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3rd

Quarter 2010 Economic Outlook

WARNING: Brace For Impact!

By: Robert Shambora

In March of 2009 several enormous changes were implemented in an attempt to save the banking system.

First, FAS 157 was implemented which changed the requirement that banks must mark down their assets

“to market” to one which permitted them to mark them instead “to model” (what they think they are

worth).

Second, the Federal Reserve announced a massive Quantitative Easing program whereby the Federal

Reserve would essentially create over $1.5 Trillion in new money through the purchase of Treasuries,

Freddie Mac and Fannie Mae bonds over the next twelve months to support the debt markets.

The net effects of these moves were to provide much needed liquidity to the markets in general, especially

to banks, to keep interest rates low and to retain an artificial bid in for Mortgage-backed bonds until

markets improved. In my opinion, however, the real problems related to debt and solvency have not been

resolved and in many cases not even addressed. Therefore, despite the swiftest stock market rally since

the 1930s, I firmly believe this upward move is just very large bear market rally.

Let’s look at some uncomfortable facts. The Quantitative Easing maneuvers are completed but the

stimulus money was spent on largely ineffective programs for favored constituencies and few if any broad

growth incentives were built into the legislation. As a result, even with near-zero Fed Fund rates and

historically low Mortgage rates, the capital markets are now clearly indicating deflation, shrinking

liquidity, diminishing access to credit, and solvency problems (especially now in regards to State and

Sovereign debt).

There is a very real risk that these problems will continue to have a profound effect on debt markets,

including Municipal Bonds and even Treasuries, finally culminating in a major blow to currencies,

especially the US Dollar.

As shown in the following analysis, it is not at all surprising, therefore, that the majority of important

indicators are rolling over sharply and swiftly.

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Indeed, I believe that it is more than likely, therefore, that we have begun the next major leg down in the

markets – much like April, 1930 when the Dow began a fall from its recently recovered level of 294 to a

June, 1932 bottom of 41. More succinctly:

The financial world is about to change very quickly, in ways that most cannot comprehend, in ways

that have very little historical precedent, and in ways that will be deemed historical – as in a “multi-

generational” sense.

The remainder of this report is a synthesis of the many trends, ideas, charts and graphs over the past three

years which substantiates the basis for these concerns.

Unemployment

There has been plenty of news recently in regards to the jobs market, and the Unemployment

Rate. A very important point to keep in mind with the official reported Unemployment Rate,

which is referred to as U-3, is that this number represents those unemployed and still looking for

a job divided by the estimated current size of the workforce. In other words, if you have given

up looking for a job and, for example, chosen to rely on Congressional extensions of government

unemployment benefits, you are no longer even counted.

As a result, due in large part to the continuing extensions of those benefits, the average period of

time that an unemployed worker has actually been out of work has become the highest since

records were kept. The following chart shows how the percentage of the civilian workforce has

even dropped over the past several years. If and when the Emergency Unemployment expires,

most of those 1.1 million workers who are not now being counted will be forced back into to

official U-3 statistics. Add the hundreds of thousands of Census workers who will re-enter the

official unemployment ranks between now and early August, and nearly 2 million people could

be counted as added to U-3 in the very near future. How about a U-3 of 11-12% as a wake-up

call to the markets?

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Source: Zerohedge.com

And just how bad has the “jobs recovery”, or lack thereof, been compared to past recessions?

The chart below compares the percentage job losses in this recession to that of earlier ones.

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This indicator is the weakest since the Great Depression. By the way, if you look closely, the

dotted red line indicates the trend excluding the Census Workers which, as they re-enter

unemployed status, will causing the solid line to migrate towards that dotted one.

Finally, it is very important to note that we have now entered the 3rd

Quarter, which is the

beginning of the fiscal year for most States and Municipalities. With 46 States carrying

enormous deficits (over $140 Billion total), and 33 States actually borrowing money from the

Federal Government to continue paying Unemployment Insurance Claims, it is very likely that

there will be new large lay-offs and firings in that sector in and for the foreseeable future..

While many economists diminish the importance of the Unemployment Rate by referring to it as

a LAGGING indicator, others such as myself believe that when an economic contraction is

caused by a crisis in the financial sector such as in the Great Depression, the Unemployment

Rate is actually a LEADING indicator. Why?

Because the person who loses their job today then misses their mortgage or credit card payment

tomorrow. This ripple effect weakens the financial banking system further and drives the overall

economy towards its next wave of contraction.

Housing

The below chart shows Mortgage Purchase Applications, which includes only mortgages applied

for to buy a house. The last spike up, triggered by the $8500 tax credit for new home purchases,

is falling off again rapidly with recent applications being the lowest in 13 years.

Source: www.Papereconomy.com

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Below are a couple of charts provided by Real Capital Analytics, a private company indexing the

prices of all residential properties and then just the apartment complex sector since 2001. On

both charts, the small tail at the far right end of the trend demonstrates that the now completed

stimulus programs only deferred the downward direction of the curves.

