Vigilant Investor

We hope everyone has a safe New Year Eve, and a Happy and Healthy 2006!

• Blissful fixed-income markets could be in for a rude, post-holiday awakening from the coming week’s economic data.
• /Home loan applications fall to over 3-1/2-yr low
• Christmas presents portend ominous future
• World imbalances: Economics, physics, philosophy?
• U.S. Economy Expanded at a 4.1% Annual Pace in Third Quarter
• Gold looks good after glittering year
• Wall St expects confusion in new numbers
• Analysts: U.S. Currency to Fall in 2006

and

• Happy 2006: Australians, Asians Celebrate

That headlines states it clearly enough. The Arizona Republic elaborates just a bit.

That the crazy pace of price appreciation would slow, well… that was inevitable. What happens next is still open to debate. Collapse? Stagnation? More moderate growth? Questions to watch include:

• What happens if ARM mortgage rates increase?
• What happens when home and condo speculators can’t unload that second or third home at a tidy profit:?
• What happens if the economy slows to a recession — as the inverted yield curve suggest might happen — and those who got themselves into tight mortgages suddenly find themselves in a pinch?
• The Fed policy related to money supply: inflation is inflation.

We shall see.

However, we can’t help but wonder why concepts like regression to the mean should not apply to the housing bubble when we consider “average rates of appreciation”.

Yet another article questioning the legacy of Greenspan — and U.S. deficits — this one from BBC:

Deficits could harm Greenspan’s legacy

While we are no fans of the Greenspan policy era, we can’t blame the guy entirely. Surely the Fed’s manipulating of rates causes misjudgment after misallocation, leading even to bubbles. But we can’t blame Greenspan or the Fed for the absurd business and tax environment that Congress has created in the U.S., making domestic business operations too costly to be competitive. That is catching up with us, and The Fed is merely aiding and abetting.

For more than a few months now we’ve been calling for a back-off in the equity markets and the second leg of a recession in 2006. How severe is to be seen — as is if such a prediction should come to pass.

As for the call for a recession, bond yields seem to confirm that a recession is around the corner when the yield of 10-year treasuries fell below the yield of those for two-year treasuries for the first time since 2000. Ordinarily yields for 10-year’s are higher, reflecting the cost of uncertainty when lending money for longer periods of time. What we have today, instead, is what’s called an inverted yield, and only twice in the last 40 years has such an inversion not delivered a recession in their wake. All of the last six recessions we preceded by such an inversion.

In response, U.S. stocks reacted .

Given our Economic Storm Cloud list, we suggest folks act with caution vs. defaulting you way along on autopilot, as if our times are ordinary. Of course, nobody has a crystal ball. But why pretend nothing is wrong??

In 2006, healthcare benefit promises will be required to be added to corporate balance sheets. To date, they have been footnotes. Now these massive obligations will be up, front and center for analysts to see — an estimated $300 billion unfunded tab. GM has already made it clear that it has little chance in honoring more than $77 billion of such promises, of which $61.4 billion is unfunded according to research at S&P.

Per S&P, that obligation stands at $292 billion for the 500 largest companies alone, nearly twice the exposure these firms have to pension obligations — a subject we’ve covered for many years already. Combined, that totals more than $440 billion — about one-fifth of the entire book value of those same companies according to the New York Post. Unlike pensions, healthcare promises have hardly anything backing them.

Read the entire NY Post article for the frightening details.

“FOURTEEN years ago, Yoshihisa Nakashima looked at this sleepy suburb an hour and 20 minutes from downtown Tokyo and saw all the trappings of middle-class Japanese bliss: cherry-tree-lined roads, a cozy community where neighbors greeted one another in the morning and schools within easy walking distance for his two daughters.”

There are still more than a few folks who are skeptical that we are in the midst of a top of a real estate bubble. Others who acknowledge that prices may have gone a bit nutty will justify them with talk that homes are now days “investments”, akin to a savings account, instead of an illiquid, depreciating consumer good that require ongoing maintenance input.

