The evidence continues to mount that the US is in a recession. In this week's
letter, we will look at the blind spot in the unemployment statistics, the
continuing meltdown in the credit markets, and the simply awful service sector
implosion in the ISM data, and then add a few thoughts on the housing market.
There is a lot of data to cover, so this week's letter should be particularly
interesting. The letter will print longer than normal, since there are lots of
But first, we are finalizing the speakers for my annual Strategic Investment
Conference (co-hosted with my partners Altegris Investments) in La Jolla April
10-12. I am extremely happy that Greg Weldon has been able to clear his schedule
to attend. Long-time readers know that Greg is one of my favorite analysts, with
his uncanny ability to tease the most important facts out of the fog of data we
are deluged with each week. He has been on top of the whole credit crisis for as
long as anyone, and his thoughts on what is coming next will be valuable. Greg
joins Paul McCulley of Pimco, Don Coxe of BMO (two of my favorite economists
anywhere, and simply brilliant speakers), Rob Arnott, George Friedman of
Stratfor, as well as your humble analyst and a dozen hedge fund managers who
will show you how they navigate in these troubled waters. By the way, George's
new book should be at the conference ahead of the bookstores. He will be writing
on how the geopolitical world will change over the coming century. I have read a
rough copy, and it is fascinating.
The conference is limited to those with a net worth of over $2,000,000, due
to regulatory requirements. I simply hate to put limits like that, but rules are
rules. You must register at http://www.accreditedinvestor.ws and
subscribe, someone from Altegris Investments will call you (again, a regulatory
requirement), and send you the detailed invitation about the 2008 conference,
including a link to past and current conference speakers and details.
Unemployment is Understated
For the first time since August of 2003 we had a drop in the employment
number. Employment fell 17,000 in January. The BLS also released its benchmark
revision with the January report. The year ended with 376,000 fewer jobs than
were reported a month ago, and 1.14 million net jobs were created December to
December. Downward revisions were spread throughout the year. This translates
into 95,000 new jobs per month, down from 175,000 in 2006. Remember, it takes
150,000 jobs per month (or so) simply to maintain the employment rate, due to
growth in the population. The January loss is likely to be revised down over the
next year. The median duration of unemployment also rose from 8.4 months to 8.8
months. The trend is most definitely not your friend. (graph from
Last week jobless claims rose
almost 20%, to 378,000. This week they came in at 356,000. These last two
weeks represent a marked increase in initial unemployment claims but, as many
bulls point out, that number is nowhere near the levels that would indicate a
As I have explained in numerous letters, the
jobs report put out by the Bureau of Labor Statistics can be misleading both
when the economy is coming out of a recession and when it is going into one. It
tends to underestimate the number of jobs as the economy is recovering and
overestimate the number when the economy is slowing down. That's because the
data is basically trend-following. A year later, better data comes in and the
numbers are revised, as they were this month. But those revisions are basically
stuck on page 16 in fine print in the Wall Street Journal. Who cares
about year-old data, except economists?
The problem is, if we're in recession we should
be seeing a higher initial unemployment claims number. The "we are not in a
recession camp" is absolutely correct about that. And yes, we've seen a marked
rise in continuing claims the last two weeks, but not as high as one would
think to be the case if we were in a recession. Yet continuing claims are up by
10%, which based on the past would suggest we are in a recession. So why the
An answer comes from David
Rosenberg, the North American economist for Merrill Lynch, who points out that
jobless claims number may be suspect. Let's look at what he says in his recent
jobless claims are being distorted right now because the seasonal factors are
looking for retail sector layoffs in January but these layoffs are not
happening because there was no hiring in November and December. So the seasonal
factors are depressing the claims data to the downside right now - look for
them to hook up in coming weeks. But anyone putting their faith in claims in
January given all the early-year distortions ... good luck. No mention made, by
the way, that the backlog of continuing claims has spiked up 10% over the past
year and the last time that happened, well, was in late December 2000 - the
recession began the very next quarter.
focus on payrolls at this stage of the cycle is fraught with risk. In 90% of
the business cycle, the payroll survey is the one to focus on, given its lack
of volatility and huge sample size. But the 10% of the time when the payroll
survey does not work well is at turning points in the business cycle. Why?
Because being a poll of companies, what the payroll number misses are the
self-employed and there are more than 10 million of them.
