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Crash Prophets, Part 2

In yesterday’s blog post, I talked about how some market watchers, specifically Richard Bookstaber, Peter Bernstein, Jeremy Grantham, and Gary Shilling, are warning of a fast-approaching U.S. financial crisis. Continuing the theme of “crash prophets,” today’s post focuses on legendary investors George Soros, Warren Buffett, and Jim Rogers, and what each is saying about the future of the U.S. economy.

George Soros is a Hungarian-born billionaire investor, philanthropist and author. The American businessman is known as “The Man Who Broke the Bank of England” as he earned $1.1 billion after speculating on the British pound in 1992, believing it was overvalued. He is also recognized for his involvement with the Quantum Fund, one of the most successful investment funds ever with an average annual return of 31% throughout its 30-year history. Back in January 2006, George Soros told an audience in Singapore that, “The soft landing (for the U.S. economy) will turn into a hard landing. That’s why I expect the recession to occur in 2007, not 2006.” Soros explained that a slowing U.S. housing market would be the catalyst for a U.S. recession in 2007. Back on June 2, 2007, AME Info quoted Soros as saying, “I believe the global economy has been sustained by a housing boom that took on the characteristics of a bubble,” and he cautioned, “I expect an initial soft landing to turn into a hard one when the slowdown does not end.” On the U.S. and global economy, “A slowdown in the United States will be transmitted to the rest of the world via a weaker dollar. That is why I expect a worldwide slowdown starting in 2007.” Finally, Mr. Soros stated that, “The savings of the world are sucked up into the center to finance over consumption by the richest and largest country, the United States. This cannot continue indefinitely and when it stops the global economy will suffer from a deficiency of demand.”

Warren Buffett, “The Oracle of Omaha,” is a famous investor, head of Berkshire Hathaway, and also the world’s second richest man. On October 26, 2003, Warren Buffet wrote a piece for Fortune entitled “Why I’m not buying the U.S. dollar.” Although a little dated, this article, and Buffett’s subsequent bet against the dollar, gives us insight as to where Mr. Buffett thinks the U.S. dollar and economy are going. Buffett said, “I started way back in 1987 to publicly worry about our mounting trade deficits — and, as you know, we’ve not only survived but also thrived. So on the trade front, score at least one “wolf” for me. Nevertheless, I am crying wolf again and this time backing it with Berkshire Hathaway’s money.” Regarding his actions on the U.S. dollar, he explains, “And my reason for finally putting my money where my mouth has been so long is that our trade deficit has greatly worsened, to the point that our country’s ‘net worth,’ so to speak, is now being transferred abroad at an alarming rate.” On the United States having avoided a financial crisis so far, Buffett says, “We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits. At a point, so it was claimed, the spree of the consumption-happy nation would be braked by currency-rate adjustments and by the unwillingness of creditor countries to accept an endless flow of IOUs from the big spenders. And that’s the way it has indeed worked for the rest of the world, as we can see by the abrupt shutoffs of credit that many profligate nations have suffered in recent decades. The U.S., however, enjoys special status. In effect, we can behave today as we wish because our past financial behavior was so exemplary — and because we are so rich. Neither our capacity nor our intention to pay is questioned, and we continue to have a mountain of desirable assets to trade for consumables. In other words, our national credit card allows us to charge truly breathtaking amounts. But that card’s credit line is not limitless.” Finally, Mr. Buffett closes with a warning to all those who think the trade deficit is just another obstacle that can be overcome. “We still have a truly remarkable country and economy. But I believe that in the trade deficit we also have a problem that is going to test all of our abilities to find a solution. A gently declining dollar will not provide the answer. True, it would reduce our trade deficit to a degree, but not by enough to halt the outflow of our country’s net worth and the resulting growth in our investment-income deficit.”

