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Proof the housing price bubble has burst


In the process of updating some older charts, I stumbled across this gem, and couldn't resist posting it. It shows the inflation-adjusted price of existing single-family homes, and very clearly depicts the "bubble" in housing prices which began around 1997 (when Clinton cut the capital gains tax on home appreciation), and the deflating of that bubble which is now complete, with prices having fallen fully 39%—in real terms—from their 2005 high.

But maybe you think that prices will have to go all the way back to 1968 levels, in which case there is still another 20% decline waiting in the wings.

As a counter to that, I would note that mortgage rates today are lower than they were in 1968, and real personal incomes have increased 250% since then. Do housing prices really need to decline further? I seriously doubt it—prices are incredibly cheap by almost any measure you care to come up with. The bubble has popped, and it's time to think about how much it might inflate again.

Bank lending accelerates


Commercial & Industrial Loans are a good proxy for bank lending to small and medium-size businesses, the kind that aren't big enough to access the credit markets directly through bond issuance. Contrary to popular belief (i.e., "banks aren't lending" despite all the reserves they have on tap at the Fed), bank lending has been picking up ever since hitting a low in September 2010. Since then, banks have increased their outstanding loans to businesses by $140 billion, with loans growing at a 13.8% annualized pace over the past three months, and at a 12.5% annualized pace over the past six months. This is a very positive development, not because bank lending per se creates new money or increases demand, but because it reflects increased optimism on the part of banks and businesses—banks are more willing to lend, and businesses are more willing to borrow.

Predictions for 2012

As detailed here, the biggest source of error in my predictions for 2011 was my belief that the economy would be somewhat stronger than expected, and that this, coupled with higher-than-expected inflation, would force the Fed to raise interest rates sooner than the market expected. I got the inflation part right, but the economy proved weaker than both I and the market expected. That in turn prompted the Fed to promise very low rates for a very long time, thereby collapsing interest rates across the maturity spectrum. The weak economy coupled with the Fed's extreme measures to resuscitate it, plus the growing likelihood of sizable sovereign debt defaults in the Eurozone, helped convince the market that the situation was dire. So now the key question, from the market's perspective, is whether the economy can avoid a calamity.

I say this because I observe that the market today is even more fearful about the future than it was a year ago. I see that in 2-yr Treasury yields of 0.25%, which say that the market fully expects the Fed funds rate to be extremely low for at least the next two years; that is likely to happen only if the economy remains in miserable shape and inflation remains relatively low. I see it in 10-yr Treasury yields, which are as low as they were in the depths of the Depression, and lower even than they were at the end of 2008, when panic reigned. I see it in equity PE multiples that are only marginally higher than they were at the end of 2008, when the market was priced to a global depression and years of deflation. Equity multiples have declined over the past two years even as corporate profits have soared to all-time highs; the only way this makes sense is to assume that the market believes growth will be abysmal and profits will collapse in coming years. I see fear in credit spreads that are as high or higher than they have been prior to previous recessions. I see tremendous uncertainty in gold prices that have risen by a factor of 6.5 over the past 10 years, a sure sign that investors have lost almost all confidence in the ability of the global economy to grow, and in the ability of central banks to successfully negotiate the current financial straits without something spinning out of control. Finally, I note that the Vix index (implied equity volatility) continues to reflect an above-average level of risk-aversion.

I do see some light at the end of this gloomy tunnel, however, and I expect it will brighten over the course of the year as the presidential elections focus the country's attention on what has caused our economic funk and how best to get out of it. If there is any good that has come out of the trillions of dollars of wasteful government spending in the past several years, it is the growing realization that government spending can not stimulate the economy, and only does more harm than good, by squandering precious resources and promoting crony capitalism. It's been a very expensive lesson in how Keynesian economics not only doesn't work but doesn't make sense to begin with. Bureaucrats cannot spend money more efficiently than the people who earn the money, and politicians cannot make better investment decisions than private enterprise. Industrial policy has never worked anywhere, and we see multiple examples of its failure almost every day in the headlines (e.g., Solyndra). 

I believe the elections this year will reaffirm the message of the 2010 elections: the electorate wants less government, not more; lower and flatter taxes, not higher; a simpler tax code, not more complexity. The changes might not be dramatic or immediate, but the political winds are blowing to the right, and over time this will push policies in a direction that will be more favorable/less destructive to growth. I believe that government spending can be throttled back without harming the economy; indeed, I think that a reduction in the size of government can actually boost economic growth, because it means that the market and the private sector will regain a measure of control over the decisions of how best to utilize the economy's scarce resources.

