Housing malaise eats into Lowe's net Lowe's Cos. said Monday that its second-quarter profit fell 7.9%, hurt by the housing market downturn, which cut into demand for cabinets, countertops and other big-ticket purchases.  Results, however, exceeded analysts' estimates, thanks to strength in seasonal sales as homeowners restored lawns and outdoor landscaping after last year's drought in much of the country. The No. 2 home-improvement retailer also benefited from the U.S. government's stimulus checks, which aided its comparable sales by as much as 1.5 percentage points, more than it projected. It also gained unit market share at its fastest pace in eight quarters as many independent operators closed shops, Chief Executive Robert Niblock said on a conference call with analysts.Despite better-than-expected results, Lowe's third-quarter profit forecast missed analysts' estimates as the retailer expected a continued challenging housing market into 2009, especially in regions such as California, Florida and the Gulf Coast. It also said it is evaluating the number of stores it plans to open for next year in light of the current sales environment. It said it will announce the final number next month. Sales rose 2.4% to $14.5 billion as the company opened in more locations. Same-store sales, or sales at stores open at least a year, dropped 5.3%.

• Lowe's beats 2Q estimates, despite profit drop

 Along with a lowered outlook you'd think that would hardly be a reason to bid up the stock. As usual what we think is going on is that the lack of grasp on the nature, timing, structure and lags in the business cycle completely escape everyone in general. For example the new meme is that while the world is headed in the tank the US is potentially headed back up. BtW - that differential explains the dollar bounce along with interest rate gaps...watch out. But other than that one line nobody gave the most important retail statistic much attention.

Let us offer up another stat that will be completely ignored - no coverage whatsoever. Real weekly wages were updated by the BLS after the CPI release. Guess what...they were down -3.1%. In fact for the last six months the figures are: -1.4, -.8, -.9, -.7, -1.1,-2.5 and -3.1% ! Remember our "Tipping Point" discussion - well it certainly looks like it's here IOHO. We're going to spend the rest of this post digging thru some big picture economic data to try and read ourselves into a more realistic, data-grounded context. Hopefully in such a way that you can reach your own conclusions. 

GDP vs Consumption

Let's start with a comparison of GDP and Consumption (PCE) back to 1980. Take a gander at this little chart which shows the YOY% change in the two. If there's any doubt about this being cyclic speak now. We'll draw your attention to the teeny little tail where both, but especially consumption, have dropped below the trendline. Now ask yourselves - what recent data you've seen, or read here, would indicate that's going to turn around ? We think the more relevant question is what will the downturn look like - '01, '91 or earlier ?

Recession vs Growth Recession

You might recall that the Fed's current published forecast calls for growth thru 2010 of less than 2% - in fact they're counting on it to reduce inflationary pressures. When the economy grows at less than its' full employment potential think of that as a "growth recession". More importantly translate that out of geekspeak and into pain indicators. That means lost jobs, lowered spending, bad earnings pressures, you name it. Just to put that in context we ran back to 1960 or so and ranked downturns as Recessions (<0%), Week Growth Recessions (0-1%) and Growth Recessions (1-2%). And ended up with this fascinating chart. Note: if you believe our measures we almost experienced a growth recession at the end of '06 but were saved by the oil price drop and saw one again this last couple of quarters. But we are, in fact, now in a growth recession !!

If you'd really like to dig a little more into what's going on we put together some more economic cycle charts running back to 1960 where possible so you can see how the economy (GDP), Consumption and Investment relate and what links to what in the lag structure. We also - and this is especially important - look at the key drivers of future consumption demand. Which are growth in employment and real wages. Like we said at the start that news is getting worse fast. See what it means and keep reading (and of course click to enlarge the charts). 

BtW - the most interesting and potentially useful chart on Wages, Employment and future demand is the last one :) ! 

Meanwhile we'll focus back on the worldwide economic news - which is almost uniformly bad. BtW - in the readings you'll find the URL's for the Economists free on-line tables for economic and financial information. A worthwhile resources. In the meantime let's consider the state of play of some key worldwide economies, largely courtesy of the Northern Trust econ team who continues to do such thorough and excellent work.

Europe and Japan

 The most recent economic numbers from Japan and Europe are not encouraging, to say the least. As you can both had pretty severe QtQ dives with the latest reports after holding up more than well thru the end of last year and the first quarter of this. Unfortunately the expectations are for rapidly deteriorating conditions in the future. Below you'll find the OECD's outlook for the G-7 which are "set to slow more sharply in the months ahead." That looks pretty sharp so far to us. In fact Friday the WSJ had a major front-page story on the "Global Economic Picture Darkens (WSJ)", which tells you how seriously this is beginning to be taken. Too bad nobody was paying attention back in Jan. or thereabouts when some pre-positioning was possible, instead of ex-post scrambling. Live and learn I guess.

