Slow Economic Growth Ahead

Recently I had the opportunity to listen to a presentation by Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco given to the local Society of Certified Financial Analysts(CFA) San Francisco, CA. on September 14th, 2009.

Now with the benefit of hindsight we know the market and economy did not fall off the cliff as many believed possible in March 2009. But now comes the guessing game over the next 12 month economic outlook. In my life time, I've learned that forecasting the economy over the next 12 months is always easier then predicting the stock markets next 12 month moves.

Below are my Cliffs Notes of her economic forecast, extracted from her presentation.

.....I believe that we succeeded in avoiding the second Great Depression that seemed to be a real possibility. Much of the recent economic data suggest that the economy has bottomed out and that the worst risks are behind us....

That’s the good news. But I regret to say that I expect the recovery to be tepid....In particular, the unemployment rate will remain elevated for a few more years.....Moreover, the slack in the economy, demonstrated by high unemployment and low utilization of industrial........gives us plenty of room to grow rapidly over the next few years.

.......At first glance, history suggests that a vigorous expansion could very well take place. Following previous deep recessions, the United States typically saw V-shaped recoveries. For example, the economy grew at an average rate of nearly 6 percent during the two years following the severe recession in 1981-82. This time though rapid growth does not seem to be in store. My own forecast envisions a far less robust recovery, one that would look more like the letter U than V. And I’m not alone. The Blue Chip consensus forecast, reflecting the views of nearly 50 professional forecasters, anticipates by far the weakest recovery of the postwar era over the next year and a half. A large body of evidence supports this guarded outlook. It is consistent with experiences around the world following recessions caused by financial crises.

For those interested in listening to a similar presentation Janet gave to The Commonwealth Club of California you may view the complete presentation broken down into small component video segments at Window To Wall Street Economics. Here is a complete PDF transcript of her speech on September 14th to San Francisco's Society of CFAs.



Historically Economist have been horrible at forecasting economic turning points and have a similar dismal record at forecasting stock market trends. Still after recently listening to seven economist speak most have mentioned a very important point regarding inventories and GDP trends that maybe a clue to the markets next big move.

Remember the stock market is a leading economic indicator. So, the door swings both ways. As I've pointed out it has an excellent track record at guessing where the economy will be 6 months from now but it doesn't have ESP to know where the economy will be in 12-18 months. If the collective wisdom of money starts believing a disappointment is coming it can turn downward even as the current good news the market was anticipating is coming true. One need only study the 1997 to 2003 American market moves for a quick lesson on this topic. And for those amazed by this markets 3,000 point DJIA climb one need only look back to the 2003 market or 1982 economy compared to the major market move.

Paul Krugman, a professor of Economics and International Affairs at Princeton University and recent Nobel Prize winning economist, published in his blog The Conscience of a Liberal, that he agrees with Janet's economic outlook. Everyone agrees with Janet's forecast which is nothing more than the current economic community consensus.

But it is Paul's chart of historical inventories and GDP changes that causes him to conclude there is good possibility of a double dip economy ahead. His basic chart was worth a thousand words to me for another reasons. It helps provide a missing link to explaining why the stock market fell for three quarters in 2002, after the recession had officially ended in 2001 and the market had advanced for three quarters. Given the much higher unemployment rate and more fragile economy today a 2002 Stock Market repeat in late 2009 to early 2010 is a very real possible.

If the economic outlook is improving but more problematic than after the 2001 or 2003 market advance it would be prudent to review your asset allocation now. Keep in mind more people than ever now see the market advancing to the pre-Lehman Brothers bankruptcy levels of 2008. Still, even the Bulls believe that would be the best one could hope for in 2009.

Those fortunate enough to have 70% to 100% gains in the China and India markets should most certainly consider downsizing your positions, if you believe the USA GDP bounce we are getting in the 3ed quarter will not be repeated (into the 4th quarter 2008 and 1st quarter 2009).

In the 60's, 70's and 80's the correlation of major foreign markets to the USA was only around .65 resulting in the notion international investing added an extra level of diversification protection. Today the correlation is closer to .90. Basically this means all major stock markets move more in tandem than they use to because of todays global trade dependences. You only need to examine the 1999 to 2003 market to see the USA and European markets and sectors moving in lock-step with each other.

Black Monday Anniversary

September 15th 2008 was another historic black monday for the USA market. Fannie Mae (FNM) and Freddie Mac (FRE) were both taken over by the government just the week before and the worlds largest (market capitalization) insurance company, AIG needed billions to stay afloat.

September 15th is the one year anniversary of Lehman Brothers' demise. The bankruptcy filing represents the end of a 158-year-old company that survived world wars, the Asian financial crisis and the collapse of hedge fund Long-Term Capital Management, but not the global credit crunch.

Lehman was the 400 pound gorilla that broke our over leveraged financial camel's back. Lehman was the nuclear bomb that set off a world-wide financial winter. Fortunately that nuclear winter ended this spring. Now we've begun the long economy road to employment recovery.



Lehman Brothers was the biggest investment bank to collapse since 1990, when Drexel Burnham Lambert filed for bankruptcy amid a collapse in the junk bond market. Based on assets, Lehman also far surpasses WorldCom as the largest U.S. bankruptcy ever.