The following chart confirms the above conclusion by showing how the supply of existing

homes is increasing again and how home prices on an annualized basis are beginning to shrink

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once again. With the next wave of unemployment about to occur, the housing market is most

likely entering another round of price contraction.

It is interesting to note that in May nearly one-third of all home sales involved a foreclosure of

some kind. This number will persist and likely increase for two reasons. First, it is taking

increasingly longer for a home even to enter foreclosure once an owner begins missing

payments. A recent report indicated that nationally, it now takes over 480 days from the time

payments cease until a home makes it into foreclosure. In the State of Illinois, that number is

over 600 days.

Second, as resale values continue to drop, many home-owners are beginning to “strategically

default” when home values drop well below what is owed on the mortgage, even if they are able

to make the payments! It will take up to two years for the home to be foreclosed, during which

time all of those monthly payments will effectively accrue as family EQUITY versus

disappearing mostly as INTEREST costs on a debt which has probably been sold to Fannie Mae

anyway! The local bank is not getting “stiffed”, it is “the government.” Home owners are using

this mechanism and every other possible one to build and conserve liquidity for the tough times

ahead and NOT for consumption and re-investment.

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In the first quarter of 2010, it is estimated that nearly 20% of all defaults were by

homeowners who were able to make the monthly payment but for whom liquidity became

more important than credit rating or even foreclosure.

The above chart illustrates the rapid rise in delinquencies with Freddie Mac mortgages over the

past few years. A chart of FNMA loans would show the same thing. Fannie Mae and Freddie

Mac were “quasi-government agencies” which traded on the NYSE.

Having lost over $185 Billion since 2008, they are now essentially wards of the state, being

completely supported by the Federal Government, and the taxpayer.

The Congressional Budget Office (CBO) recently released a report estimating that the total cost

of backing Fannie and Freddie would exceed $385 Billion over the next few years. Independent

analysts suggest the number will pass $1.1 Trillion. Despite this “implicit” guarantee and actual

backing to date, not $1 of this number is including in the government’s deficit forecasts.

Fannie and Freddie were both recently de-listed from the NYSE and not even mentioned in the

recently passed “financial reform” legislation.

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Other Indicators

At the end of the second quarter, The Consumer Conference Board reported that its Consumer

Confidence Index unexpectedly plummeted from 62.7 to 52.9, its largest drop in years. One of

the worst measures of the index was the very large drop in “future expectations”. Not only do

most people feel things are going to get worse, 76% believe we never exited the recession!

A second chart, provided by the Consumer Metrics Institute, illustrates how consistently the

measurement of their Daily Growth Index has been a six-month leading indicator for GDP. It

currently indicates the 3rd

Quarter 2010 GDP will again turn negative by about 2.2%, suggesting

we have already re-entered a recession.

Consumer Confidence Index

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The below ECRI Weekly Leading Index has turned negative again, also suggesting the high

likelihood that we are re-entering a contraction. We have avoided a recession only once, since

1965 with a reading this low of -7.7. (On July 22, the ERCI Index dropped to -10.5.)

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Over the last several weeks, many other indicators have been adding further credibility to my

conviction that a rapid decline in economic activity has resumed.

The Baltic Dry Index, which measures the pricing of shipment containers being shipped

around the world, has, fallen for a record 32 days in succession. It is now at the lowest it

has been since early 2009.M-3, which is a measure of money supply, has continued to

contract. Currently it indicates a contraction of a nearly 10% annualized rate.

Lumber prices have been falling, along with the price of Copper and other economic-

sensitive commodities.

Commercial Real Estate delinquencies continue to rise as Office and Strip Mall Vacancy

rates increase with no turnaround on the horizon.

We believe the new financial regulatory bill which by any interpretation will restrict

flows of capital.

The expiration of the “Bush tax cuts” which will dramatically reduce incentives to invest.

The re-establishment of a 55% estate tax will suck money from philanthropic causes as

elderly wealthy families opt to retain the funds versus fund charitable entities once their

own perceived needs are met.

Reports of a new Congressional Bill to tax “excess” corporate cash which not only will

cause them to hoard more in the interim but then deploy it into more tax friendly

jurisdictions (e.g. China) than the US.

The “uncertainty” associated with economically destructive “lame-duck” legislative

initiatives already being drafted in case of a loss of majority power in the mid-term

elections.

An administration which continues to propose “solution-sets” driven more by ideology

and “favored” constituencies than towards incentivizing and invigorating the system as a

whole.

The “demonization” of alternative points of view regardless of their efficacy.

Unfortunately, therefore, in the largest sense, we now live in a system whereby liquidity, as a

whole, is contracting. Indeed, the consumer appears to be in outright liquidation mode. (Oddly,

most statistics regarding “Savings” include debt reduction as an element in the calculation. In

other words, if a Credit Card line is lost, and gets paid off, that gets counted as “Savings”,

although the consumer no longer has access to that cash.) This data aberration is partly

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responsible for the myth that there is “plenty of cash on the sidelines”. Here is a chart which is

more indicative of our savings as a nation.