Europe's Big Three

 The European big three, or continental big three (Germany, France, Italy) were the driving engines for those abysmal overall numbers and judging from the outlooks the rest of the continent is following. Associated with the OECD clipping are headlines for the UK, France, Japan, India, Hong Kong, and China. Guess what - you won't like any of them. After all our domestic sturm und drang it would appear that the rest of the world is deteriorating much faster than we are. But the re-coupling thesis will start running painfully in reverse when exports start drying up as these charts tell us will happen.

European Inflation

 As it happens we may enjoy another slight advantage. While our CPI numbers were also as bad as they've been the future outlook is for inflation to start dropping as energy prices come down. In contrast Europe appears to have a more structural inflation problem setting in. Which courtesy of the 1rst Guards Tank Regiment just got a whole lot worse. Europe, along with the rest of the world, appears to be moving into the worst combination of rising inflation and slowing growth. We'll have to see how that all plays out for them. But irrespective of the geo-politics none of this was good news.

Oil, Dollar and Emerging Markets 

Just to end on a cheerful note - NOT. Sorry just kidding. We're going to leave you with a single ginormous chart that shows the dollar, oil prices and the Russian and Brazilian markets. Not coincidently oil prices are down with the growing consequences of a worldwide slowdown. At the same time the downdraft in the dollar with our slowing economy and the growing European ones is reversing. That and the expectations of fewer oil imports, a smaller interest rate differential and so on and so on. The rest of the chart couples in the Russian and Brazilian stock markets. With oil down Russia would be in trouble anyway. Add in Georgia and you'd expect them to do terribly - and they are. But this isn't solely a Russian phenomenon as the Brazilian chart makes clear. Bear in mind Brazil is a commodity export driven economy and when the world imports fewere commodities, well....was it only 2-3 weeks ago that Brazil was the one emerging market you should keep investing in ? 

 But just for fun let's quote you two different headlines on Industrial Production - both reporting on the same data and both given entirely opposite impressions.

Industrial Output Growth Slows U.S. industrial production slowed in July, pulled back by a drop in output at utilities as the weather turned fairer. Industrial production increased 0.2%, following a revised 0.4% climb in June, the Federal Reserve said Friday. Previously, June output was seen rising 0.5%.

Industrial output up 0.2 percent in July Industrial output rose in July at a slightly better pace than expected as a further rebound in the auto industry offset a big plunge in output at the nation's utilities.

Economy vs Markets

Just to set the stage let's start by considering the long-run relationship between the economy and the Markets. The meme is that markets are forward-looking though the WSJ noted that hasn't been true recently - as in the last decade ! Actually it's never been true. This multi-part chart shows the YoY% changes in GDP and the SP500 on top and the % growth in both since 1951. To our eyes the markets are still far ahead of where the state of the economy would justify their current levels.

Earnings Outlooks

Hopefully the prior post put enough evidence on the table about the structural relationships between the economy and profits that we can take it as given. And the translation between Profits and Earnings will also be taken as understood. That being the case the fundamental valuation equation we like is Graham-Dodd's: PE = (8.5 + 2*Growth)* 4.4/AAA-Yield. We'll dig into that a little later but taking it as a starting point the question becomes what are earnings expectations. And, much more importantly, do they make sense in view of our economic outlook. Take a look at the following chart which reproduces S&P's bottoms-up collection of analysts earnings prognostications and take a careful look at a) the revisions by sector and b) whether or not you believe the outlooks. And to put another point on it the two sectors that are up today and driving the market are Financials and Consumer Discretionary - with the big debate about a bottom in Financials raging onward (Riding the Storm - NOT: Breakdowns, Culture & Malfeasance in Finance).

 Now if you're readers of this blog and these two sets of earnings estimates hang together for you you can probably stop reading. But if thinking that the Financials (in read) and the Discretionary and Technology outlooks (in yellow) have some questions that should be asked below we walk thru some valuable issues of PE and valuation that should be reflected. And aren't IOHO.

 Fortunately, or not, we consider the MSM reporting to be improving but still not quite there yet. Sadly for our market positions the markets got it right the first half of the day but schizophrenia returned in the second, as they recovered. But if Mr. Market is listening let us correct your mis-apprehensions. They are indeed out to get you and here's the proof.

As always  if you'll click on a chart  you'll get an enlarged version in a seperate window.

Retail Sales

 The headlines have it that Retail sales dropped after an upward revision for last month, not mentioning the downward revision for May :). More interestingly our preferred YoY change was 2.9%, 5.8% x-Autos. Which sounds good until you look at the chart and realize it's downtrending. MUCH more important though is real retail sales which was -1.9%, negative for the eight month in a row and at an increasing rate. Let's zoom in and get a little more granular so you can see the more recent data.

Real Retail Zoom-In

I'm afraid the headlines and MSM reporting still hasn't absorbed the power of YoY reporting or of looking at the inflation-adjusted data but at least they're improving a little. When you get more granular, as in this chart, you can that we turned negative in Dec07. In other words when energy prices started going crazy people did the rational thing. CalculatedRisk's continued emphasis, supported by minor analysts like Marty Feldstein, that we most likely enterred a recession in then is looking better and better. 

