007 and ultimately reach my long-held target of 3% when deflation becomes irrefutably established.

7. The dollar will rally, but only after the recession becomes global. The greenback last year remained string against the yen but not against the euro. Of course, the global recession that will make the buck a safe haven is yet to unfold. Meanwhile, with the U.S. likely to be the first major economy to slump and the Fed the first major central bank to cut rates, the dollar may be weak early this year. Strength would come later in the year as U.S. consumers curtail spending, imports fall and, as a result, foreign economies become weaker than the U.S.

Later this year, the dollar should gain against the euro and yen and also against the commodity currencies-the Canadian, Australian and New Zealand dollars-which will suffer as global recession slashes commodity demand and prices. Emerging countries’ currencies will also suffer in global recession.

8. Commodity prices will nosedive. Commodity prices have shown unusual strength in recent years. And the robustness has not just been in the energy sector, but spread broadly. Industrial metals prices have skyrocketed. So has livestock and grains of late. Even precious metals have reached prices not seen since inflation was raging in the late 1970s.

In the long run, we don’t see any constraints that will prevent the normal reaction to high commodity prices-increased supply that will depress prices. In energy, the Hubbert’s Peak devotees believe the world is running out of crude oil so prices will skyrocket in the years ahead. But we’re convinced that human ingenuity will, as in the past, prevent a Malthusian outcome. The ongoing fall in U.S. home sales and likely collapse in prices will have very negative effects on the prices of building materials such as gypsum and copper. Lumber prices have already nosedived. And copper prices are already at a nine-month low.

9. Maybe global and chronic deflation will commence in 2007. With a global recession collapsing commodity prices and the robust deflationary forces already at work, major goods and services price indices here and abroad, such as the CPI, will fall this year if a global recession unfolds. But that doesn’t guarantee chronic deflation. Inflation usually recedes in recessions, so it’s the action in the following recovery in 2008 that will tell the tale. If price indices continue to fall then, true deflation will have arrived.

10. Maybe U.S. consumers will start a saving spree, replacing their 25-year borrowing and spending binge. The money extracted from, first, stocks, and more recently, from houses are behind the drop in the U.S. consumer saving rate. Just like the falling saving rate, the rising debt and debt service rates can’t continue forever. With stocks likely to again fall significantly, a significant fall in house prices seems almost certain to precipitate the monumental shift from a quarter century borrowing-and-spending binge to a saving spree-unless another source of money can bridge the gap between consumer incomes and outlays. But no other sources such as inheritances or pension fund withdrawals are likely to fill that gap.

With no remaining alternatives, and with baby boomers needing to save for retirement, American consumers will be forced to embark on a long-run saving spree, although clear evidence of a chronic saving binge may be postponed until after the forthcoming recession.

11. Maybe deflationary expectations will become widespread and robust. Deflationary expectations spread and intensified in 2006 as consumers waited for lower prices for cars, airline tickets and telecom fees before buying. Christmas 2006 sales depended heavily on slashed electronic gear prices.

When consumers wait to buy, producers are left 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. “Maybe” those expectations will leap this year because “maybe” widespread and chronic deflation will be recognized. If so, then buyers will wait for lower prices, and vigorously so in many more product areas.

12. Speculative areas beyond housing may suffer in 2007. Housing is not the only area of heavy risk-taking. It just appears to be the most vulnerable. A Great Disconnect between the real economy and the speculative financial world has existed since the late 1990s. It’s been fed by mountains of liquidity sloshing around the world, expectations of and demands for oversized investment returns, and low volatility, all of which have encouraged risk taking. Anticipated stock volatility remains at rock bottom. Spreads between yields on junk bonds and Treasurys are tiny as ample financing and loose lending keep corporate defaults at record lows.

The huge gap between speculative financial markets and economic reality has persisted for a decade. It will probably be closed with many tears in the next recession, only adding to its depth.


Gary Shilling
for The Daily Reckoning
January 16, 2007

Editor’s Note: Can’t get enough 2007 forecasts and predictions? Never fear, The DR’s best and brightest share what they think will be the hottest financial trends of 2007, r

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: INSIGHT

Yesterday was Martin Luther King Day in the United States. Many people stayed home from work and the U.S. markets were closed.

But, here at The Daily Reckoning headquarters, we continued our lonely vigil on your behalf, dear reader. When the end of this credit cycle finally comes, we’re going to be able to watch it with our eyes wide open. We can hardly wait!

Alas…we may have to bide our time a bit longer. The market news shows no hint of a coming crisis. You can only see it coming if you read between the lines and think…which means it is invisible to most people.

Today, Boston writer Fred Sheehan ( reminds us of William McChesney Martin’s famous speech of 1968. But perhaps we should first remind readers of the circumstances. The dollar was still tied to gold…but only by a wispy thread. And as we would see three years later, if any foreign central banks tried to pull on it, the thing would break. The U.S. federal deficit had been only $1 billion in 1965. But by 1968, the costs of the Vietnam War – the Iraq of the Johnson Administration – were mounting up. The deficit for 1967 had been forecast at $4.9 billion…then raised to $11.9 billion in August of that year. By October, Secretary of the Treasury Fowler warned that the deficit for the following year could hit $28 billion.

While the French counted their dollars and eyed the United States, investors were calm, even sedated. They had seen the stock market hit an all-time high in 1966. It had dipped in ’67, but by ’68 it was hitting another all-time record. Investors saw nothing to worry about. Stocks had been going up, more or less steadily, since 1949. The setback and reversal of ’67 – ’68 only proved to them that nothing could stop the market.