I see important signs that the economy has undergone substantial adjustments that now pave the wave for continued growth: businesses are firing fewer and fewer people since they have already cut costs to the bone; productivity and profits have improved measurably; jobs have been growing for almost two years; housing prices have reversed all of their previous excess; residential construction is beginning to come back to life; banks are once again lending, and at a faster pace; the Fed has ensured that there is no shortage of money; business investment is on the rise. Left to its own devices, and given enough time to adjust to adversity, the U.S. economy is perfectly capable of growing—and that is what is happening now. No reason this can't continue.

One key assumption I'm making is that sovereign debt defaults in Europe—which appear quite likely to happen—are not likely to be as destructive to growth as the market assumes. (Imagine the boom in risk asset prices if the Eurozone sovereign debt crisis were to disappear overnight, and you understand what a pall this has cast over all markets.) I've explained why defaults shouldn't be catastrophic here, but the short answer is that debt defaults don't destroy demand or productive capacity, and they are better thought of as a zero-sum game in which wealth is transferred from creditors to defaulting debtors. Many banks may fail as a result of major defaults, but banks can be replaced and/or recapitalized, and there is no shortage of capital in the world to do so. The losses that are eventually confirmed by a default have, in an economic sense, already occurred—they are water under the bridge. Defaults will also dictate that bloated Eurozone governments have no choice but to change their ways, and that will improve the prospects for future growth. They also will likely help the U.S. understand that we cannot continue with our spend-and-borrow ways.

I am not a huge optimist about the prospects for U.S. economic growth over the course of this coming year, because I see important headwinds to growth continuing: bloated government spending which appropriates the economy's scarce resources for inefficient and unproductive ends; the promise of higher tax burdens implicit in the soaring federal debt; huge regulatory burdens; and tremendous uncertainty surrounding the long-term implications of the Federal Reserve's massively bloated balance sheet. In short, I think the economy is growing despite all the supposed "help" from fiscal and monetary policy stimulus. I think that's because the U.S. economy is inherently dynamic and most people have a strong desire to work hard and get ahead. If the economy grows only 3-4% this year, I think the market will be pleasantly surprised, even though 3-4% growth won't result in any meaningful decline in the unemployment rate. Even modest growth would be much better than what the market is currently expecting, and that makes me an optimist in a relative sense because the market is so clearly pessimistic.

So, having outlined my assumptions—which are the key to any forecast—here goes:

The economy will grow by 3-4% in 2012, and if there is a surprise it will be on the high side. I think this is a safe prediction, since jobs currently are growing at a 1.7% annualized pace, and the productivity of the average worker tends to average about 2% a year. Growth could pick up towards the end of the year if the market gains confidence that fiscal policy will be more conducive to growth in the future, and that Eurozone defaults are not likely to deal a lethal blow to the global economy.

Inflation will moderate in the first half of the year, but will be roughly unchanged or somewhat higher by the end of the year.

The Fed will not engage in another round of quantitative easing because it will not be necessary or justifiable. If the economy grows 3-4%, inflation doesn't collapse, and Eurozone defaults don't bring about the end of the world as we know it, the Fed will be hard-pressed to justify another round of QE no matter what form it might take. Before the year is out, I think the issue of how to unwind previous quantitative easings will be more important than whether we need another round of quantitative easing.

Interest rates are likely to rise across the board as the outlook for growth improves. It is inconceivable to me that any improvement in the long-term outlook for the economy would not be accompanied by higher interest rates.

The housing market is likely to improve gradually over the course of the year. I think this is a process that is already underway, but it's very gradual. Residential construction is slowly improving, and although housing prices have yet to make a definitive bottom, I think we'll see more evidence of one as the year progresses.

MBS spreads are likely to widen over the course of the year. (I'm repeating last year's forecast here.) The main impetus for wider MBS spreads next year is likely to come from an across-the-board increase in the extension risk of MBS as Treasury yields rise. Mortgages, which currently behave like intermediate-maturity bonds, are at risk of becoming long-term bonds as interest rates rise and refinancing dries up.
Equity prices are likely to rise by 10-15%. Even if, as I suspect, the growth in corporate profits slows down, there is plenty of room for an expansion of equity multiples driven by improving confidence/receding fears.

Investment grade, junk, and emerging market bonds are likely to deliver decent returns. If Treasury yields rise, it will be because the economic outlook is improving, and that will mean lower default rates. Thus there is plenty of room for credit spreads to contract if Treasuries run into trouble. Even if we remain in a muddle-through scenarios, spreads—particularly of the high-yield variety—are generous and offer a substantial cushion against defaults.


