In our view the market is seriously overestimating the strength of the economy as the usual drivers of a sustainable recovery, namely consumer spending and housing, are in no condition to provide the catalyst that leads to steady growth. The statistical growth we have witnessed to date is merely a bounce back from the brink of a potential financial disaster that was averted by massive stimulus. However, the lingering after-effects of the credit crisis are creating strong headwinds against a typical post-war type of recovery.
The rise in consumer spending in recent months is nowhere near as strong as the media and the Street would have you believe. The extremely sharp decline in consumer spending during the recession was caused by both negative fundamental factors and outright fear of a collapse. Now the fear is gone, but the negative fundamentals remain. Unemployment remains high, jobs are hard to get and credit is tight. Moreover the consumer has barely begun to pay down the enormous debt accumulated over the last decade, and the deleveraging has a long way to go. Savings rates are still low by historical standards and will take time to return to normal.
The housing industry is still in serious trouble and appears to have turned down again after the bump created by the home buyer tax credit. Existing home sales were down 0.6% in February, the third consecutive drop. Sales are back to the depressed level that existed before the start of the tax credit. In addition new listings were up 10% to the highest level since September while inventories rose to an 8.6 months supply.
The problems were also reflected in new home sales, which were down 2.2% and have now been lower in six of the last seven months to a record low of 308,000 units. Inventories rose 1.3% to a 9.2 months supply despite the fact that new housing starts have been bumping along the bottom. The extension and expansion of the original tax credit does not seem to have given much of a boost to sales and, any event, the credit expires on April 30th. It is also important to note that reported inventories do not include the so-called “shadow inventories” of homes where mortgages are in default but have not been foreclosed as well as the 23% of homes with mortgages that are “underwater” but have not yet defaulted. Furthermore we are just now entering a period where a rising number of adjustable rate mortgages are undergoing automatic rate increases that will put additional mortgages in jeopardy of default and foreclosure.
The aforementioned foreclosure problems will put significantly more homes on the market and result in further declines in home prices. This will also have the adverse effect of creating more toxic assets at financial intuitions and further restricting their ability to lend.
At the same time a lot of the government stimulus is coming off. As we’ve previously mentioned the Fed program to buy 1.25 trillion of MBS is ending on March 31st and the housing purchase tax credit is ending on April 30th. A major portion of the economic recovery to date has been supported by massive stimulus and we doubt that the growth is sustainable on its own. While the possibility of even more stimulus exists, the angry sentiment against further increases in the budget deficit makes this difficult to accomplish.
The festering of the Greek financial crisis is illustrating the continued overhang of global credit problems that threaten to spread. As we write, the EU has announced a draft agreement to rescue Greece with the help of the IMF. Our initial impression is that the agreement, at this point, is very vague. The parties have agreed to bail out Greece only if it’s necessary, and it will take a unanimous vote on the part of the EU members to decide. As we’ve stated in previous comments there are no good options and any proposed solution has serious side effects.
Overall, the market has been on a virtual parabolic rise since last year’s low and the recent jump above 1150 on the S&P 500 has led to an apparent give-up by the doubters. The action seems to be spurred by a combination of true believers, pure momentum players and those who are just going along for the ride and ready to exit at the any negative sign. This is more in tune with an impending top than substantial new highs. The market is now selling at about 18.5 times our smoothed trendline GAAP earnings, a P/E ratio associated with market peaks for almost 200 years prior to the last decade