 Real Sales Energy-Adjusted

Thought if you just looked at retail sales x-Autos you'd think things weren't really that bad. As a big picture sidebar observation we urge you to recall our comments from a while back that the GDP numbers and component breakdowns tell us that indeed we crossed, or are crossing the tipping point into a more serious downturn. (Tipping Points, Blindsides, Ouches: Tough Times Getting Tougher) An observation obviously NOT absorbed into the markets as yet. Where you can see this is by netting out gas station sales - a statistic you can get nowhere else since it's a painful manipulation of the data, at least so far.

 When you do that it turns out real retail sales turned negative in Oct07 ! And of course that's the same month when real (estimated) gasoline sales jumped and have kept climbing. In other words real retail sales has been negative for 10 months. And the rate of decrease is increasing. Tipping points indeed. And nobody is factoring that into their pricing, valuations or business planning that we can tell. There are some very unpleasant surprises lurking in the wood work for a lot of people as the normal cyclic lags start to work themselves into view.

Just put another big picture point on it what we've seen is the air going out of the leveraged financial bubble over the last three quarters. In other words the consequences of the credit bubble bursting and destroying the Housing market and sucking out the "vital bodily fluids" from the markets. What we have not seen is the consequences of a downturn in the business cycle. But IOHO we're about to. (News Alert: Vicious Credit, Economy, Market Cycle Spotted, Markets Drivers 2 (Buyouts): the Carry to Cash Economy, Market Drivers: Liquidity, Liquidity(Buyouts) and Buyouts (Buybacks)

1.       Economists Expect 2008's Second Half To Be Worse Than First The U.S. economy is poised for an unpleasant finish to 2008, amid a consumer-spending slowdown and a weakening global economy. The emerging pattern is the reverse of what most forecasts showed at the beginning of the year.

2.       OECD Forecasts Sharper Slowdown for G-7 The world's leading developed economies are set to slow more sharply in the months ahead, according to the OECD's indicators of future activity.

3.       Predicting What's Next Gets Harder Investors often expect the stock market to behave like a crystal ball. Lately it has made a better rearview mirror. For decades, turns in the stock market typically led earnings by roughly six months. But during the past decade or so, stocks have moved roughly in tandem with, and occasionally lagged, the trajectory of profits…

4.       Is the Market Still a Future Indicator? At this point, you would have thought the Efficient Market Hypothesis would have died a quite death. The most fascinating aspect of this is the opportunity for anyone in the market to identify inefficiencies. Discover where the market has a non random error -- we've called it Variant Perception over the years -- and you have a potentially enormous money making opportunity.

 Those headlines pretty well capture the arguments we've been making for some time, are based on similar analysis and point to a lot of other folks seeing the tipping point being crossed. And as Barry Ritholz points out in his post on the Deficient Market Hypothesis "you have an ....opportunity" ....if you make the right choices of course :) ! Speaking of which the next central question is what happens when the analysts figure out that their earnings outlooks need to go in the trash ? And the markets absorb those revisions ? How long will all that take to percolate ? Somewhere in there may lie some of Barry's opportunities.

We'll leave you to skim thru the readings which beef up these arguments but will note that the blue-highlighted titles are URL's - in other words you can click thru to get to the underlying story or post if you like. Now let's jump into parsing out the profit analysis

 Corporate Profits: First Pass

Let's start with a fairly simple look by using the St. Louis Fed's FREDII data graphing tool to look back at YoY changes in corporate profits to 1980. Part of the point here is that you aren't reliant on the MSM but courtesy of the Fed can take some pretty deep dives yourself.  It may take a bit to learn the tool and data sources, and maybe a bit more to learn what the data's telling you, but generating current analysis eventually takes a few minutes. Also btw just clicking on any graphic or chart will bring up an enlarged version for closer examination.

Take a careful look here and there are several things to notice. First off the timing, patterns and business cycle relationships are exactly what one would expect. The economy drives profits, no if, ands or buts. With some aberrations  that are important.  The blue line is  "real company"  after-tax profits on the right scale and it's volatile. But that scale wouldn't be so distorted except for the huge jump since '00. Before that those profits were cycling around a trend, which turned down in the '90s. Notice also that the drop in this decade is steep, now near-zero and below and appears headed lower.

Corporate Profits: Pass II

Let's take another pass at the data courtesy of Northern Trust's econ department and zoom in a bit, albeit with slightly different data on profits coupled with some inflation data.

 First off notice that QtQ profits have been negative and dropping since Q406. Wonder where those buybacks and earnings reports are coming from ? You should. We do know it certainly didn't go into hiring or capex. And therefore won't either !

