Hard or Soft Landing?
I began warning readers about a possible business slowdown in our future back in March of this year. Now just about everyone who is paying attention to the news has heard similar projections from other analysts and signs of the slowdown are becoming more obvious.
Real estate sales are slumping and the Congressional budget office is planning on an 8% drop in corporate tax revenues next year. They are not expecting a tax reduction, just less business being done.
As Sy Harding reports in his weekly column, “The debate over the economic outlook changed significantly this week with the release of the Philadelphia Fed Index. It measures manufacturing activity in the mid-Atlantic coast area, and is closely watched because it’s frequently a bellwether for the national index. The Philly Index surprised economists this week by plunging from 18.5 in August to –0.4 in September. Any number above zero indicates manufacturing activity is still growing to at least some degree, while a number below zero indicates not just slowing growth, but contraction.
“Economists expected the number to decline some, as it has been in recent months, to indicate a slowing economy. However, not even those looking for a recession by early next year expected a plunge into negative territory so soon. By the way, it was the first time the index has been in negative territory since April, 2003, when the economy was headed in the other direction, rising from the 2001 recession.
The consensus is now that we will have a business slowdown. “How slow will slow be?” is now the question. If we wait until we read about the degree of slowdown in the news, it will be too late to protect ourselves from the financial impacts. Just like my warnings in 2005 that it was a good time to lighten up on real estate holdings—if you waited until you got validation by hearing it from multiple sources, you were already too late, and can expect a difficult time selling.
We can look at the Fed’s track record of steering the economy to soft landings. Unfortunately, when they raise interest rates to “tap the brakes of the economy”, they have a dismal record of over-doing it and pushing the country into recession. Have they learned their lessons? No one knows for sure. But remember—they are from the government and they are here to help us.
Real estate was the 800 pound gorilla of the recent economic expansion, and it may become the Achilles heel of the decline, too. Real estate accounts for about 10% of all jobs nationwide. Down the hill in Phoenix, it is closer to 15%.
Consider what happens when a big builder (used to building 200 homes a year) recognizes the dramatically slower sales and rising inventory of unsold homes and decides to cut back—to build only 100 homes this year. Half of those jobs disappear. Half of the roofers, realtors and mortgage processors are unemployed or at least underemployed. If half of all real estate workers find themselves in this fix, and the nationwide jobs percentage engaged in real estate falls from 10% to ____ (pick your number) the unemployment rolls may grow shockingly large. This is not soft landing material.
The bond markets provide one of the most reliable indicators of an impending recession. Bonds are just big IOUs. When you or I want to add onto our home we get a mortgage. When Coca-Cola wants to build a new plant they sell bonds.
There is a market for bonds just like there is for stocks, except that the bond market is about nine times as large as the stock market. It may be hard to believe, but nine times as many dollars change hands every day in bonds than in stocks. And interest rates determined in the bond market probably affect your life a lot more directly than does the stock market.
Businesses are the largest users of borrowed money. Interest is merely the price paid for using that borrowed money. When money is tight, interest rates will get bid up to higher levels until enough lenders are attracted into the market to balance supply and demand. When no one wants to borrow money, interest rates will drop until enough borrowers are attracted.
Normally, long term interest rates are higher than short term rates. This compensates lenders for the longer period their money will be at risk. When long term rates drop, it tells us that there are few borrowers out there with the confidence needed to commit to long term expansion projects. Fewer businesses are willing to expand at the moment. Why might that be? Because the amount of business they are doing is slowing down, not growing.
So, long-term interest rates are like our canary in the coal mine. When they drop it is one of the first signs of a business slowdown.
Long term rates have been below shorter term rates most of this year, and in the past couple of months, long term rates have dropped dramatically. Right now (October 1st), overnight “Fed Funds” rates are 5.25%, while 10 year T-Notes pay only 4.60%. The “inversion” in rates is no longer minor. Is this a hint of the severity of the possible recession? I don’t know, but it is certainly one red flag waving.
If the stock market were to stage a strong rally rather than succumb to the seasonal decline many analysts have expected, that would be a strong vote in favor of a soft landing over an outright recession.
How quickly will we know what the future holds for us? Not right away, unfortunately. Although the term bubble is used frequently, and bubbles burst in a split second, the markets are not like that. It took two and a half years of decline for the technology bubble to have its air thoroughly let out by 2002. Real estate is the latest field to have the word bubble applied to it. It took several years to get real estate prices this high, and prices may decline for several years before they bottom out again.