“So Mr. Nakashima, a Tokyo city government employee who was then 36, took out a loan for almost the entire $400,000 price of a cramped four-bedroom apartment. With property values rising at double-digit rates, he would easily earn back the loan and then some when he decided to sell.”

Whatever the case, the one common trait to all bubbles is that those who participate in them rarely see them for what they are until it is far, far too late to safely adjust.

Can we say for sure that the U.S. housing market is in a bubble? We can’t offer any guarantees. We can only offer regular various opinions and assurted evidence for our readers to judge.

“Or so he thought. Not long after he bought the apartment, Japan’s property market collapsed. Today, the apartment is worth half what he paid. He said he would like to move closer to the city but cannot: the sale price would not cover the $300,000 he still owes the bank.”

In our opinion the Japanese Real Estate Bubble is a good case example to study for similarities to the U.S situation. The New York Times published a nice piece (from which the quotes above are poached) covering the subject in all its glory — the go-go atmosphere, the denial, and the subsequent collapse and suffering of owing lots more on a mortgage than a property is worth.

Maybe we are not having a housing bubble. But do you really want to gamble your future that we are not?

We have been long critical of Greenspan’s work. Primarily we can’t overlook the massive increase of money supply over which he has presided:

As we’ve noted before, cranking up money supply diverts the nation’s core capital reserves and misdirects them from savers and the astute creator of capital, and on to movers and shakers — spenders and the politically connected. These latter two are not always the most prudent.

“Alan Greenspan has a record of repeated rescue operations during times of financial distress. From the stock market crash of 1987 to the S&L crisis of the early 1990s to the Asian crisis and the collapse of LTCM to the feared Y2K crisis to the bursting of the tech stock bubble, Greenspan has proven himself more than willing to bail out failed investors with additional doses of “liquidity” (the popular inflationist euphemism for inflation).

“The result of this has been to increase the willingness of investors to participate in speculative bubbles because they know that if things go wrong and they are unable to get out before the bubble burst, their good friend Alan Greenspan will bail them out and limit their losses. Greenspan has thus been responsible for bubbles like the tech stock bubble and the housing bubble both by suppressing interest rates and providing the “liquidity” needed to create the bubbles, and also by reducing investors fear of losses after the bubble bursts by creating the expectations that the Fed will bail them out.”

That’s from Stephen Carlson, who offers a fine summary of Greenspan’s work (The Mess Greenspan Leaves Behind) with which our readers ought to familiarize themselves.

Once common only to millionaires, the idea of owning a third home is making inroads with folks of dramatically more modest means. Is this yet another signal confirming the real estate bubble is worse than many folks think??

Read about it at the New York Times.

We’ve talked a good bit about the pension woes faced by the U.S. — just do a search on our site for reference. Earlier this week we even touched on the problems being faced by local governments, who for years could bury their pension obligations off balance sheet. Politicians could promise, Union leaders could benefit, leaving the ticking time-bomb for future officials, taxpayers and stunned employees to deal with.

As it turns out, the recent New York transit strike has roots in pension issues. Read about it in the New York Times.e

Stephen Roach (Chief Global Strategist at Morgan Stanley) succinctly discusses one of our biggest concerns for 2006.

For years now we have been in agreement with Roach about the unsustainability of a lopsided global economy — just one of many problems from our list of concerns for 2006 and beyond. Yet, in the face of our warnings, global imbalances continue to grow ever more distended, and few folks on any meaningful level seem to care. Regarding this indifference, says Roach, ” I suspect that 2006 will be a year when that ambivalence is shattered.”

History has a way of proving doom prognosticators wrong, if not — even when right — too early. So, who really knows when such a re-balance might occur? We can’t say for sure. However, we seriously respect the issue as a viable contingency around which folks should plan. In our opinion, this is not a matter of “if” a rebalancing will occur, but when it will start and how it will play out.

Yet the naysayers tell us that the markets continue to validate the current paradigm. So they are, but markets have proven that sometimes they get their valuations of correct information wrong — and badly so. Never mind the economy bulls’ talk of “new economic eras” and so forth, where the old rules no longer apply. That sounds all too familiar, as if its 1999 all over again. I tend to agree with Roach, who says, “I have long been wary of new theories that spring up to explain away old problems.”