What about margins ? Well when the ratio between the good CPI and the finished consumer goods PPI is dropping like a rock that tells us there's no pricing power whatsoever. It also tells us that profits have been under enormous and growing pressures for some time. And when it accelerates those pressures worsen. Now what do you think about future profit prospects ? Worse and worse we hope ! :)

Corporate Profits: Pass III 

Now let's take final pass at the big picture so you can get the full "slowly-boiling-frog" environment. The rather busy chart below shows corporate profits from 1979 from the national accounts. The UL shows the absolute number stacked up and if it looks like the Finance industry has been wallowing at the trough you'd be right. The UR shows profits as a % of GDP. We see three major structural trends that will govern things in the future. First off profits for non-financial companies were steady until this decade when they started liquidating their futures. Second, it looks like Financial companies went thru a major structural jump-shift and grabbed off more of GDP and, in the LR chart which shows % share of total profits, that's confirmed. And we now know what that was based on and how solid it was. Hm.....not promising. Remember the broken business models and wonder how that'll play out. And third, it looks like foreign profits (Rest-of-World or ROW) showed a steady rise until later in this decade when they took a big jump. That's born out in the LL chart which shows YoY% chanages, which btw, are both steady and pretty much mirror the business cycle. Note that very recently ROW profits are showing a non-cyclic jump. Brave new world indeed.

Since markets can demonstratively stay irrational longer then we can manage solvency we can at least have the pride and consolation of knowing they're NUTs. That is, they are paranoid and don't know which way the fundamentals are going and trust none of them. And schizophrenic since this week also saw 200 pt. drops - all on rather weak volume relatively speaking. After the break you'll find the usual collection of relevant readings for reflection - which we urge. And you should also consider this post as part of series, almost a hat trick or better (News Alert: Vicious Credit, Economy, Market Cycle Spotted,It's a Long Way to Tipperary: the Foreign Economic News,Take No Prisoners: Real Econ Data vs MSM Reporting) of prior posts. Not that repeating ourselves appears to be influencing the madmen in power to any extent. Nonetheless let's go into the breach another time with the following Chart sets.

UPDATE (tomorrow's WSJ): Signs Suggest Recovery  For U.S. Hasn't Arrived  (WSJ) Dead-end rallies often pervade bear markets, and while some negatives for stocks have turned positive, a laundry list of challenges still needs to be overcome. {well, well, welll...extened excerpt after the break...amazing !}

Basic Market Charts

Below are the basic comparison charts between the SP500 and the NDX showing daily back to Oct07 and weekly back three years. As you can see both are "rallying" in what we think is a bear market rally, somewhat milder than March's. Also notice that while the SPX has given up most of its' gains since '06 the tech index is clinging to everything almost thru last Fall. On the presumption of course that tech earnings will not experience any down pressures from a slowing economy and declining capex spending - despite the fact that the letter has already started tipping over ! 

 Inter-Market Comparisons

Speaking of widespread schizophrenia and paranoia how 'bout those foreign markets ? The chart set below shows daily back a year and weekly back three for selected ETFs: EEM (emerging markets), EWJ (Japan), IEV (Europe), EEB (BRICs), FNI (Chindia), GXC (China), EWZ (Brazil) and EPI (India). Didn't find a Russian specific one but in addition to their minor domestic political corruptions problems they've just started a war with Georgia. Be interesting to see how that plays out if you're not there. Meanwhile we'd say the bloom is definitely off the foreign, emerging and BRIC markets, a point we've been "chicken-littling" about for some time. With the possible exception of Brazil, which looks like a great speculative trading opportunity though, not an investment opp. At least until/if it joins its' breathen.

 Inter-Sector Comparisons

Even more interesting by our lights is how the different sectors have been doing since it appears that the runup in this little BM Rally is concentrated in Financials ! [You're kidding me, right ? (Riding the Storm - NOT: Breakdowns, Culture & Malfeasance in Finance, Cramer's Anniversary: Continuing Credit Metastasis and Economic Outlook)]. And Consumer related stocks - ditto, cf. the prior posts on the economy. Below you'll find another composite chart using ETFs again to compare the sector performances. With six-month daily charts on top and 1-year weeklies on bottom. Where the sectors are Finance(XLF), Consumers: Discretionary (XLY) and Staples (XLP), Healthcare (XLV) and Industrials (XLI) are the left. And Energy (XLE), Materials (XLB), Tech (XLK) and Telecom (IXP) on the right. Which neatly divides them - Links vs Rechts - into better and worse than the SP500. The worst of course being Finance but Discretionary not too far behind. And both doing nicely in the BM Rally. Interestingly Industrials are weakening. Energy has really taken a hit as the global slowdown advances which has also impacted Materials. But unless our assessment of the economy is completely off base those gyrations are not well-grounded. In fact, a striking point we want to re-emphasize (Bad Times, Bad Companies, Bad Markets), is that except for Finance and perhaps XLY none of these have shown a serious decline. Somethings not right here....which may make us the paranoid but not the schizoid.

What's It All Mean: the Vicious Circle Grinds On 

 

Serious indications of worldwide slowdown are showing up in all the major world economies, their inflation problems are much worse than ours and may be increasing. Ours look to be dampening down as the Fed anticipated. A small sliver of silver-lining is that the slowdown is destroying oil and energy demand which is driving base oil prices down and sucking out the speculative component. And with foreign economies weakening the dollar is stabilizing and even strengthening.

