Before he leaves Merrill Lynch, the Chief Economist has one last warning: SELL.
Need to see housing stabilize to put in a definitive bottom
We have said it once and we shall say it again, that it all comes down to housing, the quintessential leading indicator. It was the deflation in home prices in the summer of 2006 that led the crunch in the mortgage market later that year, which in turn led the credit collapse in the summer of 2007. That led the onset of the bear market in the fall of 2007; which subsequently led the recession at the end of that year. That finally triggered the severe consumer down-leg, which is ongoing, notwithstanding the seasonal noise in the data through the first two months of 2009. So, for the domino game to flip in the other direction, as is it did in the aftermath of the 1990-91 meltdown in the economy, stock market and consumer confidence – we desperately need to see housing prices stabilize to put in a definitive bottom.
A total lack of equilibrium in the housing market
To reiterate, there is simply no sustainable recovery in the economy, the stock market or the financial backdrop until we get some clarity on the outlook for residential real estate prices. It was rather telling that the Case-Shiller home price index sagged a record 2.8% in December. As the nearby table illustrates, every major city had double-digit home price declines over the past three months. And not only was January the 30th consecutive monthly decline, taking the cumulative decline from the mid-2006 peak to an unprecedented 29%, it is a critical sign that we continue to have a total lack of equilibrium in the housing market. In other words, the “price” is still telling us that, at the latest data point, we still have more sellers than buyers, which is amazing considering that this is now a three-year-old depression in the housing market, despite the fact that affordability has improved to its best level ever recorded.
Would take over three years to achieve price stability
The problem is that prices do not begin to stabilize until we break below eight months’ supply – and they tend to deflate 3% per quarter until that happens. So as impressive as it is that the builders have taken single-family starts below underlying sales, their efforts are just not sufficient to prevent real estate prices from falling further. In fact, even if the builders were to declare a moratorium immediately – that is taking starts to ZERO – demand is so weak and the unsold inventory so intractable that it would now take over three years to achieve the holy grail of price stability in the residential real estate market.
A lethal deflationary combination
The combination of a 10% savings rate and 10% unemployment rate is a lethal deflationary combination that the Obama dream team of economists seems prepared to fight hard against, and we wish them good luck, but we think we are in for another year of very weak economic growth that warrants a focus on safe income wherever you can get it, and a focus on high-quality assets and defensive sectors in the equity market.
S&P 500 will hit new lows, in our view
We remain of the view that the risk of earnings disappointments will take the S&P 500 to new lows before the bear market runs its course. Based on the outlook for corporate profits and the typical trough P/E multiple that characterized recession bear markets, it would not surprise us to see the S&P 500 gravitate in a 475-650 range for an extended period of time.
Will retest or break below 2% on the 10-year Treasury note
As for the here and now, just consider that consumer discretionary stocks have outperformed the market by 520 bps since the S&P 500 hit its interim low back on March 9, while the homebuilders have outperformed by nearly 2000 basis points. It could be time to sell some calls. As for bonds, we would just have to assume that if the yield on the 10-year note sank to 2% in December on the rumor of the Fed buying Treasuries, we will ultimately retest or perhaps even break below that level on the fact. Considering that the 10-year T-note tested the 3% threshold no fewer than four times before the Fed made its quantitative easing announcement last month, at least we know what the risks are to the view. It seems pretty one-sided.