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The State Of The Economy: Perception Or Reality?

May 31st, 2007 | by Daniel DiRito |

Well the tenuous state of the economy just elbowed its way back into the spotlight amidst the ogling over record highs in the stock exchanges. Gross Domestic Product (GDP) grew by a paltry .6 percent during the first quarter of 2007…less than half of the estimate. If this slow growth were to persist throughout the year, GDP will end the year with total growth of less than 2.5 percent.

My goal isn’t to strike the economic alarm bell, but I suspect that the state of U.S. commerce may not be as rosy as many had hoped…especially when one factors in declining home values and the associated rise in foreclosures. One must also consider the nature of the loan products that are attached to a huge number of these homes as well as the overall shift in credit strategies that can be summed up in the oft heard term “subprime lending”.

Let me share some information from a few sources and you can draw your own conclusions as to the economic prospects in the coming months.

From The Associated Press – 05/31/07:

WASHINGTON (AP) — The economy nearly stalled in the first quarter with growth slowing to a pace of just 0.6 percent. That was the worst three-month showing in over four years.

The new reading on the gross domestic product, released by the Commerce Department Thursday, showed that economic growth in the January-through-March quarter was much weaker. Government statisticians slashed by more than half their first estimate of a 1.3 percent growth rate for the quarter.

The main culprits for the downgrade: the bloated trade deficit and businesses cutting investment in supplies of the goods they hold in inventories.

“We are still keeping our head above water — barely,” said economist Ken Mayland of ClearView Economics.

For nearly a year, the economy has been enduring a stretch of subpar economic growth due mostly to a sharp housing slump. That in turn has made some businesses act more cautiously in their spending and investing.

Federal Reserve Chairman Ben Bernanke doesn’t believe the economy will slide into recession this year, nor do Bush administration officials. But ex Fed chief Alan Greenspan has put the odds at one in three.

So to begin with, the former Fed Chairman estimated that there is a 33% chance of a recession…before the first quarter GDP figures were released. Perhaps his prediction has changed?

The economy, unlike many other measurable statistics, depends in some part on the confidence of the consumer; hence consumer confidence is regularly calculated and reported. At the moment, consumers remain relatively positive about the economy…though I suspect that is driven in large part by the low unemployment figures and the stock market’s recent run of record breaking closings.

I’m of the opinion that gas prices, the drop in home values, rising foreclosure rates, and a looming bear market will soon facilitate a downward shift in confidence…which will likely initiate a compounding effect with regards to the factors that figure into this first quarter dip in economic growth.

From The Elliott Wave Theorist - 05/18/07:

There is an important event for believers in perpetual inflation to explain: the trend of yields from bonds and utility stocks. In the 1970s, prices of bonds and utility stocks were falling, and yields on bonds and utility stocks were rising, because of the onslaught of inflation. But in the past 25 years bond and utility stock prices have gone up, and yields on bonds and utility stocks have gone down. Once again, this situation is contrary to claims that we are experiencing a replay of the inflationary 19-teens or 1970s. Those investing on an inflation theme cannot explain these graphs. But there is a precedent for this time. It is 1928-1929, when bond and utility yields bottomed and prices topped in an environment of expanding credit and a stock market boom. The Dow Jones Utility Average was the last of the Dow averages to peak in 1929, and today it is deeply into wave (5) and therefore near the end of its entire bull market. All these juxtaposed market behaviors make sense only in our context of a terminating credit bubble. This one is just a whole lot bigger than any other in history.

Some economic historians blame rising interest rates into 1929 for the crash that ensued. Those who do must acknowledge that the Fed’s interest rate today is at almost exactly the same level it was then, having risen steadily—and in fact way more in percentage terms—since 2003. So even on this score the setup is the same as it was 1929. Remember also that in 1926 the Florida land boom collapsed. In the current cycle, house prices nationwide topped out in 2005, two years ago. So maybe it’s 1928 now instead of 1929. But that’s a small quibble compared to the erroneous idea that we are enjoying a perpetually inflationary goldilocks economy with perpetually rising investment prices.

As to whether the Fed can induce more borrowing by lowering rates in the next recession, we will have to see, but evidence from the sub-prime and Alt-A mortgage markets suggest more strongly than ever that consumers’ and investors’ capacity for holding debt is maxing out. I see no way out of the current extreme in credit issuance aside from the classic way: a debt implosion.

When thinking about the ability of consumers to absorb more debt, there are several factors to consider. First, Americans are addicted to credit and credit card debt is a key component of that debt. In the month of March alone, consumer credit debt rose by $13.46 billion dollars…and total consumer debt stands at $2.425 trillion dollars. More importantly, consumer debt is anticipated to rise 6.7 percent this year.

At the same time, mortgage debt has evolved to include new products…many that leave homeowners vulnerable to interest rate fluctuations…and others that actually extend the amount of credit beyond the actual value of the home predicated on evidence of the borrowers prior positive credit history (occasionally called 125% loans). The bottom line, as I view the situation, is that much of the recent run of strong economic data is a result of debt spending…debt born of easing credit standards coupled with rising home values and the ability to borrow and spend this perceived paper equity.

