Where are we in the downturn?

There are plenty of differing opinions about how far in we are, and how long we have to go, before the light appears at the end of this downturn tunnel. LOUIS COUTTS gauges to distance.

By Louis Coutts

There are plenty of differing opinions about how far in we are, and how long we have to go, before the light appears at the end of this downturn tunnel.

I came across an article the other day about the direction of the Australian dollar as against the United States dollar.

Now, there was a Sue Thrinh, the RBC Capital Markets senior currency strategist, who predicted that the dollar would bottom at about 55 cents in mid 2009 before recovering to about 62 cents by year end. As against that Westpac predicted levels of more around 69 cents, while Ozforex predicted the dollar to trade between 72 and 75 cents.

So, we have a range of predictions between 55 and 75 cents, which is nearly 40%. These are the experts.

On the second day of the second test match between Australia and South Africa everyone was predicting that Australia would thrash South Africa, and on the third day the game was virtually over, with Australia on the ropes. We can’t even predict what is going to happen in the next day of a test match let alone predict what is going to happen to the dollar.

And yet, and yet; we still desperately seek the opinion of experts to tell us what is going to happen with the certain knowledge that they simply don’t know. And yet, they still go on making predictions and we listen to them. Or do we? Surely at this stage the experts are discredited.

Haven’t these gurus done enough damage? Many of the gurus were persuading sensible people to borrow money on shares to buy more shares days before the sharemarket went south.

I have decided that I can’t rely on the experts to tell us what is going to happen because I am certain they don’t know. However, it is important to paint a picture of where we are so that we can get a sense of what all this means. I have done a little research myself and I am going to bore you with quite a few graphs. Don’t worry, they are pretty easy to follow.

The following graphs are self explanatory and are provided courtesy of the US Department of Census and Statistics. Housing sales in the US have plummeted along with the value of housing.

The number of sales of new houses has dropped from over 600,000 a month in November 2007 to 400,000 a month in November 2008. The average price of houses has halved.

Business inventories have soared and have risen more dramatically in the last half of 2008 than in any other period covered by the graph. Orders in the US for durable goods have nosedived.

The US growth rate follows the same trend for the quarter ended September and they tell me that it is in horrific negative territory in the last quarter. All of these graphs tell me how important the American consumer has been in assisting the experts achieve moments in the sun and walk away with millions of dollars in their pocket, and that the mystical wealth that the consumer believed he or she possessed has disappeared, leaving them with a mountain of debt.

If they have any money, they have no appetite for risk – and if they don’t have any money, sure as hell they aren’t going to spend it.

But wait! say the gurus; China is going to help us out. They might have had a few points clipped off their GDP but the engine will still keep the world afloat. China has “decoupled” from the US.

Absolute rot! And so says the following graph along with the opinion of people on the spot in China. The Chinese economy as you can see is in a tailspin.

Well; perhaps Japan will help us out of our problems. Toyota has experienced its first loss in 40 years. Japan depended upon exports to the US to maintain its economy. The US consumer has stopped buying Japanese products (as well as those made in the US of A).

Oh well; what about Europe? Germany has been a great economy and engine of growth in the past.

So, France? Perhaps (only fools like me are still buying expensive French wine).

Well, what about the old stalwart, Great Britain?

Every graph I see is in a tailspin.

Now, as a management consultant I have a theory that if a graph is going in a certain direction, it is likely to continue in that direction unless some external force alters that direction. It is like Newton’s first law of motion (or I think it is).

So what forces are in play to turn these graphs around?

America is printing money and lending it to banks, which are lending it back to the US Treasury. Indeed, the process is so secretive that neither the Treasury nor the banks will tell Bloomberg or Fox what has happened to the money advanced by Treasury.

In addition to the US Treasury, anyone in the US who has some spare cash is either placing it with banks that have a US guarantee or are buying treasury bonds. There are trillions of dollars in the system that are not getting out to borrowers for a number of reasons, but mainly because banks have had their fingers burnt so badly that they are disinclined to take even the slightest risk.

No one is borrowing and no one is lending and no one is spending. This is the scene in all the economies covered by the graphs I have shown.

However, we have low interest rates, cheap fuel and plenty of money in the system. What will break? The housing market will have to stabilise with billions being written off loans so that home owners regain some equity. Banks shareholders will be screaming for a return on their investment, and banks will have to start lending some of this money with margins that return a profit, but at prices so low that people will be attracted. There are already some signs that in the distressed housing market people are picking up sales at bulk auctions and reselling.

But it is going to be a long process. Are we at the bottom? Who knows? Can things get worse? Of course they can. How better can things become? Not a lot in the short term.

The fact is that the party is over, despite the belief of many who are getting into the sharemarket through fear that it might take off again and they will miss out. The one graph that is improving is that of the Dow Jones tracking of US shares.

You will see that since late December, while there has still been volatility, the graph has taken a decided turn for the better. So what is it that beckons investors to buy stocks in US companies when the American and world economy is in such a mess?

Investors look forward, and punt on what is likely to happen in six months. Do these guys know something we don’t? There must be a belief that with all the money that is being printed in the United States, with low interest rates and a massive decline in the price of oil, that sooner or later things will improve.