After the break you'll find recent news from the UK, the Euro zone and Germany (particularly bad since it was the "engine"), Japan, Italy which is nearing a recession all of a sudden, China, India, Korea and Sinapore. NONE of which is good. You'll also find a report on the intermediate to longish-term oil price outlook from Chatham House in the UK which sees oil returing toward $200/barrel because of significant under-investment in production. Wow, deja vu' all over again.

A major caveat here - you need to read the prior post and this one in conjunction. This one builds up the int'l outlook presuming you've got a good grasp on where we're at domestically and how domestic weakness is at risk from foreign weaknesses and visa versa. 

Having run the red flag of crossing a tipping point this last week we were entirely, almost shockingly, and very pleasantly surprised to find that Paul Kasriel and his team at Northern Trust walked thru everything in the Aug01 and used charts and discussions nearly identical to ours. In the readings excerpts below we've cherry-picked some critical excerpts but if you read a limited set of economic analysis and wonder where the world is going we urge you to read the July outlook and the week-in-review. We've seen nothing better. There are several other readings of course but THE strategically important one is Larry Summers, which you won't like but is honest, accurate and worth thinking about IOHO. We'll leave you to it and will devote the rest of the intro to some key NT charts that make the points almost exactly. 

Current Situation and Outlook

The following composite chart shows real consumption, the real business cycle (GDP), employment net of the Birth-Death adjustment and NT's version of my future consumption demand, Employment X Wages. Needless to say you can reach your own conclusions but every single one of these major indicators has turned negative. A key point to bear in mind btw is that when Employment is updated for the B/D adjustments there are going to be some very surprised people.

 Future Drivers

 The next composite chart looks at Residential Investment and Housing Prices, Net Exports and Capex spending (Equipment & Software). No surprise that RI continues a serious downward trend as do house prices. It still hasn't dawned on many commentators how long this is going to run but historically housing prices aren't likely to bottom for a couple more years. One of the readings btw is a report from Zillow that nobody thinks there prices have gone down - this is going to be a VERY sticky market indeed. This could go on for years. Exports have been the only good story but with the dollar stabilizing AND worldwide slowdown the growth in exports will stop increasing, and that was the only thing that kept us out of recession. Finally, and perfectly naturally in business cycle lag structure, capital spending is turning over.

 Conclusions

You really need to "process" what these charts are telling you vs what the flashing headlines are. Consumption is down and headed downer, future consumption demand is dropping, housing will continue bad and investment is going away. And employment net of the B/D assumption shows severe job losses. Now translate that into investment and business performance implications. Anybody selling to consumers is gonna get hurt more, anybody selling to them ditto. Capex, e.g. tech spending, is going to start dropping more. The uptick from currency translation and export demand may not go away but it's going to drop at best. 

That's about as clear as I can make it. 

CDO Market Is Dead, Not Just Pining for Fjords Hedge-Fund Guy enters an investment bank. ``I wish to complain about this derivative security what I purchased not two years ago from this very boutique,'' he says. ``Ah yes, the Collateralized-Debt Obligation,'' says the Wall Street Banker. ``What's wrong with him?'' ``I'll tell you what's wrong with him, my lad. He's dead, that's what's wrong with him!'' Wall Street Banker: ``No, no, he's ... restin'.'' Hedge-Fund Guy: ``Look, matey, I know a dead derivative when I see one, and I'm looking at one right now.'' ``No, no, he's not dead, he's restin'! Remarkable investment, the CDO, isn't it? Beautiful plumage!'' ``The plumage don't enter into it. He's stone dead.'' ``Nononono, no, no! He's restin'!'' 

GSE's as Exemplars: Fannie, Freddie and
the Disaster of Our Making

To understand what's going on with the breakdown of the markets we're going to use the GSE's Fannie and Freddie as our bad examples along with a large collection of other readings - all from the last few days (think of this as something like 20 normal blog posts rolled into one as usual). The Marketwatch vidclip (H/T BigPicture) of an interview with real estate economist Ken Rosen walks thru ALL the big problems facing the GSEs and the rest of the industry. Capital raising, more housing downturns (and other loans for others), more write-offs, more capital raising, shareholder dilution (destruction) and a long way to go in Housing alone. Listen to it for itself, to set the stage and on a third level think that this applies to every other financial firm in "same differences".

Risk Management vs Prudence

Not since this week it's become fashionable to get the crap out of Fannie and Freddie, as as the accompany chart shows you, there's some good reasons for that. (click to enlarge in a seperate window please). What's startling about that is that as several astute and prescient observers were already waving their arms and shouting fire the GSEs were lowering their loan standards and upping the Loan-to-Value limits beyond all reasons. All in the name of a) business competition and b) in adherence to their charter (see below for a couple of CNBC interviews with the current Fannie CEO on this). Lest we think too harshly of these guys however let's remember that not to long ago (three months ?!!) the entire country was banking on these guys to bail the entire country out of the housing disaster. After we all knew that they were in serious trouble.