From Contrarian Chronicles at MSN Money - 02/26/07:

Meantime, the big question remains: When will folks be forced to connect the dots? Unknowable though the answer may be, my friend in London provided a clue, via a recent e-mail:

“You and I and a select group of others have been all over subprime for months now. But today (last Wednesday) is the first day where equity managers have been in to us, asking questions about subprime. Until today, most of the equity managers knew something bad was happening in subprime, but were prepared to assume it was not going to be a problem for the wider credit market, the economy, and so on.

“Slowly but surely, people are starting to get it, and slowly but surely, I am starting to think that the tipping point in credit — via a subprime-generated shambles in CDO (collateralized debt obligation) land — is closer than anybody imagines.”

Behind the scenes in the land of financial black boxes, the time bomb is ticking.

Lastly, I would like to share a quote from Easy Al, taken from a speech dated April 8, 2005 (not so very far from the zenith of the real-estate market). I don’t talk much about Al Greenspan anymore, mostly because he’s gone from the scene, and I spilled so much ink on him before he left. But if you had to pick one man responsible for the imbalances in America and the financial hangover coming our way, it would be Al, who said:

“Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants…With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers…Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending…fostering constructive innovation that is both responsive to market demand and beneficial to consumers.”

Note that Greenspan was singing the praises of subprime lending while working to keep the economy moving forward…calling it “innovation” and defining it as “advances in technology”. Excuse me, but when a lending institution alters its credit standards based upon the need to compete with other lenders in a tightening market that has been in an extended period of acquisition and consolidation…whereby smaller banks and lenders are acquired based upon total assets and growth projections…is there any doubt that “innovation” and “technology” are simply code words for the mechanisms that have been instituted to serve the players that stand to benefit most from merger mania?

If one accepts the rhetoric, one would have to conclude that lenders have been able to magically extract reasonable risk borrowers from the trash heap of bad credit scores. Don’t get me wrong, the extension of credit ought to cut both ways…meaning that there are clearly borrowers who deserve a second chance and there ought to be a means to allow as much…but the historical take on bankers has been that they like to lend money to those who don’t need it. If I understand the new dynamic, the prevailing momentum is to create the rationale to lend more because size and sales have supplanted stability as the gold standard.

From - 05/29/07:

May 29 (Bloomberg) — Home prices in the U.S. dropped last quarter for the first time in almost 16 years, as 13 out of 20 cities reported declines in March.

The value of a house dropped 1.4 percent in the first three months of the year from the same period in 2006, according to a report today by S&P/Case-Shiller. Prices last fell during the third quarter of 1991.

The retreat may deter owners from tapping into home equity for extra cash, economists said. Combined with record gasoline prices, lower home prices raise concern consumer spending, which accounts for more than two-thirds of the economy, will slow.

The decline in prices may not be large enough to concern the majority of home owners, economists said. The drop in prices in the 12 months ended March pales in comparison to the 157 percent gain over the previous 15 years.

A recovery in housing is being held back by a wave of subprime mortgage defaults, which is throwing homes back onto the market and prompting banks to tighten lending standards for borrowers with poor or limited credit histories.

“These data are probably only just beginning to reflect the impact of problems in the subprime mortgage market,” said James O’Sullivan, a senior economist at UBS Securities LLC in Stamford, Connecticut, in a report to clients. “Further declines seem likely.”

Again, I’m convinced that economic insiders are hesitant to acknowledge the full breadth and depth of the growing list of negative factors. Keep in mind how consumer confidence works when reading that declining home prices “may not be large enough to concern the majority of home owners […] in comparison to the 157 percent gain over the previous 15 years.” I view the prior fifteen years of growth as the dam that is holding back a rising tide of reality…a reality that once released from its state of anesthetization will rapidly catapult consumer confidence in the opposite direction.

Human nature is such that we prefer to ignore the obvious if the obvious has the potential to disrupt the status quo. At the same time, our human nature tends to lead us to panic once reality escapes its domicile of denial. Word of mouth about the family down the block that is in foreclosure along with the neighbor that has dropped the price of their home for the fifth time as well as the number of for sale signs mom sees while carpooling the kids to school have a way of breaching our built in barriers to bad news. Once that happens, it’s a new world…one that seemingly emerges overnight. I used to have a saying that went, “Everything’s shit…until it isn’t”…and in this instance, the reverse may well hold true.

There may not be a comparable match for the relationship between perception and reality that exists within the construct of consumer confidence. These two forces have a tremendous impact on the actual direction of our economy…which is a direct byproduct of the economic decisions we make. As it now sits, if today’s perceptions cannot withstand the growing body of evidence that foreshadows economic tumult, we may be fast approaching an all too dreadful day of awakening.

Cross-posted at Thought Theater

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