Jim Rogers is a legendary commodities trader who picked the bottom of the commodities bull market in 1999. He is also one of the co-founders of the Quantum Fund, along with George Soros. Of the three investors profiled, Rogers is the most vocal regarding the direction the U.S. is headed. In a Reuters article on December 16, 2006, Jim Rogers talked about the future of the U.S. dollar, and predicted, “It’s only a matter of time before the beleaguered U.S. dollar loses its status as the world’s reserve currency and medium of exchange.” He added, “The dollar is a terribly flawed currency… You should hold as few dollars as possible. The dollar’s decline would go on for years to come.” In an interview with iTulip on April 3, 2007, Rogers said that a U.S. recession will occur soon. “I see a recession, and for a variety of reasons. Automobiles are in recession. Housing is in recession. There’s been an inverted yield curve for a while. You have a slowdown in business spending. The subprime mortgage and junk bond markets are a disaster happening or waiting to happen in the financial area. There are plenty of things going on. Plus we’ve had recessions every four to eight years since the beginning of time, so there’s nothing unusual about the fact that we’re about to have another one.” On housing, Jim Rogers is especially bearish. In the same iTulip interview, he responded to a question about the housing downturn and the consensus of economists that the correction is largely over by replying, “It has a good long way to go because never before in American history have so many people been able to buy houses with no money down. Even during the 1920s when the banks first tried interest-only mortgages borrowers at least had to put some money down. This time a lot of borrowers have put no money down on interest only mortgages. The results will be much worse.” In a May 14, 2007, Reuters article, he predicts an eventual U.S. real estate crash. Rogers said, “You can’t believe how bad it’s going to get before it gets any better.” He adds, “It’s going to be a disaster for many people who don’t have a clue about what happens when a real estate bubble pops… Real estate prices will go down 40-50 percent in bubble areas. There will be massive defaults. This time it’ll be worse because we haven’t had this kind of speculative buying in U.S. history.”

“When markets turn from bubble to reality, a lot of people get burned.”

To be continued…

Crash Prophets

Yesterday I read an article on MarketWatch that I want to share with you. Mutual funds columnist Paul Farrell wrote “ ‘Pop!’ Bubbles are great for America!” in response to author Daniel Gross’ new book Pop!: Why Bubbles Are Great For The Economy. In all fairness, I haven’t had a chance to read the book yet. But from what I’ve heard so far, Gross argues that economic bubbles and their subsequent popping are not to be feared, as innovation and infrastructure are utilized in the bubble’s aftermath to spur new economic growth. Rather than placing a positive spin on this “creative destruction,” Farrell sympathizes with the Main Street investors squashed by the popping of these bubbles. More importantly, he points out several prominent market watchers who are warning us that we are in the midst of economic bubbles today.

Richard Bookstaber, a risk manager and derivatives designer, played a role in the 1987 Wall Street crash and 1998 LTCM collapse. In his new book, A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation, he says, “The financial markets that we have constructed have become so complex. And the speed of transactions so fast that apparently isolated actions and even minor events can have catastrophic consequences . In the Wall Street Journal on May 18, Bookstaber warned, “The odds are pretty high that we’ll see other dislocations that match the type of turmoil we saw with the crash in 1987 and with the LTCM crisis… Any one derivative, with some exceptions, may be easy to track. But by the time you layer a lot of them one on top of the other, it becomes increasingly complex, so a small, unexpected event can propagate in surprising and nonlinear ways — and there’s no way to anticipate all these possible events.”

Peter Bernstein, a Wall Street legend who encouraged Bookstaber to write his book, is also deeply worried about the threat posed by derivatives. Bernstein, author of the just-released Capital Ideas Evolving and 1992’s Capital Ideas, fears derivatives because of the number of inexperienced investors (speculators) utilizing them. Farrell adds, “Meanwhile, the irrational exuberance of all the inexperienced masses continues blowing the bubble while ‘playing’ with $370 trillion in derivatives worldwide.”

Legendary value investor Jeremy Grantham, chairman of the global investment management firm Grantham Mayo Van Otterloo (GMO), said in a recent letter to shareholders we are now witnessing the first global bubble in history, covering all asset classes. “From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure and the junkiest bonds to mundane blue chips; it’s bubble time!” Grantham adds, “Everyone, everywhere is reinforcing one another. Wherever you travel you will hear it confirmed that ‘they don’t make any more land,’ and that ‘with these growth rates and low interest rates, equity markets must keep rising,’ and ‘private equity will continue to drive the markets.’ ”

Finally, economist Gary Shilling’s says the United States is fast approaching a financial storm in his INSIGHT newsletter. He notes, “An unusual confluence of five forces in recent years created a virtual world of financial speculation that departed spectacularly from the real economic world, the ‘grand disconnect’ we’ve called it.” The five forces, according to Farrell, are:
1. Global liquidity.
2. Investors’ misguided belief in “20% annual returns each and every year.”
3. Risk desensitization due to recent low volatility and the belief the Fed will “bail them out.”
4. Rampant, aggressive speculation.
5. American consumer spending, highlighted by instant gratification and the inability to save.