We Were All in This Together

While we're all finger-pointing at Fannie, Freddie, the malfeasant Finance Industry and the evil real estate and mortgage broker types we ought to remember something. Directly or indirectly we all bellied up, or down as the case may be, to the trough to get our share of the slops. After the Tech Bust we were headed for a major downturn that was only averted by a historically surprising and entirely anomolous sustained level of consumer spending. Take a look at the associated composite chart, courtesy of CalculatedRisk. The top sub-chart shows GDP with and without Mortgage Equity Withdrawls. It doesn't take much decipherement to figure out that without MEW we'd have been in a really serious downturn - the D work might have been even appropriate. Or least the Japanese malaise. After the construction kept confusing people CR started just reporting MEW - absolutely and as a % of Disposable Income. From his work we can see that MEW ran between $100-$200B per quarter. And we're all excited about a single $150B stimulus ? Without Housing where would consumer spending have been ? And jobs ? And the markets ? The bottomlines here my friends are that without all those financial shenanigans we'd have been in the you-know-what.

Profits and Outlooks

After the break you'll find a large collection of readings that start with documenting the Dead Parrot bounce we're going thru and what some of the real data mean. For example a wonderfully eloquent rant by Barry Ritholz on really understanding Pending Home Sales - which almost everybody got as wrong as possible. We then dig into the cultural and institutional reasons for how and why we got into this mess - in particularly read "Confessions of a risk manager " for a realistic tale of the trenches. The last section talks about particularly players and uses three key ones to tell critical aspects of the story. From AIG we learn why being blind to the hand-writing on the wall is deadly dangerous. From FNM and FRE we learn that and how much farther there is to go for them and for the rest of the key players. We start that section with two old history softclips - sorry no URL's available - to remind us that once they were widow and orphan stocks then sequed into exemplars of bad practices and malfeasances from which they hadn't recovered when business urges and congressional and public pressure pushed them into bad decisions. With half the US mortgage market mind you - and the faith and credit of the entire US now at risk. Think about that for a minute. And finally we use Merrill to show what happens when the wolves catch the sleigh - somebody gets thrown overboard to buy some more time.

The point remains that we are barely thru the early part of this re-pricing of risks, de-leveraging and the resulting destruction of specious financial business models and dealing with the vicious feedback cycle between a slowing economy, loan losses, tight credit and more writeoffs. After the break you'll find a short selection of excerpts that reinforce these points - the most important of which is that months after many of us have been shouting out about it and years after the truly knowledgeable began warning the tsunami is beginning...beginning we say...to be apparent more broadly. Here we're going to walk thru several of the elements you need to keep in mind graphically. We do recommend reviewing Red Sky Mornings, Investor Take Warning: More Finance Industry for a discussion of the Finance Industry and its' broken business models.

Loan Situation 

The place to start is with the level of activity in loans. The chart below shows the most recent Fed banking activity statistics for several loan types. You might want to read it clockwise starting in the UL where total Loans & Leases plus Loans & Investments are shown on the left with the YoY% change in Loans on the right since 1980, giving you a good view of the cyclic relationships. The UR shows Commercial loans just lipping over, Consumer loans not doing badly and Real Estate loans nose-diving. As we'd expect for the latter. The next two charts show all the major types and the aggregate compare since 1980 and 1998. On our reading a bubble we didn't know about in Business Loans is beginning to pop.

Credit Tightening and Money

A natural consequences of banks drawing down their reserves is that they have much less to lend. Which should in turn be reflected in loans but so far not much. Where it is beginning to show up is in the inflation-adjusted monetary base, i.e. the effective money supply that lubricates the whole massive economic engine. As you can see below, and we've discussed before, real growth in Money has been and continues to be negative. And has been declining rather rapidly for some time. The Fed can lower short-term rates all it wants but markets are markets and will tighten as standards are increasingly tightened. What the Fed can do is keep the wheels from falling off but it can't force them to turn.

The middle sub-chart shows real money growth as -3% while the other charts wrap some bigger picture monetary and rate indicators around it. The top shows various spreads with the 3Mo-Treasury spread showing continued fear and weakness, the AA-Bas commercial spread showing quality fears and the 10Yr-FF spread showing a steeping yield curve. The latter is normally a sign of either inflation fears or a growing economy yet the bottom sub-chart shows inflation and TIP spreads. While headline inflation has been painful the worldwide slowdown is likely to do exactly what the Fed anticipates and lower commodity prices. Hence the TIP spread over non-inflation-protected bonds is around 2.5%. Inflation aint' the problem - fear, uncertainty and doubt are. Otherwise known as a metastasizing credit crisis that continues to be ever-present in the markets.

More Rocks in the Pond

The credit crisis was started by problems in sub-prime mortgages and related synthetic debt instruments but it was just a catastrophe waiting to happen. Now we're beginning to see other problems succumb to the same pressures, starting with Alt-A quality mortgage loans as well as Option ARM resets. Lined up behind those private real estate loans are all the commercial real estate loans, then various consumer and business loans and so on. Consider the graphic below which tries to conceptualize what the continued tremors roiling thru the market mean for more asset class rocks to topple into the credit pond and keep it churning.