Bubbles rarely just level off. Most give up almost all of the gains they made in the spectacular run that earned them the “bubble” label. In the 2000-2002 decline, all of the major stock indexes gave up the gains made since 1997, the hey-day of the bull market mania. Will real estate give up 5 years of gains like the stock market did? Only time will tell.
None of these factors tell us whether the economy will have a soft landing and just experience a mild business slowdown or a hard landing that leads to a recession. My professional opinion? I can’t say for sure that we will experience a recession, but I’m sure not willing to bet on a soft landing.
The Primary Trend System® is a strategy I have been offering to clients since 1999. The Primary Trend referred to in the name is the trend of money flows into the stock market. Money is the raw material of supply and demand, and without money to carry demand into the markets the markets will not go up. I use money flows to generate a signal as to when to be invested in stocks and when to be out of the market.
These money flows in the financial markets have an annual cycle, and tracking and using this cycle is what gives the Primary Trend System® an edge over normal buy-and-hold investing.
During winter, the economic activity that accompanies Christmas ripples through the economy as factory workers, store clerks and delivery people all get more hours, bigger 401k deposits and the like. Profit sharing and mutual fund distributions often occur in the winter months, also. Some of this extra money becomes savings and finds it’s way into the financial markets.
These cold-weather money flows taper off just as people begin to buy more homes in warmer weather. Perhaps you have heard that many more homes are sold in summer than in winter? So where do you think much of the house purchase money is saved? Right, in the financial markets (stocks, bonds, CDs, etc.). So the winter flow of money into stocks and bonds reverses as investments are liquidated to buy houses.
How powerful is this cycle?
Dow Jones Industrial Index, 1/1/1956 to 12/31/2005
$ 2,206,846 – if bought and held
$ 2,879,124 – if held during 6 colder months only.
$ 76,815 – if held during 6 warmer months only
(assumes no interest when out of the market.)
What this means to you as an investor is that over the long term, most earnings come from the colder months. Furthermore, an investor is not compensated for the risk of holding through the unfavorable warmer months, so why do it?
However, as with most things investment-wise, it is not as simple as it sounds. The markets don’t follow a calendar. So the Autumn entry signal can occur anywhere during a 60 day window, and the Spring exit signal can occur as early as April 1 or as late as the end of June.
The May drop in the stock markets was the type of event that often marks the annual sea-change in the markets. During the Spring, the market seemed like it was trying to set records for tameness as it rose very steadily. In May the bottom dropped out in one of the sharpest reversals in recent memory. Since the slowdown of money flows into the markets normally reach their tipping-point about this time, I was expecting more stock market declines to follow during the summer. But they didn’t happen.
So, the question becomes what is really happening, and what does this mean for future stock market activity?
I have the words of successful hedge fund manager Michael Price in my head, saying when the market is doing something different than you expect it simply means that there is something bigger going on that is not yet evident and it is time to back away and reassess things. So in September I made changes in our portfolios to reflect the market conditions as they were, not as I expected them to be, and I proceeded to scratch my head about the meaning of it all.
Many times over the past few years, while discussing real estate with friends and clients, I suggested that one of the reasons the real estate market was so strong was all of the folks that got burned in the stock market a few years back began looking for something other than stocks to invest in – anything but stocks!
Contributing to today’s unexpected strength in the stock markets may be that some money from today’s real estate sales are not going back into real estate and have to find another home. Stocks may now be getting the benefit of the dynamic that helped real estate a few years ago, and this increased money flow into the stock markets greatly reduces the chances of any large scale sell off in stocks this fall as some of my earlier work called for. Remember, you heard it here first!
Please don’t take this as a recommendation to jump into the market with both feet, because there can still be market declines. Especially in an election year, the likelihood of a political ambush creating uncertainty in the markets is something to be wary of. Money flows can change as quickly as investor sentiment can. But if my analysis is correct, the severity of any near term decline may be muted by the extra real estate money entering the stock market.
A client called me last week to ask about a post card they received regarding “their annuity that had reached the end of it’s exit fee period.” The client was not aware that they owned a ‘no-load’ annuity with no exit fee, but I was, so this postcard struck me as odd. When I asked the client if the name of her annuity company was mentioned, she said no, just a place called “The Annuity Service Centeer”. I told her it was a scam and to toss the card away.
The very next day in one of my trade magazines, I noted in an article that five states are suing to shut down The Annuity Service Center. (ASC also does business under several other names.) It is definitely (allegedly, ahem) a scam to lure unsuspecting investors into making an ill-advised move. Sadly the world is awash in similar scams.
If you receive anything regarding your investments, either in the mail or email, please send me a copy before acting on it. Perhaps I can save you from making an expensive mistake.
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