Friday, July 9, 2010

Second Half Outlook 2010

I churn through just about every piece of economic data that is released on a daily basis.  Similar to watching the Red Sox scores at night, it helps me track where we are in respect to the direction of the global economy.


I pay less attention to the day to day movements of the markets, or the technical charts that the that traders love to follow. (Although this is still an important piece to the complete picture)

Looking ahead to the second half of this year there are three important questions: What is the picture that the data is painting, what will be the political and monetary response to that picture, and how will that affect the markets and different investments?  It is a series of causes and effects that the world economy continuously follows.

Let's begin with the picture itself.  The sky is darkening across the board for the economic recovery as just about every indicator is rolling over.

Today we received the weekly Leading Economic Indicator index which has now fallen to -8.3% from -7.6%.  I discussed this index in detail in The Stage Is Now Set.  As a reminder, when this index falls to -10%, it has forecasted a recession 100% of the time.  We are closing in fast.

A second indicator released daily is the Baltic Dry Index.  90 percent of the world's traded goods are shipped by sea, and this index tracks the cost  to ship dry commodities.  When the cost drops it means that global trade is slowing.  (To understand why imagine there are five ships on a dock.  If only four ships are needed then they all have to compete for that service and they will lower their prices to attract the customers.)

This index has now seen 31 consecutive drops and is back to the March 2009 lows.  It is not showing a slowdown in global trade, it is showing a depression.

For the 9th week in a row money has left equity (stock market) mutual funds and moved into bond funds.  The public continues to feel the slowdown and they are moving their money to protect themselves.  While they are probably making the right choice in the very short term, the bond market will be the next market to experience tremendous pain.  Most investors will not get out in time. (More on that to come in the future)

As I have discussed in detail in the past, our economy is fundamentally flawed in that it is based on borrowing and spending.  This structure is what created the credit bubbled that burst in 2008, and we have only just begun the deleveraging process. 

Over the past two months consumer credit has fallen by $24 billion, a remarkable plunge.  This means that Americans are paying down debts, specifically credit cards, instead of borrowing additional money to spend.

While we have experienced an "inventory re-stocking" since the March 2009 lows, many cautious observes have worried that there will not be final demand from the consumer for these goods.  During the financial crisis companies slashed inventories (smartly) as the demand fell rapidly.  They have now re-stocked their shelves, car lots, stores, etc, as consumer confidence has risen with the stock market and social mood.  This re-stocking improves the look of economic recovery and GDP as businesses are buying goods.

However, when the stores are re-stocked it is important that someone actually comes in to buy the goods.  Unfortunately, retail numbers and the consumer credit data are showing the exact opposite taking place.  Consumers are not borrowing to go out and spend; they are paying down existing debt and saving.

There is no final demand, and this is will bring our make believe fairy tale economy to its knees.

It appears that both residential real estate and the jobs market are poised to roll over during the second half of the year.  This will be another crushing blow to consumer confidence.

Our political leaders and Federal Reserve chairman, Ben Bernanke, understand that this is happening.  The second question now that we understand the economic outlook is how will they respond?

My guess is that you will see another round of Quantitative Easing, a fancy word for printing money and buying assets, from the Federal Reserve.  They may begin to buy municipal bonds, corporate bonds, additional mortgages, or treasury bonds.  Anything to free up cash for consumers and businesses to continue to spend.

The government will most likely step in with stimulus 7.0, or whatever number we are on now.  This will come in the form of unemployment benefits, help to local governments, or even sending checks to mail boxes in creative ways. 

Both these actions will be the most destructive possible for an economy that is desperately trying to heal and re-structure itself.  The heroine patient is lying comatose in the emergency room, and Bernanke and Obama will soon enter with enormous needles filled with more poison.

Now that we understand the economic picture and can see how our leaders will respond, the last question is how this all affects the markets and your investment strategy.

My view is that we will enter a period of disinflation over the second half of the year.  Assets across the board will fall in value and it would be wise to raise cash now, safe cash, to prepare for better opportunities.

I am not selling the investments I already own, but I am not putting new money to work in any markets at this point.  My hope is that the most desirable investments, such as precious metals, will fall in value with everything else, and investors will have one last opportunity to buy in at lower prices.

Enjoy this time in history, its going to be incredibly exciting.

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