 As one "rock" toppled it rippled up the entire chain of instruments built by leverage, greed and bad business practices and destroyed the underlying asset base. When the process works in reverse that's de-leveraging. Worse the ripples from one chain's breakdowns immediately spread to other credit markets, even ones that weren't necessarily adjacent in the sense of being technically linked. The Fed's new instruments appear to have prevented these topplings that would turn into a tsunami that drowned all us "innocent" bystanders but hasn't stopped the process. And the reverberations impacted other assets classes, each with their own sub-components, e.g. bonds, equities, etc. We didn't really realize how bad it could be until Bear-Stearns collapsed but now with Merrill and Lehman almost aground on the rocks it's clear what the consequences are.

An Example: Option ARM resets.

Just as one small example consider the next wave when Option ARMs, adjustable rate mortgages where the loanee has the option of deferring part or all of the payment until a cap is reached, are likely to do as they reset. Reset meaning that that rates are going higher so payments will and the expectation is that defaults are going to rise unmercifully. The lefthand shows just resets. And they aren't really going to start hitting until early '09 and then they build and build thru '09, '10, '11 and into early '12. Yet insiders and, now, the financial press are seriously worried about the default levels we're seeing now. The right-hand side shows the increase in payments - and if nothing else - what's that going to do to consumer budgets ? And therefore consumer demand. Recovery, schmovery. Thain was interviewed on CNBC and let slip one telling quote: "if there are not more problems there wont' be any more writedowns and we won't need to raise more capital. but if....". You know the rest.

Ripples and Credit Metastasis

As a closing note we leave you with this graphic which tries to trace some of the links between various instruments coming under pressure, bank writeoffs and the resulting tightening of credit. And then link it back into the economic consequences to establish a feedback process. Yes, judging by the readership stats, you've seen and looked at it before. But if Option Arms are just one tiny piece of a piece in the chart below what happens then ?

The final reading is Jim Jubak's most recent column discussing how Merrill's recent stock sale to raise capital destroyed the investment positions of everybody, especially the multitude of small stockholders, except Temesek. He's right but what's he's forgetting is that without capital MER was going to run aground and nobody would get anything. Put the pieces together - more rocks, more ripples, more write-offs, fewer loans, tighter credit, slower economy. Whaddya get ? And where's that leave MER, LEH, and so on and so on.

Where this all is important to you is that some of the reporting got the idea that real consumer spending was down - which is immense progress over reporting the nominal spending. We're still hoping to see the YoY% change approach become more common. The thing that everybody has missed so far is that there were major revisions downward to the consumer spending estimates. And those revisions tell us that the downturn, our infamous tipping point argument, has already started and so far almost everybody's missing it. Certainly the markets didn't react at all like they should - which may mean a speculative opportunity for you. Who knows ? :)

After the break you'll literally find a week's collection of excerpts grouped in Economic Outlook, Credit and Finance problems and Foreign Markets. A few points before we dive into some charts: 1) Menzies Chin and Jim Hamilton's dissections of likely revisions to GDP, the impact of oil, etc. are a little technical but the gist is that we may in fact see a negative GDP for Q2. Then 2) real credit problems (as we've been predicting - drum-pounding ? - for months) are really beginning to rear their ugly heads. Which leads to some excerpts on BSC and MER which boil done IOHO to we had no clue then and let the ship run aground in Cayne's case, and we still have no idea what's going on and aren't going to tell you what we do think in any case despite being a lot smarter than Cayne in Thain's case. Finally, just a sample, somebodies are noticing that foreign markets, e.g. Brazil, and currencies, e.g. the Loonie, are really beginning to take it in the shorts. 

Revised Consumer Spending

Like we said there were some significant downward revisions stretching back a ways in nominal and real consumer spending estimates, but the biggest differences started in '07.

 In some ways we'd argue that this chart almost speaks for itself. The top sub-chart shows real consumption monthly since Jan05 with the last dataset and this month's revisions. Notice the accelerating diversion that begins last summer, almost about this time :). More importantly take a very careful look at the differences in the YoY% changes. Originally spending was slowing but not quite as steeply as now and had picked back up a tad. Now it's deeper, faster and not improving (remember this is the data with the stimulus in it !).

Nominal vs Real Consumption

With all that in mind let's go back to our stand comparisons of Nominal vs Real Consumption but keep the major revisions in mind. This charts shows monthly YoY% changes back to Jan03 and quarterly back to Q188.

