The Economy on The Brink?

I should make a comment on the state of the economy, especially in view of my comments in mid-2006 when I started to urge caution to all who would listen. Here’s what I think is going on:

First things are not as bad as the losses on the stock market suggest. That is to say the real economy, and not the fanatsy world of stock market analysts, is not on the edge of some disaster. Overall the outlook is for a muddled year in 2007, slow growth, but positive not negative. There is an increasing chance of a recession with that risk centered on two areas: housing, which is a mess right now and likely to get worse before it mends [more in a moment], and the fall out from the drop in stock prices. National fiscal policy has been inept for years now and we have managed to adjust to the lack of any kind of clear economic leadership from our MBA president. In view of his extraodinary incompetence in other policy fields his lack of interest in the economy has actually served us well. Let’s hope he stays away while people who know what they’re doing fix things. Monetary policy was way too lax for several years at the end of the Greenspan regime, and his unwillingness to tighten money supply or raise rates earlier created the conditions for our current housing malaise. The dollar will have to continue to fall so we can attract foreign investment to pay for our trade and federal debts; and corporate earnings will come under pressure as consumers start to realize that housing is a place to live not a source of savings: look for consumption to flatten out through the year, if it slows too much then look for a recession. [America is a consumer economy, not an agricultural or industrial one: consumptio is two thirds of GDP]

Second: housing is only now starting its correction. Any thought that prices have fallen sufficiently, or that we even know how far prices will fall is nonsense. I would be the first to state that I have no idea how far down we have to go. What I can say is that house prices have risen so far beyond ‘normal’ limits that a further drop of 20% beyond the decline we’ve seen already is perfectly reasonable. There is a solid relationship between house prices and earnings [that should be obvious but investors seem to forget the obvious sometimes]; that relationship has been fairly steady for decades. The housing bubble blew the ratio of house price to earnings away. I suspect that the correction in prices will return us to ‘normalcy’. That’s great news for anyone trying to buy a house in a year or two, but rotten news for anyone who just bought, or who bought in the last two years. Anyone who thinks that home prices have some magic and can defy long term relationships with earnings should be locked up safely somewhere where they can’t harm the rest of us [are you listening National Realtors Association?]

Third: the stock market fall is entirely expected. I’ve been advising people to cash out for months. Why? Corporate profits do not support the prices in the ranges we had up until last week. The ratio known as the P/E ratio is another of those boring statistics that those dewey eyed analysts all think is old hat and not reflective of the ‘new reality’. Well: Gotcha! Excessively high P/E ratios are always a sign that something is amiss in stock valuations. Remember the technology bubble a few years back? thsoe P/E’s were ridiculous, but we all imagined that high tech stocks we ‘different’. What’s even more absurd is to see boring businesses like banks and industrial comapnies being valued as if they were specualtive stocks. So now reality is intruding and stock prices will move down to a more reasonable level before starting to climb again. Look for more down days on Wall Street over the next few weeks. But also remember that this is not a collapse, there is no panic, just a more realistic viewpoint emerging.

So here’s my overall take on things: the economy is slowing down [there are all sorts of monthly stats that support that view]; the risk is rising that we might drop into recession later in 2007; but that risk is still smaller than 50%. The most likely outlook is for very slow growth in the second half of this year and the first months of 2008, followed by a gradual acceleration going into 2009. The risks are well known: an over reaction to house prices falling could make consumers too conservative, in which case they’d stop spending and thus would plunge us into recession more certainly.

And please everyone, stop looking at your house as a piggy bank: save money elsewhere. The American savings rate is the world’s worst, without savings there is no money to invest in new factories etc without borrowing from abroad, putting all our money into housing means we put less [or none] into investmsnts that actually create future wealth for us all!. I know there are a lot of people who have made tons of money from their houses, that was dumb luck and inflation. But right now there a ton of people who are losing money on their houses, they were stupid in thinking that gravy train would run forever. Economics is not a forever thing. That’s a good lesson to learn in 2007.