Commodity prices are likely to rise. This follows from my belief that activity is severely depressed by fears of a sovereign debt crisis, and that these fears should dissipate or prove exaggerated. It also is a bow to the very accommodative nature of monetary policy around the world.

Emerging market economies are likely to improve.

Gold prices are likely to be very volatile, with the potential for a major decline. I think gold has already priced in the expectation of so many bad things (e.g., a big increase in inflation, a global depression, collapsing currencies) that any improvement in the outlook should convince investors that equities and corporate bonds offer much more attractive long-term returns than gold.

The dollar is likely to rise as the prospects for the U.S. economy improve relative to other developed economies. The dollar is still quite weak against most currencies from an historical and inflation-adjusted perspective.

Cash and Treasuries will likely be very poor investments.

5 million discouraged workers




The market is not impressed with the bigger-than-expected December jobs gain and the decline in the unemployment rate. The decline in the unemployment rate is indeed overstating the health of the labor market (see below for details), but I think the market is not fully appreciating the significance of the growth in jobs.

The decline in the unemployment rate has been driven not so much by the growth of jobs as it has been by the decline in the labor force. As the top chart shows, more than 5 million people appear to have dropped out of the labor force, so discouraged about their job prospects that they have given up looking and are thus no longer counted in the labor force. As the two top charts show, the labor force for many years has grown about 1% a year, but beginning in 2009, growth ground to a halt. The bottom chart shows the labor force participation rate—the proportion of the population that is in the labor force—and it has dropped two percentage points since 2009. 2% of the 322 million U.S. population equates to about 6 million people, confirming the implication of the top chart. If you added 5-6 million people back into the labor force (as unemployed looking for jobs), the unemployment rate would be 11-12%. Something happened starting in 2009 that resulted in many millions of people deciding to "drop out" of the labor force; the only question at this point is whether they have permanently given up or whether they could be enticed to return. In the meantime, they have been the cause of the sizable decline in the unemployment rate, rendering it fairly meaningless as an indicator of improving economic health.

But: the jobs gains we have seen in the past two years are a legitimate indicator of a slowly but steadily improving economy. The most important thing is not the level of employment, or the participation rate, but the change in employment on the margin, and that is decently positive. As I mentioned in the previous post, both the household and the establishment surveys are registering similar rates of growth (1.7% annualized, or about 160K per month on average), and that has been the case for several months now. These jobs may be "low quality" jobs, but they are still jobs.

The economy is growing and things are improving, even though we would probably be doing much better by now if it weren't for the huge increase in government spending since 2008 (which wastes the economy's scarce resources), the huge increase in regulatory burdens (which make it more difficult and expensive to start and run a business), the huge increase in the deficit (which increases the expected burden of taxation), and the Fed's massive increase in the monetary base (which creates tremendous uncertainty about the future of monetary policy and the stability of the dollar).

A decent jobs report


As the top chart shows, both the household and establishment surveys of jobs are telling the same story: the number of jobs continues to expand at a fairly steady pace. The unemployment rate is still very high (it would be higher still if millions of discouraged workers had not given up looking for a job), and economic growth is sluggish, but nevertheless, a little more than 3 million private sector jobs have been created in the past two years. Moreover, as with a lot of recent data releases, there is no sign in today's report of any emerging weakness.



The pace of job creation is not a strong as it should be to keep pace with the growth of the working age population and reabsorb those laid off in the past, but the economy is creating private sector jobs at about a 1.7% annualized pace, which translates into roughly 160K new jobs per month. December was a bit stronger than that, with 212K new jobs reported—more than the 178K expected, but not as much as the 325K new jobs found in the ADP survey reported yesterday. At this rate of job creation, the economy is perfectly capable of growing at a 3-4% pace (~1.7% growth in jobs plus ~2% growth in productivity).


It is encouraging to see that the public sector workforce continues to shrink, since it had grown much more than the private sector over the past decade. It's also comforting to see that growth in government spending has slowed to a crawl (up only 2.7% in the past year), as that has resulted in some important shrinkage in the size of government relative to the economy. As the public sector continues shrinking its body count and its spending relative to GDP, this returns resources to the more productive private sector and should allow stronger overall growth in the future.


2011 review

My predictions for last year produced mixed results (7 out of 12 right or mixed, and 5 out of 12 wrong), but on balance they were handsomely rewarded from an investor's perspective.