Whatever the case, give Roach’s piece a read. Most folks are oblivious to this argument, and you’ll be better able to read the signs should such a rebalancing start if you know a bit of the details surrounding it.

Be vigilant. Think. Be smart!

Around Ernharth Group and this journal site, we communicate to others the evidence suggesting that there is a massive herd mentality when it comes to assessing the investment environment and the economy.

Joe Mysak at Bloomberg has a short piece on how Main Street follows whatever Wall Street tells it to do. While this covers complex laws surrounding bond issues for municipal treatment, in our opinion, it applies to the industry as a whole.

One question our site posits on a near daily basis is, how can Wall Street seem to be so indifferent and dismissive of so many core structural problems with the economy to suggest investing as usual in a healthy economy?

Yet most folks should have learned from the debacle of the bubble burst from 2000-2002 was that Wall Street had it awfully wrong in the late 1990s when suggesting that nothing was out of line, and that the new economy meant the rules were now different.

Many still will tell you the rules are different, and that the old boring restraints of economic gravity no longer apply. But that’s a risk you can take at your own peril.

General Economy

• Some prices plunge, but not for long
• CBO: U.S. likely to face long-term fiscal woesHouse passes bill to strengthen pensions
• Oil Super spike, Phase Two
• Goldman Sachs: Oil prices to stay high for years
• Time Bombs May Await Bernanke

Real Estate Updates

• Late Mortgage Payments Increase
• Home sales have seen better days
• Orange County housing prices back near peak
• State-backed mortgages aim to open up ownership
• Risky mortgages could be harder to get
• House Poor author takes hard look at the housing boom
• Home-sales pullback seen in 2006
• Housing Bears Bet on Shaky Credit
• Pssssfffffftt. Bubble, Bubble — Then Trouble
• Calif. home affordability holds near record low

While the current account gap (the U.S. Trade Deficit) narrowed unexpectedly in the 3rd Quarter, there are still plenty of reasons to be concerned about the general indifference we see day to day about current debt levels. (Of course, issues related to the trade deficit are far from resolved.)

For example, retail sales are supposedly more sluggish than expected, and retailers are forced to go out of their way with credit in order to make things move… like with zero percent financing.

Meanwhile, we hear lots about how corporations are flush with cash. Yet simultaneously, according to the Wall Street Journal, the Fed “borrowed $362 billion through credit market instruments in the third quarter. That’s not far off the levels of 1999 and 2000, points out Northern Trust economist Paul Kasriel. What’s more, corporate borrowing relative to corporate spending is quite high.”

Of course, then there are the risky adjustable rate and interest only mortgages that became very popular in the past few years. Many who have them could be in for a rude surprise when rates finally retrace their way in the inevitable process of regression towards the mean.

Meanwhile, we in the U.S. are not alone with our debt concerns. The Bank of England, according to the Guardian Unlimited, is growing alarmed at increasingly reckless lending by banks.

Of course, all of this hinges on the willingness of those providing liquidity to the debt markets — and their surprising willingness to lend in the face of an unprecedented economic environment. That’s the missing vigilance that “Bond King” Bill Gross of PIMCO warned of some time ago (The Last Vigilante: February 2004). When that vigilance returns after such a long absence, the correction could be extreme.

That process may be starting as across the globe investors begin discarding junk bonds, forcing the cost of borrowing up.

“The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it.

The first lesson of politics is to disregard the first lesson of economics.”

             –Thomas Sowell (Economist)

Our management firm has been bullish on Gold for several years, for all the reasons enumerated daily here at our site. In our opinion, it is not a short term play, though — and the recent ups and downs make it abundantly clear that you need to hold on to your hat for a wild ride. And of course, there is nothing guaranteed.

For our readers questioning the wisdom of owing the metal at the moment, George Kleinman has a nice piece explaining the metal in the context of the recent big upswing to $540 and the giveback (as of this writing, Bloomberg shows gold trading at $504), and from a historic perspective.