The enormous stimulus by our government, while helping to liquefy some banks, is not making

it to Main Street, the small business and the consumer. In fact, it is having the opposite effect:

New Government Debt Issuance and far more stringent regulation and threat of still further

regulation is crowding out access by a great many to credit at all.

This fact feeds into the phenomenon of corporations hoarding cash. Companies are not as able

to issue new publicly-traded debt instruments. The $2 Trillion Commercial Paper market has

shrunk by over one-third just since the beginning of the 2010! Corporations, fearing the inability

to raise future cash and losing access to credit are continuing to cut expenses and limiting hiring.

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As Consumer Credit and Small Business Credit continue to contract, however, the Government

continues to issue more debt at a breath-taking pace. As such the Defecit continues to grow

unabated and much faster than any “official” predictions. The next chart is the most recent

Projected Defecit revision by the Congressional Budget Office. The light blue bars represent the

former projection, with the dark blue bars now including the costs of recently passed legislation.

The important point here is These projections assume a GDP growth rate of 4.5% per year

for the rest of the decade! As a previous chart indicated, the GDP is most likely dropping back

into negative territory over the Second Half of the year. Even with a 4.5% GDP growth rate, the

CBO estimates that the Defecit begins growing again by 2014. How will it look with a negative

GDP growth rate? Or with another round of Quantitative Easing?

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These trends are not sustainable. Eventually, and perhaps quite soon, these trends will provoke

further dislocations in the credit markets, currency exchanges, and the US Dollar itself. Severe

dislocation will be felt in the Equity Markets as well.

Importantly, now let’s look briefly at a technical analysis comparing today’s market trends

with how they have performed historically in parallel environments.

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Technical Analysis

Starting with one of the best Leading Economic Indicators, the stock market, take a look at the following

six-month chart of the Dow Jones. What you see is known as a “Head and Shoulders” pattern. The right

shoulder is lower than the left shoulder, the “shoulders” and “neck line” are both declining and fairly

parallel. Most importantly, the recent market has dipped below the trend line – A VERY BEARISH

SIGNAL.

Source: www.netixis.com

Now, look again. At first blush it looks like it could be the same chart, except…….

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Source: www.Netixis.com

….it’s a chart of the past twelve years! Notice, however, that the low made on March 9, 2009 is lower

than the low made on October 9, 2002. The current low of this bear market has “taken-out” the low of the

previous bear market--a VERY bearish signal. The last time that happened was during the Great

Depression. For the market to merely “test” the low trend line would necessitate the Dow dipping back

into the 6000 range.

So, what happens if the low 6000 range on the Dow is reached, and that support level does not hold?

Take a look at an even longer period, starting from 1973.

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Source: www.danerics.com

Notice that the 1982 to 2007 Trend “Channel” has already been breached. The next major support from a

“low trend line” would be somewhere around 2500.

A chart of the Dow going back to 1928, and running through March 2009, shows another long-term trend

line, under 2000!

Source: www.danerics.com

Another recent technical indication bears noting. The S&P 500 is now exhibiting what is referred to as

the “Death Cross”, which occurs when the 50-day moving average (blue line) crosses below the 200-day

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moving average (red line). Notice what the market did the last time this happened, back in the Fall of

2008, when the S&P was near 1500. Another very Bearish signal.

A chart of the Dow, during the Great Depression, would show a very large rally off of the lows of the

1929 crash, followed by the next big leg down. When the Dow started that next leg down in 1930, and

ended by falling 89% from its high, the news of the day involved Sovereign Debt Default in Europe.

Sound familiar?

Conclusion

We have had many economic contractions in the past. When was the last one caused by a

Systemic Financial Crisis? The answer is the Great Depression.

Is this financial crisis different? Certainly, but unfortunately at this particular stage we are in far

worse shape to weather it. The nation is in far more debt. Households are in far more debt.

Public Entitlement Programs are far more costly, and we have far more national overhead. Put

quite simply, we do not have the ability to outgrow the costs of the problems we now face.

The likely outcomes are two. The first involves rampant Deflation, including continued declines

in liquidity, State, Federal and Sovereign defaults, and a drastic decline in standards of living

lasting a generation. The second involves outright monetization of debt (read: hyperinflation).

The reality will resemble some unfortunate combination of these possibilities.

The idea that all somehow will return to normal is spurious at best. Severe caution is advised.

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The opinions voiced in this material are for general information only and are not intended to

provide specific advice or recommendations for any individual. To determine which

investment(s) may be appropriate for you, consult your financial advisor prior to investing. All

performance referenced is historical and is no guarantee of future results. All indices are

unmanaged and cannot be invested into directly.