With the emergency rate cut by the Federal Reserve, it is not a question about going into a recession but how deep of a recession it will be. The markets have not bounced aside from a few sectors including those bottom fishing in the financial sectors thinking a bail out is in the works or that the Fed will simply not let them fail. The technology sector is having a hard time digesting information from Apple and Intel showing weaker than expected quarters. Other tech giants have also announced that they will be cutting their workforce back. The Federal Reserve does not have much power besides a direct influence on monetary policy and at this point, that weapon is being ineffective. Now that they have exhausted that measure, they will attempt to use fiscal stimulus to jump start the economy. There is talk about rebate checks that will go straight into the hands of consumers but this would still take one or two months at the earliest. Also, we are entering a year where the IRS is working to revamp the tax systems to accommodate the large increase of those filing with the AMT tax.

There are many factors at work here. Yet as much as the government wants to avoid a recession these are simply normal healthy signs of a system trying to revert to sustainable growth measures. Like a wildfire in the forest, this is intended to wipe out all the excess money. Each time the Fed tries to insert liquidity into the market it is only propping up and giving more ammunition to the purveyors of the current credit excess. The recession will be led by housing and all indicators are still pointing to this. Let us look at four factors that show us that housing is no longer sustaining the economy.

#1 Housing Permits

*source: Census.gov

As you can see from the above chart, housing permits have been steadily decreasing since April of 2006. These are great leading indicators letting us know where housing is heading. We are still at a very high rate of housing starts so we are simply returning to more stable numbers. You need to remember that behind these numbers, there is an entire industry catering to housing and housing related services so what this means is large contractions in the industry.

What this means to you? Expect to see declines in builders as current market excess is washed out.

#2 Homeownership Rates

*source: Census.gov

Home ownership rates have also started to decline with the rise in foreclosures. Historically homeownership rates have oscillated between 62 and 65 percent nationwide. We peaked in 2005 reaching a 70 percent homeownership rate. Of course much of this large jump was on the backs of people being put into dangerous mortgage products that they had no way of paying off. We are now back down to 68 percent and the trend is lowering.

What this means to you? Look for the trend to revert to historical means and expect a 66 to 67 percent homeownership rate in the future. This could even drop lower in the short term since many foreclosures are currently hitting the market with projects coming online.

#3 New Home Sales

*source: Census.gov

What you see is a clear signal of the peak. 2005 is the clear peak for new home sales while 2006 was the peak for housing permits. This demonstrates the art of picking peaks. Why is there a year discrepancy? First, the peak in 2005 new home sales gave the impression that we still had room to run so builders sought to meet this demand by building more homes. They were behind the curve by one year trying to meet the demands of peak 2005 which of course overstated their estimates now creating a glut of new homes competing with an already saturated market. New home sales have almost dropped in half since their peak in 2005.

What this means to you? Look for inventory to increase as sales decline and new homes keep hitting the market through projects being completed. This will compete also with rising foreclosures so ultimately this means a continuation in prices dropping. Supply is outstripping demand at the moment and until this trend reverses, you can expect much of the same.

#4 Construction Spending

A couple of charts above. First we have construction spending tapering off hitting a peak in 2006. With over $1.2 trillion in construction spending, even a small decrease means a reduction of $55 billion in one year. Keep in mind that the peak as we mentioned in our previous chart of housing starts showed the peak in the middle of 2006 so we are only starting to see the trend starting to emerge. The next chart, shows the amount of construction jobs. This is a large number and big segment of the economy. We had a peak in September of 2006 with 7,725,000 jobs in the sector and now currently we are at 7,489,000, a decline of 236,000 jobs.

What this means to you? Look for more declines in construction jobs as permits drop and the current housing inventory is washed out. This will take a few years since we had an unprecedented boom. Invest wisely and keep these things in mind if you are planning in going into REITs or have a heavy portfolio allocation to housing related fields.