However, we have to be wary of those who predict the future. There are few Nostradamuses in the financial world. But there are a couple of people who have a track record of calling the present disaster.

Gary Shilling, a US contrarian investor made these predictions in January 2008. In that issue of his INSIGHT newsletter, Shilling outlined his 13 investment recommendations for 2008.

1. Sell or sell short homebuilder stocks and bonds.
2. If you plan to sell your home, second home or investment houses anytime soon, do so yesterday.
3. Sell short sub-prime mortgages.
4. Sell or sell short housing-related stocks.
5. Sell or sell short consumer discretionary spending companies.
6. Sell low-grade fixed-income securities.
7. Sell or avoid most commercial real estate.
8. Short commodities.
9. Sell or sell short emerging market equities.
10. Sell emerging country bonds.
11. Buy the dollar before long.
12. Sell or sell short US stocks in general.
13. Buy long treasury bonds.

Then back in 2007 Nouriel Roubini, professor of economics at New York University, made similar predictions based upon an assessment that the housing market would collapse and this would bring down institutions such as Fannie Mae and Freddie Mac and bankrupt financial institutions. His predictions were uncannily accurate.

Wall St analysts are vigorous in denouncing him, particularly now when he predicts that the recession will go into 2010 and there is more damage to be sustained along the way. Shilling takes the same view.

Many analysts maintain that we have reached the bottom and now is the time to buy stocks as they are cheap. They maintain that a turnaround will occur in the US in the second half of this year and that is the reason for the sharemarket to be turning around at the moment.

However, the guys who foresaw the disaster are now urging caution in maintaining expectations that the worst is over, and believe that we have a long way to go to get out of the mess.

Furthermore, for reasons that seem very compelling, and it is to do with an ongoing “deleveraging” (which means that people are taking every opportunity to reduce debt incurred to acquire dubious assets), it will take quite a while for sufficient confidence to return to the market to support a consumer lead recovery.

There is a belief that the massive financial injection by governments has stemmed the tide, but will only be a holding operation and only time will tell how effective this operation might be.

In the meantime, the equity that American householders have in their homes continues to diminish. The sub-prime mortgage fiasco created an illusion in the minds of Americans that their wealth was increasing by the minute and this prompted them to play the compliant part of consumer, resulting in importations of every conceivable product from China and Japan.

This in turn drove the engines of those economies, which in turn resulted in our commodities boom. Sufficient credence has not been given to the fact that our growth in the past few years was largely influenced by this illusion of wealth by the American consumer, and once this illusion vanished, everything came tumbling down like a stack of cards.

If is difficult to see how the American consumer will come back into the supermarket with a full purse any time soon. In the meantime, people who called the bursting bubble with accuracy are predicting that the turnaround will take a long time.

There is one other concern that I have, which relates to this massive printing of money to inject unprecedented trillions (the word is becoming common place, just as once “billions” was the frequent measure of money). It is what they call “Keynesian” economics.

It has never been tried on such a massive global scale. In fact, during the Asian financial crisis, the International Monetary Fund rejected this theory and put Asian countries to the torch. How confident can we be that a massive economic experiment (based upon the theory of a person who is famous for responding to the question “what is your greatest regret in life?” with the now legendary reply “I wish I had consumed more champagne!”) will work, as those implementing the theory hope?

My own view, for what it is worth (and for those of you who follow my column in SmartCompany you will have picked up that nearly 18 months ago I was alerting people to my concerns about the sustainability of our then current direction; I even used the words “financial tsunami” in one of my columns and urged people to be prudent and “keep something in the till”) is that the decimation of the wealth of the American consumer, coupled with the unemployment that is being experienced in the USA, will seriously erode American consumer spending that has been driving world growth and maintaining Chinese hyper growth.

This spending is not going to revive in a hurry with the result that we can’t expect any spectacular financial or market turnaround in a short space of time.

At the moment, investors and particularly younger ones, see the current situation in terms of the sharemarket. They have been used to spectacular results (with equally spectacular losses) and assume that we will get over this punctuation mark and things will get back to “normal” as they see it.

I believe that this mentality is driving sharemarkets at the moment, and in a sense it is a fear driven phenomenon. There is a fear that the sharemarket will take off and if you aren’t in it, you will be left behind.

Looking at every statistic available to me (and there are massive amounts published each day on the web) I can only see continuing decline in the GDPs of countries; companies giving downgrade warnings in relation to profits and dividends; newspapers talking about hundreds of thousands of people losing their jobs this year; politicians telling “how bad things are looking for 2009” and I just wonder what drivers are in place to propel sharemarkets back to the irrational levels they reached in the boom times.

Just yesterday, it was announced that new car sales in the USA contracted by over 30% last quarter and that General Motors experienced the lowest number of sales in 49 years.

Recovery will take place, but returns for investors will be more like the old days when you expected to receive a dividend, and over the years, the value of your stock holdings would gradually appreciate faster than the rate of inflation.

We are in for a long period of rebuilding and consolidation and those who expect to get rich fast will have a tough time.

One interesting view that I came across in researching this was that the market will have a bounce because of the massive injection of funds into the economy, but pay day will come in about 2014 when the real asset value of stocks will be far less than their market value – and that is when the proverbial will hit the fan.