"So the bottom
line is that what the payroll data have missed is the fact that over the past
six months, 520,000 self-employed individuals have fallen by the wayside (more
than were lost in the entire 2001 recession). This may also be why it is that
claims are suppressed - having never paid into the unemployment insurance
program, these people are not necessarily entitled to any benefits. The
population- and payroll-concept adjusted data show that employment fell 400,000
in November-December combined (because Thanksgiving landed so late in 2007,
both months have to be looked at together, whether it be for jobs or retail
sales). So we think the view that job growth is hanging in is, just in plain
simple language, wrong."
unemployment to rise to 6% (or more) in the coming quarters. This will of
course put a damper on consumer spending.
Credit Crisis is Simply Getting Worse
Goldman Sachs CFO
David Viniar warned yesterday that some key mortgage bond insurers could
collapse. Viniar, speaking at a CSFB conference, said credit markets are
trading as if we are in a "worst recession"; and there is a "total
disconnect between the equities market and the credit market." (The Bill
There was a
convention this week in Las Vegas of the American Securitization Forum. I
talked to good friend Michael Lewitt who attended the conference, and he said
the mood was simply dismal. The credit markets have gone from bad to worse.
There's almost no trading being done in the $2 trillion Collateralized Debt
Obligation (CDO) markets. Perfectly good bank loans are trading at discounts of
between 10-20% to par, in addition to much higher and wider spreads. There are
a lot of opportunities for intrepid investors who can distinguish solid value,
as funds, banks, and pensions are having to unload loans without regard to
value. It is a buyer's market. Let's take a look at a few graphs from
This first one is an
index of asset-backed paper, mostly mortgage-backed. This is the BBB-rated
paper issued last year. It is trading at an 86% discount. This pays a coupon of
3.89%, so it is yielding almost 30% if you are looking for yield. (For the four
people who might be tempted to do that let me point out that was a joke.)
I should also point out that this index is composed of bonds and trusts put
together by some of the biggest names in the investment banking world less than
one year ago. One year ago these banks sold these bonds as investments worth 100
cents on the dollar. Cue lawyers. I was recently sent a link to a conference
that will be held in New York next month. It is basically for people who are
interested in litigation over the subprime and credit mess.
Look at some of the topics:
"Look inside the mortgage industry,
its underwriting, risk analysis procedures and loan approval technology...Get
up-to-date on who is suing whom and the status of the recent wave of securities
complaints ... Learn the key elements necessary for proving or disproving fraud
and negligent misrepresentation ... Find out what to look for when it comes to
disclosures, disclaimers and limitations on standing ... Learn the role played by
rating agencies, insurers and the feds ... Acquire the skills necessary to
successfully prosecute or defend mortgage-backed securities suits."
This is going to take years to sort
I wrote in late 2006 that the
housing and subprime crisis was going to result in massive litigation. The
lawyers will be looking at every deep pocket to see what they can get for their
clients who lost money. I can guarantee you the rating agencies are in the
crosshairs of hordes of attorneys from around the world. (If you are interested
in the conference you can go to http://www.lexisnexis.com/conferences/.)
The Falling Knife of Credit
Let's talk about credit spreads for a moment.
The "spread" is the difference you pay, typically over LIBOR (or the London
InterBank Offered Rate). LIBOR is the most important interest rate in the
world, as massive amounts of debt are set according to it. Let's say you are an
AAA-rated borrower. Last summer you might have been paying as little as 3.84
basis points over LIBOR. If LIBOR was at 5%, you would be paying 5.0384%. There
was very little premium for what was considered risk-free money.
Today you are paying as much as 1.89% more.
Granted, 3-month LIBOR is now at 3.10, down 2.16% over the last six months, due
to aggressive Fed, Bank of England, and ECB (European Central Bank) action.
Thus your net cost of funding is the same, but only if you are AAA. There are
actually very few AAA borrowers in the world. Let's look at how your costs may
have risen if you are still barely investment-grade at BBB.
Now you have a problem. Your costs may have
risen from a mere 1.45% over LIBOR to as much as 13%! The spread on some junk
bonds is running as much as 18%! (All this data can be had at
www.markit.com) This is a credit market that
is in serious trouble. No one wants to lend unless they can be sure of getting
repaid, so the price of risk is rising rapidly.
Interestingly, there are many who actually
benefit. For example, I am involved with some hedge funds in Europe that use
modest leverage. We borrow at a fixed rate over LIBOR. Our spread has actually
done down, as well as actual LIBOR going down. So we are well ahead of where we
were last summer in terms of borrowing costs. It is an ill wind that blows no
good to at least someone. Those borrowers with solid balance sheets find their
costs going down.
