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Another piece of the puzzle fell into place last week as the economy slides into a recession. The manufacturing index fell to 48%, anything below 50 signals an economic contraction. The December jobs report was mixed. 18,000 new jobs were created but the unemployment index rose to 5.0%. Don’t be surprised to see the January or February jobs report turn negative, at which time the last remaining significant economic indicator will have slipped into the red.
The likelihood of further declines in existing home values was reemphasized last week. Housing prices will have to fall 15% to return to their historical relationship with rents – the point at which renters will consider/be able to afford buying a house. Commercial real estate does not suffer from the same speculative excesses of the residential market but some cracks are appearing in commercial properties as well. Unsold houses being rented are impacting apartment owners, weak retail sales are effecting shopping centers and an economic downturn will effect office rents.
Companies are revising their 2008 earnings forecasts downward or issuing cautionary statements, except for the U.S. auto industry. That’s odd since the auto companies biggest sellers are pickup trucks, followed by SUVs, and the demand for trucks is weakening. Oil hitting $100 a barrel last week doesn’t help the auto industry. Although, the $100 mark is a noteworthy psychological level, the different between $92, $95, $98 a barrel oil is immaterial. Rising food prices, driven by crops being planted for biofuel, is a more significant inflationary worry.
It’s no wonder that the Dow and S&P are down 4% for 2008 and the NASDAQ is down 6%. Hopes of a Fed rate cute may temporarily buoy the stock market but a rate cut, or cuts, won’t enable the U.S. to avoid a recession. Financial firms and banks have to loosen credit and the residential housing market has to return to equilibrium before the Fed’s actions will have a lasting effect. Look for the stock market to work its way 15% lower.
The economy faces serious challenges in 2008: 1. New home sales are at a 16 year low and may go lower; 2. Inflation will be high for the next few months as energy and food prices work their way through the economy; 3. Retail sales will be weak, as evidenced by the Christmas season; 4. Illiquidity in the credit markets will spread from mortgages to auto loans and credit cards due to financial companies tightening their lending standards; 5. Adjustable rate and subprime mortgage problems will continue; 6. Corporate profits will turn negative. These factors will contribute to, but not cause, the 2008 recession and they will be somewhat mitigated by strong export demand (thanks to the weak dollar) and, at least for the time being, good unemployment numbers.
The decline in the value of existing homes is what will cause the 2008 recession and cause it to be the most severe recession since the early 1980s (although not all that bad by historical standards). The bulk of the average American’s savings is in their home and their net worth is decreasing. There will be far fewer mortgage refinancings and home equity loans to monetize housing values. Declining housing values will cause/force consumers to cut back spending.
Existing home prices were down 3.3% for the twelve months ending in November. Although sales were up slightly in November, they’re still down 20% from a year ago. Record levels of foreclosures and mortgages which rates adjust in 2008 make it unlikely the November up tick will be sustained. There will no economic recovery until housing prices bottom. The Fed will cut rates to combat the economic downturn but financial institutions stricter lending standards will mitigate the impact of the Fed’s actions. Thus, we should expect up to four quarters of negative economic growth.
Morgan Stanley, in their December 10 Strategy piece, looked at historical stock market declines and concluded that, on average, the S&P declines 9.5% from its peak to the start of a recession, 18% from there to its bottom, then rebounds by 25% through the end of the recession. The S&P (and the Dow and NASDAQ) is off about 5% from its 2007 high. This suggests another 23% decline until it reaches its recessionary low. Forecasting is not an exact science (far from it) and the U.S. economy has proven to be remarkably resilient. Also, the S&P is trading at a reasonable level, based on its P/E ratio, so maybe the decline will be less this time, say 15% from current levels.
How do you invest for a recession? For stocks and mutual funds look for companies which sell consumer necessities, heath care companies, companies with large foreign sales, high dividend (make sure its secure) stocks and invest internationally. Bonds typically perform well during recessions because of falling interest rates. But with Treasury yields already low and the uncertainties surrounding corporate bonds, you would be wise to keep your fixed income investments short-term until the credit situation resolves itself. What you shouldn’t do, though, is get out of the stock market. The U.S. will come through this recession as it has every other and economic growth will drive the stock market to new highs. As the Morgan Stanley report points out, the stock market rises sharply prior to the end of a recession and nobody can pick the turning point. Lastly, although I don’t advocate market timing, I’d put new 401-K and IRA contributions into cash for the time being. Cash is king in times like these.
All of us at MUTUALdecision.com and the MUTUALdecision blog wish you and yours a safe and happy holiday season. Our next blog will appear on January 2. We wish you a prosperous New Year.
The countdown to the New Year has begun but before the ball drops, actually before 4 PM EST on that Monday, review your investments and place your sell orders for tax-driven transactions. For stocks and other securities, make sure your order is placed in time for it to be executed. This is particularly important for thinly traded stock and bonds. Taking a loss will offset gains and you can take an additional $3,000 of losses (on a joint return; $1,500 on a single return) in excess of capital gains as a deduction on your income tax returns. For the maximum advantage, try to offset short-term gains with short-term losses and long-term gains with long-term losses.
For mutual fund investors, even if you haven’t sold any funds this year, you still many have a taxable capital gain. Mutual funds must pass through their net capital gains or losses, and income, to their holders. Give your fund a call if you haven’t heard from it about its 2007 distributions. And, as a general rule, sell a fund before its announced distribution date and buy a fund after that date. This avoids your having to pay taxes on its distributions.
If you’re selling your entire position in a fund or security skip to the next paragraph, but if you’re selling a portion of your holding you need to specify the tax lot(s) you’re selling or the First In, First Out (FIFO) rule will apply. The potential trap here is if you hold a fund or security which you bought at various times, the cost basis of each transaction could be very different. Make sure you specify the most advantageous tax lot to sell. Mutual fund investors have a third option which is to use the average cost of their holding. Note: Before you make any tax-based decisions you should consult your tax adviser.
It’s not too late to make, or maximize, your 2007 IRA and 401-K contributions. Why make them? Because these are tax-deferred accounts. Even if your income is such that you can’t take a deduction for your IRA contribution, once contributed all income and gains are tax deferred. Then, the power of tax-free compounding works for you. Using these accounts, investors can convert taxable interest and dividend (especially non-qualified) income into tax free (until they begin withdraws at age 70 ½) income. For investors seeking to diversify their portfolios in a tax efficient manner, retirement accounts are a great place for high yielding taxable investments.
So before you settle in to watch football or hide from the in-laws review your investments and minimize your tax liability. When the flowers come up in April, you’ll be glad you did.
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