Lehman had assets of $639 billion at the end of May, while WorldCom had $107 billion when it filed for bankruptcy protection in 2002.

At the end of August 2008, Lehman had $600 billion of assets financed with just $30 billion of equity. Having so little capital meant that a 5 percent decline in assets would wipe out the value of the company, which investors saw as a real risk due to the company's billions of dollars of mortgage securities.



The Lehman failure was the straw that broke the fragile USA financial camel's back. In 2008, a series of bank and insurance company failures triggered a financial crisis that effectively halted global credit markets and required unprecedented government intervention. Fannie Mae (FNM) and Freddie Mac (FRE) were both taken over by the government. Lehman Brothers declared bankruptcy on September 14th after failing to find a buyer. Bank of America agreed to purchase Merrill Lynch (MER), and American International Group (AIG) was saved by an $85 billion capital injection by the federal government.[1] Shortly after, on September 25th, J P Morgan Chase (JPM) agreed to purchase the assets of Washington Mutual (WM) in what was the biggest bank failure in history. In fact, by September 17, 2008, more public corporations had filed for bankruptcy in the U.S. than in all of 2007. These failures caused a crisis of confidence that made banks reluctant to lend money amongst themselves, or for that matter, to anyone.



The crisis has its roots in real estate and the subprime lending crisis. Commercial and residential properties saw their values increase precipitously in a real estate boom that began in the 1990s and increased uninterrupted for nearly a decade. Increases in housing prices coincided with a period of government deregulation that not only allowed unqualified buyers to take out mortgages but also helped blend the lines between traditional investment banks and mortgage lenders. Real estate loans were spread throughout the financial system and world in the form of CDOs and other complex derivatives in order to disperse risk; however, when home values failed to rise and home owners failed to keep up with their payments, banks were forced to acknowledge huge write downs and write offs on these products. These write downs found several institutions at the brink of insolvency with many being forced to raise capital or go bankrupt. These firms had become so highly leveraged that just a small 5% to 10% decline in asset values required masses amounts of new capital to be raised or file for bankruptcy.

For those wishing a refresher course in the fall of 2008 financial crisis, CNBC has an excellent summary of the headline stories of that time. Wall Street in Crisis.

FDIC, Banking & Real-Estate Deja Vu Two

click on graphics to enlarge

It took eight years from the start of the Savings & Loan crisis in the 80's and 90's to reach a peak in bank failures from the last real-estate boom turned bust. Let's hope we are not in for 6 more years of large quantities of bank failures. Mr. Bill Isaac JD who headed the Federal Deposit Insurance Corporation during the banking crisis of the 1980s said he doubts we'll come close to the volume of failures of the S&L crisis. Still, history is repeating its self. It's like a domino effect. First it effects the largest financial institutions leveraged to real-estate sales through the mortgage securitization and derivatives markets. Next came large Insurance companies and regional banks with large investments in real-estate and related loans. Now it's smaller state banks effect by commercial real-estate construction loans.

One single common denominator jumps out...real-estate. Yes, REAL-ESTATE SPECULATION fueled by historic low interest rates, easy credit, little money down and excessive value appraisals.

Real-Estate Implodes, Banks Fall and FDIC Funds Nose Dive

At the tail end of the Savings & Loan (S&L) debacle L. William Seidman, former chairman of both the Federal Deposit Insurance Corporation (FDIC) and the Resolution Trust Corporation, stated,"The banking problems of the '80s and '90s came primarily, but not exclusively, from unsound real estate lending".

In May of 1991 the Los Angeles Times reported, "The FDIC faces problems with the bank insurance fund expected to be insolvent by the end of the fiscal year. The House and Senate banking committees have passed separate bills providing $70 billion in temporary borrowing authority for the fund, with the money to be repaid by premiums from the banking industry. Seidman's replacement at the FDIC will run the fund at a time of great uncertainty for the banking industry, during a depression in commercial real estate that threatens the solvency of many banks".

For years after the 80's and 90's Savings & Loan financial crisis had ended hundreds to thousands of Articles, Whitepapers and Books were written on what created the problem and what was needed to prevent a future meltdown. To insure we learn from our past mistakes the FDIC has web pages listing FDIC reference books deticated to the S&L crisis memory.

Congress Passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991.

This legislation authorized the Federal Deposit Insurance Corporation (FDIC), for the first time in its history, to charge higher deposit insurance premiums to S&Ls and Banks posing greater risk to the FDIC Insurance Fund. This historic piece of legislation empowered the FDIC to charge members premiums linked to risk.

A 1996 report by accomplished economist Frederic Mishkin a longtime friend and research partner of Fed Chairman Ben Bernanke reaffirms the need for the FDICIA stating the provisions were designed to serve two basic purposes: 1) to recapitalize the Bank Insurance Fund of the FDIC and 2) to reform the deposit insurance and bank regulatory system so that taxpayer losses would be minimized.

The United States General Accounting Office (GOA) issued a report in November 1996 entitled Bank and Thrift Regulation. The very first sentence of the executive summary states, "The thrift and banking crisis of the 1980s caused deposit insurance fund losses estimated at over $125 billion. One of the many factors contributing to the size of the federal losses was weakness in federal regulatory oversight".