 Again it sorta speaks for itself, doesn't it ? Nonetheless we've highlighted a coouple of key things to notice in red. On the top monthly chart consider that spending is dropping way below any rates we've seen for quite a while in real terms, though it's not showing up in nominal terms as clearly yet. And on the longer-term chart the faint red line should be really scary:

GROWTH IN REAL CONSUMER SPENDING IS NOW LOWER THAN IT WAS IN '03

In case you don't recognize the name Miller had, until recently, an unbroken 17-year record of beating the market with a rigorous value-investing discipline. He's gotten creamed in the last year or so by value the standard wisdom of that discipline, particularly by investing in Financials (another area where we hope our opinion is crystal clear, having been hammered home enough we hope). Rather than schadenfreude our biggest response to the Mr. Miller's troubles are profound sadness and the conclusion that it stands as a critical lesson to us all. You see, and this is a point we return to often, the Financials got hammered because their business models are broken. They further got hammered, and will get more so, because we've a long way to go on the consequences of the credit crisis. Yet Miller got into severe trouble, we think, because he applied his old valuation approach and performance evaluation methods without thinking thru the consequences of these deep changes. Even sadder he apparantly had nothing much to say about how he was going to fix it. Before enlightenment chop wood, grow food, draw water. After enlightenment the same. But what do you do when your enlightenment fails you ? Well what we try to do around here...RETHINK THINGS. 

We looked at the emerging markets when we looked at the International Economic situation so let's take a deeper dive on the US markets starting with the following composite chart which compares the SPX and NDX daily since Oct and weekly for three years.

The first chart shows Finance (XLF), Con. Discretionary (XLY), Con. Staples (XLP) and Healthcare (XLV). Staples are holding up pretty well, which looking back at the time trends of non-durable consumption is not surprising. XLF got really hammered of course but bounced. The great irony in all of this was the proximate cause for the rally's beginning was MER's earnings not being as bad as expected followed by a surprise, dare we say malfeasant, announcement of more writeoffs and capital raising a week later. Sure, they know what they're doing ? Yeah, right. And Healthcare is somewhat akin to Staples. 

The second composite charts looks at Utilities (XLU), Industrials (XLI), Materials (XLB), Energy (XLE), Technology (XLK) and Telecomm (IXP). All of which had been doing better thant the S&P though with distinct differences. Utilities of course are both defensive, more so than Staples, and a bit of an inflation-hedge. If anything holds up they'll probably be it. Industrials have sufferred slightly lately and as the world economy plays out the "foreign earnings will save us" theme will get stress tested. Materials and Energy have enjoyed significant strength due to worldwide demand for commodities and energy but have also sufferred recently. Looked at this way instead of via the NDX index Technology is fascinating - it's essentially back to where it was in early '07. What lies ahead we wonder ? 

BUT...none of these indicators would seem to match up to our economic assessment so far. With that in mind AND the RETHINK THINGS THRU as well we highly recommend the following (via BigPicture):

Seven Forehead-Slapping Stock Blunders 

Nassim Nicholas Taleb: the prophet of boom and doom

Which means that if foreign economies slow and/or the dollar quits moving down as much as it has in the last three years that we'll face a significant drop. Well let's turn to a recent Nouriel Roubini interview (via CalculatedRisk) for the world outlook:

 Roubini: Global Recession Watch From Nouriel Roubini: Global Recession Watch: Recoupling rather than Decoupling [T]here is now fresh evidence that at least a dozen major economies and some emerging markets are at risk of a recessionary hard landing. [W]hile we will not experience a global recession we will get close to one as the US will have a severe recession, Japan is entering one, a third of Europe will go into a recession, the rest of Europe will have a severe growth slowdown, the rest of the G-10 advanced countries is sharply slowing down and a few emerging market economies are entering a recession. And if the advanced economies are sharply slowing down or entering a recession the idea that China, India, the other BRICs and emerging markets can happily decouple from these recession or sharply slowing economies is far fetched. This is an important key to the depth of the U.S. recession. As Professor Roubini notes, there are a number of key countries now either in, or flirting with, recession. If the global economy slows enough - causing U.S. exports to decline - we might start to see significant job losses in manufacturing, and then the current recession could be more severe than I currently expect.

 We won't add much to that. It pretty well captures the state of things and reinforces what we've been saying. After the break you'll find some more specific readings on the general trend in various countries that back up the general argument. There are three structural issues that may not bite immediately but are nonetheless significant: Currencies, Oil/Food problems and the collapse of international trade discussions. The latter in particular is the sounding of the war tocsin - not an immediate problem per se - but it tells you that the countries who benefited most from trade liberalization are pulling in their horns in self-destructive and contradictory ways. Which in turn tells us how scared they're running.

Just as a final note you might consider this chart on the major foreign markets (China, India, Brazil, Russia, Europe and Japan). Notice that the recent bubbles are disappearing in several of the Emerging Markets though Brazil's holding up. Will that continue if worldwide slowdowns lead to less demands for their commodities ? Similarly Russia's self-inflicted governance problems are beginning to lead to marketplace problems. And Europe and Japan are definitely not un-coupled from the US, though still moving synchronously. Nonetheless consider this.....if we're only seeing the very earliest stages of a worldwide slowdown what's the outlook ?

 UPDATE: just added major excerpt on India's economic outlook, reform and market mis-perceptions. Makes the case in general as well as being a superb survey of India's situation.