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 shouldn’t come as a shock to you that California has a higher rate of inflation than the rest of the country. If we are to look at historical measures, what should the price of a California home be in 2007 accounting for inflation pressures? Using the CPI for California, which includes all urban consumers we can get an idea how fast housing prices have outpaced even California inflation which has a higher rate than the rest of the nation. Let us take a point in time where home prices were reasonable in California. We will use the base point of 1999. Let us take a look at a region that has seen some of the wildest inflation, Southern California:

CPI 1999 = 168.5

CPI 2007 = 217.4

How do we derive the current price of goods for today? We follow the following formula:

2007 Price = 1999 price X (CPI 2007 / CPI 1999)

2007 = $198,000 Southern California Median Home X (217.4 / 168.5) = $255,000

And what is the current median home price for the region? How about $425,000. Prices are currently trending lower from the $500,000 peak that was reached for the region. The question that exists for many is will prices come back down to inflation adjusted prices? That is yet to be seen but the trend is definitely pointed toward this.

Incomes not Keeping up

Why are you not feeling any richer even though you are making more money? It is the eroding nature of inflation and the fact that California is already in recession even though we do not have the official label as of yet and we will touch upon that later. Let us use the above formula again for the state and show how inflation is still eroding the purchasing power of current consumers:

California Household Income

2000: $47,493

2007: $54,385

CPI 2000: 174.8

CPI 2007: 217.4

2007 Income = 2000 Income X (217.4 / 174.8) = $59,067

Not a big difference but you can see that even though households bring in more than in 2000 the power of inflation has actually taken away more than $4,600 in purchasing power. The fact that housing has adjusted at a pace unseen and justified by a rise in incomes only points to the inevitable reality that prices will continue to come down further in the upcoming years.

What is a Recession?

Ronald Reagan, the once Governor of California and former President once said that “a recession is when a neighbor loses his job. Depression is when you lose yours.” This is a very accurate quote on how society perceives economic downturns and the way things are currently playing out, it seems like the economy is once again going to be the main item on the menu. The macroeconomic definition of a recession is a contraction in GDP for two consecutive quarters. Taking a look at the actual dollar amount of GDP we are still growing:

So what is all the clamoring about? Well the data is actually a lagging indicator since it takes time and 3 months worth of data to make a quarter but the trend is clear that 2007 had a slow year. It is quite possible that we are already in one quarter of declining GDP. GDP stands for gross domestic product and is a way of measuring a country’s productivity. Basically the formula is as follows:

GDP = consumption + investment + (government spending) + (exports − imports)

Now you know why the decline in retail sales was watched over so closely. Consumption is roughly 70 percent of the US economy so any slight decrease in this area is disastrous in the GDP equation. Also, investment declines are also hurting the country as more and more businesses tighten their belts. You are also aware that we have a trade deficit which exemplifies are uncanny ability to import more that we export. This all combines for the prospect of a very deep recession. Most serious economist already know we are going to head into a recession but the only question is to what severity will it be?

Investing During Recessionary Times

Take a look at the below chart. The gray areas highlight past recessions:

The last recession hit us in 2001 after the tech bubble burst and the attacks of 9/11. It was a double whammy that knocked this economy on its back but keep in mind we were already heading down this path. The chart above shows the amount of disposable household income that goes to servicing debt. This is a crucial chart because it shows how Americans are now becoming more and more heavily pressured by servicing their current debt out of income that would go into consumption or investment (refer back to the GDP chart above). $1 going to pay your credit card debt is $1 that you don’t spend on a widget.

These are important factors to note when planning on how to invest. We are seeing interesting things occur. Take a look at the price of oil chart:

Oil has skyrocketed during this decade and this is important because it increases the cost of energy and many Americans in metro areas are dependent on energy for household needs and also automotive needs. With incomes lagging inflation and energy outpacing inflation the bottom line is households have switched to deficit spending in order to maintain their current lifestyle. Given the massive growth of China and India who are now increasingly hungry for oil it is very possible that oil will not come down anytime soon. No longer are we the only one’s needing oil on a mass scale. Short of the government investing large amounts of money (ala NASA) into energy independence we can expect energy costs to consistently go up. Invest accordingly here.

While certain areas of the economy are seeing radical price jumps we are also seeing depreciation in certain asset classes. Housing for example is trending lower across the USA and in large amounts in Florida, Virginia, Ohio, and California. I think many people get confused with inflation and get caught up in the semantics. The official definition of inflation is an increase in the money supply. Take a look at the below chart:

If we are to look at the M1 money stock chart it would seem that this area hasn’t grown that significantly:

So if we are to adhere to the hard definition that inflation is the growth of the money supply we can say that there is no inflation. But this is not the case and is evident even in under reporters of inflation such as the CPI. If we are to look at the real growth of the monetary system we need to look at M3:

M3 which includes M1 + M2 and repurchase agreements is the place where we have seen explosive growth. This is why we have the enormous credit bubble that we are currently living in. You can almost track and pinpoint the exact moment Alan Greenspan dropped rates to 1 percent and essentially killed the US dollar and setup the US economy for the current credit bubble.

Ben Bernanke has made if very clear that he is going to chop rates even further which bodes well for: commodities, foreign currencies, and paying off debt! Believe it or not paying off debt in a deflationary environment is actually a wise investment move. It is always a wise move but when prices are declining it is important to pay off debt with current dollars since today’s dollar won’t have the same value tomorrow while your debt remains pegged. Case and point is people underwater in their mortgage. You buy a home for $500,000 that is now valued at $400,000. If your income drops from $75,000 to $70,000 because the impact of declining purchasing power, that $500,000 gets more and more expensive. Yet if we have massive wage inflation (do you see this happening?) then that $500,000 won’t look so bad if your income jumps to $200,000 and your home is now valued at $700,000.

It is important to understand the entire scope of the economy especially in a week were most major markets such as the DOW, NASDAQ, and S&P were off by approximately 5 percent. Where are you investing in 2008?

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