The bulls are saying that the market is now a buy based on investor fear, a bottom in housing, no recession or a mild one, a resolution of the credit crisis and a second half economic recovery. On the other hand, what we see is investor complacency, continuing deterioration in housing, more credit turmoil and a serious recession. All in all this looks like a typical rally in a bear market based on hope and a denial of what is really happening.
From the cyclical peak, home sales are down 35%, housing starts down 60% and home prices down 9%. January existing home sales were down 23% year-over-year with record inventories equaling 10.3 months of supply. The Case-Shiller home price index for 20 leading cities was 9.1% below a year earlier, and the only way to work off these inventories is for housing prices to drop much further. A number of mainstream economists are looking for an eventual price drop of 20% or higher from the peak. Foreclosures have already been rising sharply and could get a lot worse. An estimated 550,000 mortgages are now in default, and interest rate resets on subprime and Alt-A are on the rise. Defaults are a leading indicator of foreclosures. On current house prices an estimated 8.8 million homeowners have zero or negative equity in their homes, and this figure will climb steeply as houses undergo additional price declines.
The stress on the credit system has been obvious. Announced writedowns by financial institutions, mostly due to structured debt securities related to housing, now amount to about $150 billion and are rising almost every day. We still keep hearing about stress in markets that few ever knew existed. Although the credit crisis has been with us since August the full extent of the risks remain unclear, and, as a result, large segments of the credit markets have stopped functioning, causing interest rates to soar on a wide array of securities previously thought to be safe.
All of this has spread to the real economy, and it is probable that a recession started in December. Jobless claims have now been more than 350,000 for five straight weeks while continuing claims are climbing steadily. The unemployment rate has risen from 4.4% to 4.9%, a rate of increase that has preceded or coincided with past recessions. Year-over-year chain store sales for January and February were the weakest for the start of any year since 2003. The conference Board Consumer Confidence index dropped a whopping 12 points in February to the lowest level in over 14 years with the exception of the start of the Iraqi war. The six-month annualized growth rate of the Conference Board leading indicators is at its lowest level since April 2001. The Fed’s regional manufacturing surveys have been weakening substantially while the non-manufacturing index plunged in January. The weakness in consumer spending is likely to lead to weaker capital spending as well and a further deterioration of the labor market.
In our view the market has not priced in the highly negative current and prospective conditions in the credit markets and the economy. Investors always tend to get overly optimistic in bear market rallies until they run into another dose of reality. In the bear market of 2000-2002 there were five separate rallies of 10% or higher, and during each one, investors thought a recovery was in sight. We think this remains a highly risky market.