Capital Ratios Are Under More
and More Pressure
There are hundreds of billions of dollars of
Leveraged Buy Outs (LBOs) that were done last year that are still on the
various lending banks books, which they thought they were going to be able to
sell to investors. However, the price of risk has risen and no one is willing
to take the loans at anywhere close to the original rates the banks committed
to. I talked with one major investment banking executive this week, and they
are having to cut back on the loans they are currently making, and tighten
credit standards, as they now have to carry those old loans at very low rates
on their books.
This means those loans count against the capital
reserves they are required to maintain. If they move those loans off the books
at today's higher interest rates, it would mean large, and I mean LARGE,
losses. That is in addition to the losses they are already admitting to. If they
keep the loans on their books, it simply means they are not getting as much
interest as the market is paying today, but does not require them to book an
immediate loss, unless the loan goes into default. But it does mean they have
less money to lend, so banks are becoming quite picky about whom they lend to.
The news just keeps getting worse. We are now
told that we are nowhere close to the end of the writedowns by banks all over
the world. Goldman Sachs now estimates that the total loss in the mortgage
security world will total $400 billion (this includes more than just subprime
mortgages), up from an estimated $200 billion only a few quarters ago. And that
is if home prices only fall about 20% on average.
And that probably assumes normal
default patterns. The Wall Street Journal noted today that Fitch has
warned of an additional $139 billion in mortgage-related losses from
individuals who are simply walking away from mortgages where the homes have
lost value. They are doing this in advance of foreclosure proceedings. Fitch
expects that losses will be 26% of the value on subprime loans made in 2007.
But returning to the rise in spreads, this also
means that subprime credit cards, subprime auto loans, and subprime student
loans will start costing a lot more, or become less available. There are tens
of millions of subprime credit cards. And their cost is going to go up. But
here I refer not to the borrower but to the lender.
Defaults on credit cards are rising. 7.6% of all
credit cards loans were 60 days past due in December. Credit card debt is sold
to various investors as bundled securities, just as mortgages were. If
delinquencies rise, then the rates that investors want must rise to cover the
defaults. Interest rates are going to rise on all but the highest-rated credit
And speaking of consumer debt, something
happened in December that is quite unusual. This week the Federal Reserve
announced that total credit card debt rose by just 2.7% annually in December,
after rising 13.7% in November and 11% in October. In fact, new credit card
debt was on a tear right up until December, which as I have previously written
is the month I think we will look back on and see that a recession began.
Notice that credit card debt rose by less than inflation.
Wal-Mart sales rose just 1.4% in the year ended
February 1, which is the lowest increase in the 30 years since the company has
been making that data public. With inflation running at 4% (and more if you
think about how much of Wal-Mart sales are food), that is quite weak indeed.
It now looks like the US consumer is finally
beginning to slow down. No more Mortgage Equity Withdrawals, and better use
that credit card less. Consumer confidence surveys continue to drop. Today the
RBC Cash Index of consumer confidence dropped to its lowest level since 2002.
Hardly an environment for robust consumer growth. We will come back to this
point in a page or so, but let's finish up my thoughts on the credit crisis.
Over in Europe there is a disturbing set of
circumstances. The European Central Bank is (properly) lending massive amounts
of money to banks to maintain liquidity, making the Fed look miserly in
comparison. They are allowing the banks to post asset-backed paper (including
presumably some mortgage paper that is still rated subprime) as collateral.
This amount has risen to a massive EUR430 billion, or about $623 billion. There
are estimates that as much as $500 billion in asset-backed paper is on European
bank balance sheets, and much of that is being used as collateral at the ECB.
This means that European banks may still have several hundred billion in paper
to write down.
No wonder European banks are not
lending to each other. No one knows who is in serious trouble. As I reported a
few weeks ago, there are serious rumors from credible (and off-the-record)
sources that one of the largest European banks is technically in a condition of
negative equity due to the massive amount of asset-backed (mostly mortgage)
paper on its books, which it has not yet written down, since it has not yet
Finally, let's look at what is the
spear point of the current credit crisis: the monoline insurance companies like
Ambac and MBIA. I have been warning for months that they are either insolvent
or on their way to insolvency. If they are downgraded, they are essentially
forced into bankruptcy. Let's look at what Professor Nouriel
Roubini wrote this week:
"Next, the downgrade of the monolines will lead to another $150 of write downs on ABS portfolios
for financial institutions that have already massive losses. It will also lead
to additional losses on their portfolio of muni bonds. The downgrade of the
monolines will also lead to large losses - and potential runs - on the money
market funds that invested in some of these toxic products. The money market
funds that are backed by banks or that bought liquidity protection from banks
against the risk of a fall in the NAV may avoid a run but such a rescue will
exacerbate the capital and liquidity problems of their underwriters. The
monolines' downgrade will then also lead to another sharp drop in US equity
markets that are already shaken by the risk of a severe recession and large
losses in the financial system."