The economy will grow by 4% or more in 2011. Wrong. Through the third quarter of 2011, real GDP grew at an annualized 1.2% pace, and given current expectations for growth in the fourth quarter, the year-end tally will probably be 1.7%. One reason for the shortfall in growth was the Japanese tsunami, of course, which disrupted economies all over the world. The biggest reason, however, was the flareup of concerns over sovereign debt defaults in the Eurozone, a prospect that sent tremors through global financial markets and capital fleeing to the safety of Treasuries. The tsunami was an act of God, but sovereign debt problems were well known at the end of 2010, so I can't claim to have been blindsided by that—I simply didn't think the situation would escalate to the degree it did.


Inflation will trend slowly higher. Right. All measures of inflation moved higher over the course of the year. On a year-over-year basis, the CPI rose from 1.5% to 3.4%; the PCE deflator rose from 1.4% to 2.5%; and the GDP deflator rose from 1.6% to 2.4%. A popular inflation-adjusted bond portfolio (TIP) enjoyed a total return of 13.2%. 


The Fed will raise rates sooner than the market expects. Wrong. For the past three years I have consistently underestimated the Fed's willingness to embrace monetary ease, and at the same time I have underestimated the world's demand for dollar liquidity. In retrospect, I would say that the Fed did the right thing by keeping rates low and pursuing quantitative easing, even though I thought they were making a mistake by doing so. This is one mistake I'm not too sorry to have made, even though it led me to be too optimistic regarding the potential returns to equity investing.


The housing market will be showing signs of life by the end of the year. Right. Housing starts turned up over the course of the year, rising some 30% from their year-end 2010 level. Activity remains extremely depressed, of course, but on the margin construction activity is definitely improving. Moreover, the decline in housing prices has slowed overall, and in some areas prices appear to be firming.


Interest rates on Treasury bills, notes and bonds would be higher than the market expects. Wrong. This prediction was driven by my Fed and GDP forecasts, which were also wrong. Treasury yields fell to levels not seen since the Great Depression, as weak growth and fears of a Eurozone financial collapse drove safe-haven demand to unprecedented levels and convinced the Fed that they needed to pursue an aggressively accommodative policy. A diversified portfolio of Treasury Notes and Bonds returned 9.8% last year.


MBS spreads are likely to widen over the course of the year. Right (but for the wrong reason). I thought that mortgage rates would be driven higher as Treasury yields rose, but as it turned out mortgage rates fell by less than Treasury yields. However, as I suspected they would, mortgages delivered a decent return of 6.1% for the year despite wider spreads.


Credit spreads are likely to decline gradually over the course of the year. Wrong. Credit spreads widened mainly because Treasury yields collapsed, and also because of fears of a Eurozone-sparked financial crisis that could lead to a global slump. Despite wider spreads, however, corporate bonds were a profitable investment. Investment grade bonds returned 7.5% for the year, while high-yield debt returned 4.4%. One popular high-yield fund (HYG) enjoyed a 6.7% return.


Equity prices are likely to register gains of 10-15% next year. Wrong (but not terribly). The S&P 500 produced a total return of 2%, the Dow 8.4%, and the NASDAQ -0.8%. However, Apple, my favorite and highly recommended stock, posted an impressive return of 26% last year.


Commodity prices will continue to work their way higher over the course of the year. Mixed. The CRB Spot Index of non-energy commodities fell by 7.4% last year, but oil prices rose by 8.2%.


Emerging market economies are likely to do somewhat better than industrialized economies. Mixed. On average, emerging market economies grew by more than industrialized economies (China, for example, most likely grew by at least 8%), but due to declining commodity prices and fears that a Eurozone financial collapse could prove highly contagious, emerging market equities suffered. On the other hand, according to JP Morgan, emerging market debt delivered a return of 8.1%.


Gold will probably move higher. Right. Gold prices rose 10% last year, but along the way they suffered a 20% correction. This reinforced my belief that the potential volatility of gold prices was very high, making gold an extremely speculative investment. 


The dollar is likely to move higher against most major currencies, and hold relatively steady against emerging market and commodity currencies. Mixed. Against a basket of major currencies, the dollar rose by 1.5% last year. It rose against the Euro and the Canadian dollar, was basically flat against the pound and the Aussie dollar, and fell by 5% against the yen. Meanwhile, the dollar rose against most emerging market currencies. 


On an absolute return basis, a portfolio holding almost any reasonable mix of long positions in dollar-denominated equities, commodities, corporate, high-yield, and emerging market bonds, mortgages, and TIPS—all consistent with my forecasts—would have enjoyed a return substantially in excess of the return on cash. Avoiding cash, in other words, was a very rewarding experience. Despite my mixed forecast record, I don't feel bad at all about the results.

Service sector steady as she goes


The December ISM service sector survey was lackluster, in that it showed no unexpected strength. But neither did it show any unexpected weakness. On balance, it was consistent with an economy that is growing at a modest-to-moderate pace, and that is something that we already knew. If there is optimism to be found here, it is that to date there is no sign of the much-anticipated double-dip recession that many, most notably the folks at ECRI, have been calling for.


