Market Comment

The Developing Storm

The housing situation is continuing to worsen, and it is spreading to the rest of the economy, increasing the probability of a recession that has not been factored into the stock market. August new single-family home sales were down 8.3% from July and off 21.2% from a year earlier to the lowest level in seven years. Median prices were down 7.5% year-to-year with inventories of unsold homes rising to an 8.2-month supply. This reinforces the previously released data on August existing home sales, which declined 4.3% for the month and 13% from a year earlier to the lowest level since mid-2002. Continuing volume weakness, tighter mortgage credit, weak pricing and ongoing mortgage resets are likely to lead to more mortgage credit problems and foreclosures that will keep economic and financial risks high.

The industry data was confirmed by individual companies as well. Lennar reported a record loss attributable to a drop in sales prices, a decline in home deliveries and heavy write-downs. The company said it has cut its workforce by 35% this year and expects to pare more employees soon. CEO Stuart Miller stated “Overall, the supply of homes to sell continues to climb in many of our markets and we’re not yet able to get a good reading on how quickly the inventories will be absorbed or whether it will continue to increase as foreclosures increase and add to inventory.” Lennar reported that new home orders were down 28% with a cancellation rate of 32%. Similarly, KB Homes reported a big third quarter loss with CEO Jeffrey Mezger stating “We see no signs that the housing market is stabilizing in the near future.” In addition the Case-Shiller 10-metro housing price index dropped 4.4% in July while the 20-metro index declined 3.9%. This happened prior to the August credit market upheaval that probably made things even worse. It is notable that the NAHB housing index recorded its lowest level on record for September in every subcategory.

The severe housing slump is already beginning to hit consumer spending. The International Shopping Center Chain Store Index has now declined more than 1% for two straight weeks for the first time since December 2004, and has broken down to its lowest level of the year as a result of slower job growth, a diminishing wealth effect, record debt burdens, little savings cushion and high energy prices. Target has reduced its September forecast of same-store sales growth to 1.5-to-2.5% from a previous 4-to-6% while a number of other retailers have reduced their estimates as well. Furthermore, ISI Group points out that a revision of mortgage equity extraction (MEW) estimates has further negative implications for the consumer spending outlook. The 2006 peak for MEW has been raised to almost $1 trillion with the second quarter 2007 estimate still at a relatively high $500 million. ISI states that that this means the coming decline in MEW will be greater than previously estimated, increasing the coming hit to consumer spending.

Furthermore, the developing economic weakness is not restricted to housing and consumer spending. Core new orders for durable goods fell 0.7% in August and are down 2% since year-end, indicating future weakness in capital goods expenditures. The economy.com survey of business confidence has been falling sharply, also not a good omen for employment or capex. ISI Group also points out that the Conference Board leading indicators have been unchanged for 21 months. That has proven to be a recessionary signal in the past. In addition, we note that the OECD leading indicator has been declining significantly while Japan’s GDP has declined in the most recent reported quarter.

In our view, therefore, the chance of recession is high and will not be stopped by the current Fed rate cut or those to come. History indicates that once recessionary forces take hold they play out despite any moves by the central bank. In addition, since the stock market has not discounted a recession the downside risks are high. The last eight recessions were associated with an average market decline of 30%. In comparison the S&P 500 at its low a few weeks was only about 10% below its peak. The current rally has been a psychological reaction to the Fed rate cut and is likely to lose momentum soon as economic reality sets in. Market observers seem to have the same faith in the Fed that four-year olds have in their mommies and daddies. Although we all wish that the Fed could wave a magic wand and make everything OK, that is not the way the economy or the markets work, and eventually we have to face reality.