In talking with friends in the
credit markets, in order to return to more normal credit markets, the thing
that has to happen first is that the monoline insurance problem MUST be
resolved. I agree with Nouriel that $15 billion being written about in the
papers will not be enough. I have no idea what the correct number is, but it
needs to happen soon, before the rating agencies are forced to downgrade the
While Nouriel thinks the use of
public funds is unlikely, I am not so sure. The failure of the monoline
companies could trigger a very serious crisis, beyond what we have already
seen. Of all the things on my worry list, this is at the top. It could trigger
a counter-party credit risk in the credit default swap markets that might
simply cascade to something hard to imagine. I don't want to sound too alarmist
- but we should be alarmed. This needs to be settled, and soon, so we can go on
to the next set of problems. I think if the monoline problem can be resolved,
we would be a major step toward the solution of the crisis.
The ISM Services Survey Simply
Falls out of Bed
The ISM services (technically, the
non-manufacturing) survey came out this week, and it was simply horrible. I am
going to use the entire graph and table from www.economy.com
(a very useful source of data). The consensus expectation was for an index
number of 53. It came in at 41.9. This was the first drop in almost five years.
I cannot ever recall such a one-month drop. And the internal numbers were ugly
For those of you not familiar with the index, a
number above 50 suggests the factor being measured is increasing, and below 50
suggests a contraction. The higher or lower the number is from 50 simply
measures the degree of increase or contraction.
Notice that the graph of the last year shows a
fairly stable index. This index represents roughly 70% of the economy. It is
retail stores, restaurants, and all manner of services. This suggests that
business expectations are being drastically reduced. Employment expectations
are sharply down, suggesting that it will be harder to get a job in the near
future. New orders were down severely, as well as all the other forward-looking
indicators. Take a moment to look at the data, and compare January's number
with just six months ago. The trend is not your friend if your business is tied
to consumer spending.
Finally, one last statistic. The
growth rate of the ECRI Index of Leading Economic Indicators is down 7.9% from
7.1%. It continues to point to a recession.
I read and listen to the various
bull arguments. I think there is a major disconnect between what we see in the
economy and what they see as "value." Remember, if you're managing money in a
long-only fashion, you cannot go on TV or in print and say, "The economy sucks,
the market is going down, so redeem from my fund." Not going to happen. When
Art Laffer throws in the towel, there is a bear market coming.
You need to use these bear market
rallies to lighten up your long-only exposure, with the usual caveat that there
are exceptions. I in fact do own one micro-cap stock I am holding on to for
long-term reasons. But I would not want to be anywhere close to an index fund.
And it is not too late to get out. There is still more downside in this bear.
Upgrades, Orlando, and a Proud
I am lifetime platinum on American Airlines,
which means that I have over 3,000,000 miles. I was used to getting upgraded,
even with cheap tickets, at least 80-90% of the time. Then the last six months,
no upgrades at all. I know they are selling cheap upgrades to full coach
tickets, but not one upgrade, even during the middle of the week.
Today, I got to the airport early so I could get
in line for an upgrade, as it is easier to write in first class and I needed to
finish this week's letter. I was informed that there were eight platinums in
front of me. I asked the friendly rep, "How can that be?" She looked on the
computer and found out that the first guy had checked in at 6:30 am for a 2 pm
flight, and the second checked in at 7 am. She saw my skeptical look and said, "Oh,
you can now check in online 24 hours in advance, and your priority on the
upgrade list is made by when you checked in online." Someone forgot to send me
the memo, I guess. Maybe my luck will change.
I have just agreed to speak at a conference in Orlando March 13. Part of the
lure is to get to go for two days to the Arnold Palmer Invitational. It should
I got a call from my 22-year-old daughter Abbi,
who goes to school in Tulsa. She started as an intern with the local minor
league basketball team, the 66'ers. A month later they put her on the payroll
and made her responsible for floor operations during the game. She called me
Wednesday and said, "Dad, they just promoted me to be the head of the entire
game operations." The list of what and who she is responsible for is quite
long, as professional games are now major entertainment spectaculars during
timeouts and half-time. Quite the jump for a young girl in just a few months.
Clearly management there is astute and good at recognizing talent when they see
it. Dad is very proud. Mark Cuban, there is major talent there that needs to be
brought to Dallas, even if she is only 4'10."
Your looking forward to Phoenix weather analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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