And what will trigger the meltdown? According to Farrell, Shilling still sees the subprime debacle as the catalyst. But like Bernstein, Bookstaber and Grantham, he also feels the “speculative excesses” of private equity deals may preempt the subprime blowup. In addition, Bookstaber fears that financial derivatives and hedge funds will prick the bubbles. Regardless, the most important thing to realize is that a number of threats exist simultaneously, thereby increasing the odds for a major financial crisis in the United States and beyond.

To be continued…

Latest Housing Reports

U.S. foreclosure filings rose 90% in May from a year earlier, according to a report issued by RealtyTrac Inc. earlier today. RealtyTrac Inc. is a seller of foreclosure data based in Irvine, California. James Saccacio, the CEO of RealtyTrac, said, “Such strong activity in the midst of the typical spring buying season could foreshadow even higher foreclosure levels later in the year.” That will add “to the downward pressure on home prices in many areas.” Typically, more than half of all home sales take place in the April-June period.

The findings by RealtyTrac come on the heels of Monday’s release of the “State of the Nation’s Housing” report by Harvard University’s Joint Center for Housing Studies. According to the report, in 2006 median house prices increased at least 10% in 23 of 149 metropolitan areas studied, and prices fell in 34 of these areas. Of the 11 that declined more than 3%, 9 were in economically-depressed areas in the Midwest, which suggests local economic trends were more significant than national trends at the present time. However, home prices should slide further, according to the report. One finding reveals just how far homeowners are stretched to afford their residence. According to Rachel Drew, a research analyst for the Center, “In just one year the number of households spending more than half their income on housing increased a startling 1.2 million to 17 million in 2005.” The traditional limit for housing expenses, still used by many lenders, is 28% of gross monthly income, while some financial advisors recommend capping your outlay at 25%. Too much of a house payment can, at the very least, leave you with too little money for other goals, such as retirement. At worst, it can leave you vulnerable to foreclosure and bankruptcy.

April Trade Deficit: Nothing To Celebrate

Last Friday the Commerce Department reported that the U.S. deficit in international trade of goods and services (the trade gap) declined from $62.4 billion in March to $58.5 billion in April. The narrowing of the U.S. trade deficit by $3.9 billion prompted some economists to celebrate and raise their forecasts for economic growth going forward.

Source: U.S. Census Bureau

Miller time, anyone? Hardly. Glancing at the chart it becomes readily apparent that no progress has been made on reducing the trade gap over time. And the significance of April’s adjustment? Like Peter Schiff explains in his book Crash Proof, “Given the state of our economy, that’s like celebrating the fact that your kid brought home a report card with an F instead of an F minus.”

Americans continue to import much more than we export. But why should we care, since there have been no apparent repercussions of such actions? Because a sustained trade gap increases the danger of a financial crisis. The longer the U.S. trade deficit remains at high levels, the more Americans must effectively borrow from foreigners to pay for all of the goods we buy overseas. As our indebtedness to foreigners rises so does the danger that overseas investors might dump their dollars and unload their holdings of U.S. securities in a panic once they realize that the United States cannot repay all that debt. Last year, legendary investor Warren Buffett told business students and faculty at the University of Nevada-Reno that, “The U.S. trade deficit is a bigger threat to the domestic economy than either the federal budget deficit or consumer debt and could lead to political turmoil… Right now, the rest of the world owns $3 trillion U.S. more of us than we own of them… In my view, it will create political turmoil at some point. Pretty soon, I think there will be a big adjustment.”

Weekend Edition: June 9-10, 2007

Whew! It’s been an exciting first week blogging for Boom2Bust.com. I forgot how much I enjoy writing, although I’m still trying to shake the rust off. I hope you find the blogs worthwhile as well. I am always open to comments from readers. Let me know what you think at editor@boom2bust.com. Just don’t contact me expecting to get into a debate. If I’m not blogging I’m too busy conducting research and getting a new business off the ground.