The prices paid survey continues to show that a majority of businesses are paying higher prices. Inflation is alive and well—albeit still relatively muted—and deflation remains a distant memory.


The employment index shows no meaningful improvement in hiring activity, and that is about what you would expect from an economy that is growing at a 3% rate.

The good news from this survey is that there was no bad news. That may not sound very impressive, but I think it is, since I believe that the market continues to be priced for disappointing news. When the market expects deterioration, the simple absence of deterioration becomes bullish.

The labor market continues to improve


Weekly claims for unemployment continue to decline, and the improvement in the past three years has been impressive, as the first chart shows, with claims falling from a high of 659K to 372K—a decline of 44%. The current recovery to date has been notable for its dearth of new jobs, to be sure, but the significant reduction in firings that shows up on this chart is strong evidence that businesses have undergone tremendous adjustments in order to adapt to new economic realities. The economy may not be growing very fast, but it remains very dynamic and adaptable, and that alone is reason to remain optimistic about the future.


This second chart shows the non-seasonally adjusted number of people receiving unemployment insurance benefits. It normally moves up around the end of each year, but today the number of people "on the dole" is 15% less than at the same time last year: 1.15 million fewer people are receiving unemployment benefits, and that is a very healthy trend. It may be politically incorrect to say this, but Congress' willingness to extend and extend unemployment benefits in recent years (via "emergency claims," a move without precedent in modern times) has undoubtedly contributed to the weak nature of this recovery. A person who is paid to not work has much less incentive to find and accept a job than one who is not paid.


The Challenger survey of announced corporate layoffs shows that the corporate world was quick to make some big adjustments—layoffs have been unusually low for the past two years. (The bulge last September was caused by planned troop reductions.) It also shows that the corporate world has not run into any unexpected difficulties, and that businesses in general are structured in a very "lean and mean" fashion. This has undoubtedly contributed to record levels of corporate profits, and it means there is plenty of room for corporations to expand hiring activities if the economic outlook improves. On that score, Washington holds some critical keys in the form of spending and tax policy. If spending can be cut back and corporate tax rates can be made more competitive, we could see some dramatic improvement on the new jobs front over the next few years.


Today's ADP estimate of December private sector jobs growth was so much higher than expected (372K vs. 206K) that most observers suspect it was a fluke caused by seasonal factors which can be difficult to get right at year end. But even if the reality is less than the ADP estimate, it is still likely that there was some substantial improvement in December relative to November. This holds out the promise for an upside surprise in Friday's jobs number, currently expected to show a gain of 175K private sector jobs.

Overall, lots of good news on the labor front today.

The outlook for construction brightens


November construction spending beat estimates, but that's pretty old news by now. I think the more important observation is that both residential and nonresidential construction appear to have hit bottom, as this chart shows. Residential construction has been flat for almost 3 years, and nonresidential construction has been flat for almost 2 years now.

Real estate markets operate with very long lags (typically 5 years or so), and construction activity has had plenty of time to adjust to the surplus of homes that appeared in 2006. That was a painful adjustment that required massive amounts of the economy's resources to shift from the construction sector to other sectors. Meanwhile the population continues to grow, the economy continues to grow, incomes continue to grow, and sharply lower real estate prices and historically low mortgage rates have allowed the market to unload a ton of excess housing inventory. The real estate problem, in short, most likely has been largely solved. Instead of worrying about whether more foreclosures are going to cause another price collapse and further reductions in construction activity, it makes more sense to wonder when construction activity and prices will begin to pick up, and by how much.

The good news, in other words, is that we have probably seen the end of the bad news in the housing and construction sectors. The lack of more bad news will optimism to return to a market that has been literally crushed by the worst setback in modern memory.

A decent manufacturing report




The December ISM manufacturing report was yet another in a string of recent reports that shows the U.S. economy is slowly improving rather than sliding into another recession. The weakness that surfaced last summer has been at least partially reversed. As the top chart suggests, the current level of the ISM index is consistent with real GDP growth in the fourth quarter of at least 3%, and possibly as high as 4% (I think 3-3.5% is likely).


Even export orders picked up, which is good since this suggests that Europe's financial woes have not seriously affected the health of the global economy.

The ISM report was far from being robust, but it definitely refutes the notion that the U.S. and global economies are struggling. In the context of a market that is still priced to something like a global recession or even depression (i.e., 2-yr Treasury yields of .25% and 10-yr Treasury yields of 2.0%), this is very good news.