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It isn’t a secret that the overall economy is entering into a rough patch. The declining housing market, poor retail sales, and overall debt are breaking the back of the economic machine that is the U S of A. As an investor, what can you do to protect your wealth during these hard times? First, let us look at how a few sectors did in 2007:

January 1, 2007 – December 31, 2007

Gold: 34%+

Euro: 12%+

DOW: 6.4%+

S&P 500: 4%+

NASDAQ: 9.1%+

This is all well and good but how are these sectors now doing considering that we had a very tepid holiday shopping season and now the housing market is in full crisis mode and people are openly talking about recession? Let us take a look at year to date performance:

January 1, 2007 – January 13, 2008

Gold: 6%+

Euro: .537%+

DOW: -4.96%

S&P 500: -4.59%

NASDAQ: -8.01%

In this context, practically all the gains of 2007 were wiped out for the DOW, S&P, and NASDAQ in the first 2 weeks of 2008. If you were heavily invested in real estate or financials your portfolio took a much larger hit. It is important to recognize that investing in recessions is very different and requires the ability to rebalance your portfolio. I would venture to say that we will see continued pressure on the major indexes and would not be surprised if we see major losses in 2008. Why will there be continued pressure? Here are a few reasons:

1. The Housing Market

It goes without saying that there is major excess in the housing market that needs to be purged. Home prices last year saw their first annual median decline since the Great Depression. While certain areas in the south avoided the bubble altogether certain areas such as California and Florida will see major corrections as the easy credit is flushed out of the system. If you are invested in real estate or financial in your stocks, you really need to think twice about what you are going to do about that for 2008.

2. Job Losses

With a declining economy job cuts in construction and real estate related industries are going to be steep. There are estimates that for the past decade, about 30 percent of all added employment was somehow related to housing. Whether it was Home Depot or Lowes to Black and Decker and mortgage brokers. With the unemployment rate surging to 5 percent last month we can expect this trend to continue as the credit market and the housing sector contract.

3. Weak Consumer Spending

There is a major wealth effect when housing prices are healthy. Consumers feel richer because their homes go up in value. This perceived added value pushes them to spend. And from many estimates the American consumer is 72 percent of the economy. So with the weak holiday numbers and continued credit contraction, the American consumer is spent to the max. This will only continue as we are seeing and even giants like American Express have announced poor numbers.

Where does one Invest?

This is really the million dollar question. I believe that gold and the Euro will continue to do well in 2008. Why? For one, gold does well on perceived inflationary pressures and even in deflationary environments. With the Fed signaling that they are going to take “substantive” action to reduce the risk of economic problems, it is clear that they are going to cut interest rates which is only going to devalue the USD and make gold more attractive simply because of the fall of the dollar in relation to gold. Also, for this same reason the Euro should continue to appreciate in the face of current conditions. What you can do as an investor to balance out your portfolio is to buy the gold ETF GLD. No need to buy bullion although this is the preferred method. In regards to the Euro and other foreign currencies, you can open up a global checking account and start saving some money in foreign currencies. Unless the Fed demonstrates that they are concerned about the dollar gold and the Euro will rise. All evidence is pointing toward a serious recession and the Fed is worried about keeping the system running so it is highly unlikely they will raise rates even if the CPI takes a jump up and starts showing signs of retail inflation (which it already is).

You can also take a small portion of funds and buy put options on certain sectors. With some puts you can buy up to 1 year out. You can use this as a hedge against a severe market drop. Buying put options you are only out the premium plus any charges for purchasing the contract. A contract controls 100 shares of a certain stock. For example, you buy 1 put contract of XYZ for $100 and the strike price is 8. Let us assume the stock drops to $6. So now you have $8 - $6 minus any commissions for the sale = approximately $2 x 100. So you nearly doubled your initial investment of $100 to $200. If the stock goes up to $9 your option expires worthless and you lose all of your $100. Option trading is risky and this is a topic that needs to be further investigated before investing but it does makes sense as a portion of your investments especially in a market where very few sectors are going up.

What concerns me is how many people with their 401(k) or IRAs have so much money allocated to index funds and think all will be okay if they simply leave their funds and do not touch them. Let us assume the above scenario and use the data from the 3 indexes. If you started investing in 2007 all your gains have been wiped out. You may think to yourself this is better than losing money but in effect, you have. The dollar during this same time period dropped and inflation kept increasing thus eroding your purchasing power. Unless you returned 7 to 10 percent, you are in the red.

I’m not encouraging you to take all your money and buy gold or buy all put options but these are 2 of many strategies for investing in the current climate. People that do not have 20 to 30 percent of their portfolio in bear investments will be sorely disappointed in 2008.

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