Speaking about new businesses, I would like to tell you about a piece that was written by Richard Russell entitled “The Perfect Business.” For those of you not familiar with Richard Russell, he has been the editor/publisher of Dow Theory Letters since 1958. From his website:

Russell gained wide recognition via a series of over 30 Dow Theory and technical articles that he wrote for Barron’s during the late-’50s through the ’90s. Through Barron’s and via word of mouth, he gained a wide following. Russell was the first (in 1960) to recommend gold stocks. He called the top of the 1949-’66 bull market. And almost to the day he called the bottom of the great 1972-’74 bear market, and the beginning of the great bull market which started in December 1974.

“The Perfect Business” was written by Mr. Russell in the early 1970s and appears on his website under the heading “Popular Articles.” It is his most requested and most quoted work. In “The Perfect Business,” Mr. Russell lays out the criteria necessary for the “ideal business.” The more criteria you can apply to your new job or business, the better off you will be, Russell says.

Finding myself in the position of starting a new business, I find the article inspirational. But the reason I’m mentioning “The Perfect Business” in this weekend’s blog is that it contains a segment that should serve as a caution to those contemplating a startup anytime soon, based on my belief in a coming financial storm. For all you would-be entrepreneurs, take heed of the following advice Mr. Russell’s father gave him:

Here’s what my dad told me: “Richard, stay out of the retail business. The hours are too long, and you’re dealing with every darn variable under the sun. Stay out of real estate; when hard times arrive real estate comes to a dead stop and then it collapses. Furthermore, real estate is illiquid. When the collapse comes, you can’t unload. Get into manufacturing; make something people can use. And make something that you can sell to the world. But Richard, my boy, if you’re really serious about making money, get into the money business. It’s clean, you can use your brains, you can get rid of your inventory and your mistakes in 30 seconds, and your product, money, never goes out of fashion.”

I can’t predict whether the U.S. financial crash will be swift or drawn out over time, but for someone looking to start a business in the near future, you may want to make a special note of those comments regarding real estate and manufacturing with a global emphasis. Furthermore, be wary of any business that focuses on providing non-essential services. As times get tough, these will be the first to fail. Building a successful business is hard enough. Make sure the type of business you choose is one that will prosper in the coming financial storm.

Enjoy the weekend!

Christopher E. Hill
Editor
editor@boom2bust.com

CFOs Pessimistic On Economy

The latest Duke University/CFO Business Outlook survey shows that the level of optimism about the U.S. economy has dropped among chief financial officers, with pessimists now outnumbering optimists. The June 2007 survey asked 484 American CFOs from public and private companies about their expectations for the U.S. economy. Those surveyed expect slow growth in earnings, capital spending and hiring. In addition, they are very concerned about rising labor costs and weakening consumer demand.

The CFO optimism index for the U.S. economy fell into negative territory for the first time this year. Only 26% of chief financial officers are more optimistic about the economy than in the previous quarter, which is down from 35% in the last survey conducted in March. This is in contrast to the 30% who are more pessimistic. John R. Graham, director of the survey and a finance professor at Duke’s Fuqua School of Business, states on Duke University’s Office of News & and Communications website that, “The optimism index has sunk below the water again, to a level that is low by historical standards.” He adds, “With pessimists outnumbering optimists, the prospects for the U.S. economy are poor. The CFO optimism index has a good track record of predicting future capital spending, employment and earnings. The main reasons that CFOs cite for their reduced economic optimism are increased fuel inflation and slowing consumer demand, driven in part by a weak housing market.”

Mortgage Rates Increasing

More bad news for the housing sector. Mortgage rates rose for the sixth consecutive week. The 30-year, fixed-rate mortgage now stands at 6.53%, or a 10-month high. Rates continue to climb as strong economic data and Federal Reserve Chairman Ben Bernanke seem to suggest that the Fed will not be lowering interest rates anytime soon. A strong employment report along with positive data from both the manufacturing and service sectors dampened expectations for a rate cut. Also, Chairman Bernanke said on Tuesday that the U.S. economy should grow at a “moderate” pace in the next few quarters, casting further doubts on the Fed lowering rates in the near future. As a result, yields on 10-year Treasury notes have steadily approached the 5% mark, surpassing it earlier today for the first time since August 2006.

