RISKY
BUSINESS Investing in a fool's
paradise By Jephraim P Gundzik
The rapid slowing of America's economy has
been shrugged off by stock markets worldwide,
which continue to vault higher on the increasingly
misplaced notion that corporate profits will grow
perpetually.
In sharp contrast, currency
markets have grasped the idea that the US economy
is falling into recession, punishing the dollar.
As economic weakness intensifies in the months
ahead, expect
dollar
depreciation to accelerate. The dollar is likely
to drop by at least 15% against most currencies by
the end of 2007.
Cracks in the facade of
America’s economy first appeared in early 2006
when the housing market abruptly began to whither.
Rather than tightening credit conditions, the
housing market’s decline was initiated by plunging
affordability of new and existing homes combined
with rampant overbuilding across America.
The growing weakness of the housing market
was ignored by investors and analysts who assumed
that very easy credit conditions engineered by the
Federal Reserve would prompt a rebound.
Instead of rebounding, weakness
intensified. According to statistics produced by
the Department of Commerce, new home sales plunged
by 18% in 2006, a decline unmatched since 1981.
Though Commerce statistics showed that new home
prices edged higher in 2006, this data was greatly
distorted by enormous incentives that home
builders lavished on buyers, which artificially
propped up prices.
Adjusting these
statistics for the impact of incentives like free
swimming pools, landscaping, custom kitchens and
even new cars would show that actual new home
prices fell sharply in 2006, an event
unprecedented in the US since 1970. As the housing
market collapse unfolded in 2006, it was joined by
collapsing private investment.
Initially,
the collapse of private investment was driven by
plummeting residential fixed investment, which was
flat in the first quarter but dropped at an
annualized rate of 17% during the final three
quarters of 2006. The decline of residential fixed
investment was the predictable outcome of falling
home prices and the subsequent drop in home equity
traditionally used to finance such investment.
During the fourth quarter of 2006,
nonresidential or business fixed investment also
began to weaken, falling by three percent. This
sudden decline of business investment signaled
that economic weakness emanating from the housing
sector had begun to spread throughout the economy.
It also signaled that much leaner economic times
were close at hand.
Equity investors and
analysts universally ignored the obvious weakening
of the US economy and its negative implications
for global economic growth, relentlessly pushing
stock markets around the world to record highs
during the final months of 2006 - a trend that has
continued during the first four months of 2007.
While stock markets have come to view
economic recession as benign, the same is not true
for currency markets, which pushed the value of
the dollar down against most currencies beginning
in late 2006. Dollar weakness has accelerated in
the first four months of 2007. The dollar has
plummeted to 25-year lows against sterling and has
reached record lows against the euro recently.
More broadly, the trade weighted value of
the dollar is also falling off a cliff. The
Federal Reserve’s Trade Weighted Currency Index
dropped to a record low last week, indicating that
dollar weakness has become pervasive. Economic
statistics showing the US economy weakened further
in the first quarter of 2007 were the principal
factor prompting renewed downward pressure on the
dollar.
From silver to lead lining Like equity investors, most economists refuse
to believe that growing weakness in the economy
portends economic recession later in 2007. As of
early April, the consensus forecast for US
economic growth in 2007 among leading economists
was 2.3%-plus. At the same time, less than 25% of
economists surveyed expected the economy to fall
into recession. Such bewildering optimism has
inspired the world’s financial media and fueled
stock market advances.
This optimism will
fade as America’s very weak economic reality
dissipates the clouds on which investors and
economists are floating. Last week, several
important economic indicators were released all of
which showed America’s economy continued to weaken
in the first quarter of 2007. Commerce Department
statistics showed that new home sales fell by 23%
in the first quarter of 2007 compared to the same
period in 2006.
Statistics produced by the
National Association of Realtors showed a similar
decline of existing home sales and sliding home
prices. The housing market collapse is prompting a
surge in foreclosure filings, which were up 35% in
the first quarter of 2007 compared with the same
period in 2006. During this period, one of every
264 households in America was under some type of
foreclosure. Rapidly rising foreclosures are the
main factor undermining America’s besieged
subprime mortgage lenders.
Commerce
Department statistics on durable goods orders,
which showed a rebound of 3.4% in March, impressed
investors, prompting a stock market rally. Somehow
these investors ignored the fact that this rebound
was entirely driven by unusually large orders for
aircraft. Unnoticed within these statistics was
data showing that business capital spending orders
went into freefall, contracting at an annualized
rate of over 15% in the first quarter.
The
coup de grace of course, was the
preliminary estimate of first quarter growth
released on Friday. According to the Commerce
Department, domestic growth was just 1.3% in the
first quarter of 2007. Economists had expected
growth to be closer to two percent, revealing
again that unfounded and widespread optimism is
coloring perceptions. This preliminary estimate of
growth will be revised lower as neither private
consumption nor business investment was as strong
as initially indicated.
With foreclosures
and subprime defaults spreading and credit
standards tightening across the banking system, a
rebound in America’s housing market during 2007 is
extremely unlikely. Without a housing market
recovery, business investment will continue to
decline, prompting layoffs, and much weaker
private consumption growth. The probability that
the US economy will fall into recession during the
second half of 2007 is about 75%.
As the
US economy continues to weaken in the months
ahead, the dollar’s depreciation will accelerate.
A further decline in the value of the dollar of at
least 15% against most currencies is likely by the
end of 2007. This depreciation is likely to be fed
by plunging US equity values as economists are
forced to revise their economic growth forecasts
much lower and America’s weak economic reality
overtakes strong economic dreams.
Jephraim P Gundzik is president
of Condor Advisers. Condor Advisers provides
investment risk analysis to individuals and
institutions worldwide. Visit
www.condoradvisers.com for more information.
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