But Martin saw what was coming. “We have been living in a fool’s paradise. We face a financial crisis that is not understood by the public.” And then, “There is no disposition on either side of the aisle in Congress to face up to the problems,” he went on, apologizing for his emotional state.

“How could he have made it clearer to sell the dollar?” asks Sheehan. “Yet the charade went on for another three years before President Nixon officially closed the gold window on August 15, 1971. Gold rose to over US $800 an ounce by the end of the decade, and paper assets were an easy avenue to lose a life’s savings.”

Every generation has its formative experiences. For those of us with our eyes open in the ’70s, this was it – when the financial going gets tough, tough-minded investors should stay away from U.S. stocks, bonds, and the dollar.

The question we face today is simply – to what extent is that experience still relevant? The generation of the ’30s had learned to save dollars and mistrust stocks. Yet, those savings were largely wiped out in the inflation of the ’60s – while stocks soared. The generation of the ’60s learned to spend and to buy stocks. Do we now wait for them to learn their lesson?

We don’t know. But yesterday, we began to explain what was wrong with this economic boom. It is not your father’s boom, we said. Because it is not a broad-based economic boom, with higher earnings spread throughout the economy. Most people are not really earning more money. The only way they can afford to spend more is by drawing down savings or selling off assets. What they have been doing, of course, is both. Savings rates have gone to near zero. And householders have taken out so much of the equity from their homes that they have come to the end of the biggest bull market in residential real estate with less of their houses in their own hand than before the boom began.

Let us linger on that point for emphasis. If you own a $100,000 house with a $50,000 mortgage, your ‘owner’s equity’ is 50% or $50,000. If the house doubles in price to $200,000 your equity shoots up to 75% or $150,000. But in the great housing boom of the last 10 years the typical owner’s equity actually went down – from 58% to 54%.

Meanwhile, people with real financial assets – stocks and bonds, mostly – have done very well. So have the people who monger these things. As Marc Faber points out, the 173,000 employees of New York’s leading financial houses made more money last year than the entire population of Vietnam, some 84 million people.

At the top end of the financial pyramid, it is party time. The median price of a New York condo is over $1 million. Even that is peanuts in central London. There, houses have just seen their biggest increase since ’79…(More below). And, last year, a single art auction at Christie’s brought in $269 million – a new record. Christie’s chairman said he had never seen anything like it.

Stopping for two cups of tea and two muffins near Waterloo station in London last weekend, Elizabeth and I spent $20. The price seemed reasonable; the little coffee shop was full. But we wondered…how many of the world’s people can afford to live like this?

But therein hangs a tale…and lies a problem. Most people are not getting rich. Most people are barely making ends meet, because the great boom is a fraud. It does not lift up all boats; it lifts up only the luxury yachts. Why is that? Because it is an asset-price boom, not an economic boom.

Faber quotes Bank Credit Analyst:

“Increases in asset prices do nothing to create new resources for investment as the gains can only be realized by selling the asset to someone else, who must come up with the money from somewhere. The exception is if domestic investors sell their assets to foreigners (as the [United States] has been doing.)”

American householders are selling their houses (via mortgage refinancing and ‘taking out’ equity) to the lenders…who package the loans and sell them to investors worldwide. As assets rise…the 1% of the population in the financial industry or with significant financial assets gets rich. New wealth is not being created; it is merely being redistributed.

Never have so few done so little and made so much doing it.

More news:


And more views:

*** China has passed two important trillion-dollar milestones. Last year, its holding of U.S. dollar reserves rose above $1 trillion. And last week, China’s stock market topped $1 trillion. Since ’78, when China threw off politics and turned to money as its principal enthusiasm, its economy has grown 1,000%.

*** We are prepared to believe that both China and India (and, in fact, most of Asia) are rising rapidly. We are also prepared to believe that great fortunes will be made in these booming economies as they play catch-up with the West. What we are not prepared to believe is that a U.S. investor is likely to make money by buying into these high-priced markets now.

An investor could have done well in the United States in the 20th century too…but not by buying at market highs – ’29, ’66 – ’68, or ’99.

*** And here’s a sad note. Down at the lower end of the financial pyramid, we find old people are feeling a little pinched. According to the Dallas Morning News, more and more retired people are getting into financial trouble. Instead of using savings to get them through rough patches, they’ve gotten used to using credit cards as a safety net. The trouble with the plastic elastic is that it doesn’t snap back. Once a person uses credit cards to get out of a jam, he finds he has an additional expense – the credit card bill. Older people have few ways of increasing their incomes, so they often just get farther and farther in the hole.

*** And here comes news that the rising price of gold has caused a shortage of gold coins in Dubai and the Gulf region. Amid all the noise of today’s markets…with their derivatives, swaps, trade imbalances, public deficits, managed currencies and managed expectations, jiggled corporate profits, soaring prices and so forth…about the only thing in which we have any confidence is gold. We don’t know how or when things will go wrong. But, like William McChesney Martin in 1968, we can’t help but feel that we are living in a fool’s paradise.

*** And a word of advice from our commodities guru, Kevin Kerr:

“With a new year comes a chance to wipe the slate clean, and also a chance to venture into new profit opportunities for your portfolio.

“Don’t dive into the deep end with a market like gold or crude oil futures; instead, try some of the soft commodities, like grains, orange juice or cocoa, which can offer the new trader good experience without the major expense and volatility of markets like gold and oil. Sure, all the markets have risk, but some commodities are better (and cheaper) training ground then others. It’s always advisable to seek some type of assistance with these markets, from a broker, newsletter or mentor.”

The Daily Reckoning