Rising U.S. government bond rates have a significant effect on prospective homebuyers, since mortgage rates are benchmarked to the yield on the 10-year Treasury note. The average rate on 30-year fixed-rate loans climbed to 6.53% for the week ending June 7. When home loan rates rise, the borrower’s monthly mortgage payment increases. Since buyers look carefully at monthly payments to gauge a home’s affordability, higher monthly costs can limit the amount they can offer for a home. And if rates march as high as 7%, as Doug Duncan, chief economist for the Mortgage Bankers Association (MBA), expects, that could have a major impact on buying patterns, says Keith Gumbinger of financial publisher HSH Associates, which tracks the mortgage industry. “It would make it more likely that [buyers] would sit on the sidelines,” he said in CNNMoney.com earlier today. “That would put downward pressure on housing prices.”

As for future interest rate moves? Goldman Sachs does not expect the Federal Reserve to cut rates in 2007 or 2008 for that matter, according to statements issued Tuesday. Interest rate futures traded in Chicago show traders are betting on a nearly 40% chance the Fed will raise rates by the end of 2007.

Housing Rebound Ahead?

The latest housing headlines come from the National Association of Realtors (NAR), which is reporting that home sales and prices in 2007 will decline more that originally forecasted before picking up later in the year. A month ago, the NAR predicted that existing home sales would decline 2.9% and home prices would drop only 1%. Now, the Association is calling for a 4.6% decline in existing home sales to 6.18 million units. They also forecast that the U.S. median existing home price will fall 1.3% to $219,100. The NAR is also revising its new home numbers. The median price for new homes will fall 2.3% to $240,800 with new home sales declining 18.2% to 860,000 units. Last month, they predicted new home prices would remain unchanged with sales totaling 864,000 units. The trade group, representing more than 1.3 million real estate professionals, has revised its forecasts downward several times since the beginning of the new year. The NAR continues to predict the first annual decline in the median national existing home price since it began compiling data in the late 1960s.

However, the National Association of Realtors did offer a glimmer of hope for the beleaguered housing sector. “Home sales will probably fluctuate in a narrow range in the short run, but gradually trend upward with improving activity by the end of the year,” says Lawrence Yun, an economist for the trade group. In 2008, existing home sales are projected to rise 3.7% to 6.41 million units. The national median existing home price is forecast to rise 1.7%. The median new home price is expected to rise 2.6% next year as well.

It is still too early for the National Association of Realtors to call an end to the housing bottom. The sub-prime mortgage debacle has led to a tightening of lending standards, making it impossible for a growing number of potential homeowners to get credit. Also, the rising number of foreclosed properties is adding more supply to the inventory glut. ZipRealty Inc., a national real estate brokerage firm based in California, just released a report showing the number of homes listed for sale in 18 major U.S. metropolitan areas at the end of May was up 5.1% from the previous month. This is important because on a national basis, housing inventories have typically remained unchanged in May over the last two decades, reflecting the fact that May is a peak home-selling month as families are moving during the summer vacation. The growing inventory of unsold homes will continue to put downward pressure on prices as well as sales, since the remaining buyers will hold off until better bargains come along.

Foreclosure Tsunami

This morning, Federal Reserve chief Ben Bernanke spoke about the U.S. economic outlook in remarks prepared for a bankers’ conference in South Africa. Regarding housing, he noted that the downturn in this sector continues, and that its drag on the rest of the economy may last “for somewhat longer than previously expected.” In addition to weakened demand for housing, Mr. Bernanke spoke about the issues of increased delinquencies and foreclosures, and the possible continuation of this trend in the next 2 years as many adjustable-rate sub-prime loans face interest rate resets.

The latest predictions of foreclosures paint a grim picture. HousingPredictor.com forecasts more than 250 local housing markets futures in all 50 states, and has maintained more than an 85% accuracy rating. Based on a survey of the nation’s 100 largest real estate markets, HousingPredictor.com predicts that at least 2 million residential properties will be foreclosed within the next two and a half years.

Another study by the Center for Responsible Lending predicts an even worse scenario. This non-profit organization, which focuses on abusive lending practices, is forecasting a total of 2.4 million foreclosures nationwide. The figure exceeds the 2 million homeowners thought to have been created by the housing boom (2 million being the most optimistic estimate).

The latest reports show the number of existing homes for sale nationwide jumped 10.4% at the end of April to 4.2 million, equal to 8.4 months’ worth of sales at the current selling rate. The number of unsold properties relative to sales hit a 15-year high. One can only imagine the effect on home prices should 2 million plus foreclosed properties be added to the growing glut of inventory for sale.