If There's A Recession?

The market's already celebrating a 50 basis point cut in the Fed Funds rate, which Ben Bernanke may deliver on Tuesday. Unless you can creep into the head of a Fed chairman and know what he's going to do before he does, find some other work.

I'm sticking with my call for a weak economy but no recession--I could be wrong. All the economists missed the inflection point of the employment stats which turned negative, not the 100,000 job creation consensus. There's more to come. At least 100,000 layoffs in the construction-mortgage servicing sector will percolate through the next few months.

Corporate earnings flatten out in my scenario of gross-domestic-product momentum at 1.5% to 2% for several quarters to come. This is how I derive my projection of 1,425 for the S&P 500 Index. If corporate earnings decline next year, the market's as attractive as a frozen package of carrots and peas. The Federal Reserve Board will be viewed as behind the curve in righting a demoralized economy. Take at least 5% off my 1,425 number.

The investment problem then segues into a timing issue. When do you look across the valley and see blue birds over the white cliffs of Dover?

The vise on new home construction tightens inexorably. Cancellation rates run close to 35% and the glut of existing homes for sale swells. Not only is it unlikely for the home building cycle to bottom before 2009, but prospective bankruptcies of home builders with national footprints could mar the 2009 landscape. Loan covenant violations could loom by mid 2008. Home building is capital intensive, and many banks are involved.

Gross margins on new home sales average 15%, compared with 24% a year ago. This kind of margin compression doesn't cover overhead, which for a big operator can run half a billion annually. Short of abolishing dozens of divisions, overhead is sticky, and closing down subdivisions triggers write-offs on land options and lots in subdivision. Again, hundreds of millions.

The cresting of home prices is a critical macro event as it limits the wherewithal of consumers to spend more than their normalized amount of disposable income. For several years, middle America has monetized home equity and increased spending by a couple of percentage points. Housing stock is more than half the net worth of many individuals. Even a 10% decline in home value runs into trillions of bucks.

Retailing is impacted directly and the stock market indirectly, as corporate profits flatten out, maybe decline even if the Fed cuts the Fed Funds rate in lock- step fashion. Clearing our existing homes inventory could take years. After all, prices elevated for a couple of decades.

The reading on Fannie Mae in 1982 was a basket case as mortgage delinquencies in the Southwest and California surged alarmingly. In the 1960s, I saw families in Palmdale, Calif. walk away from a 2,000-tract home development. They threw their toilet seats in the trunk of their cars. Douglas Aircraft had just declared bankruptcy. It took too many fixed-price bookings for their DC-9 jet and couldn't get production lines to function efficiently.

I was a young savings and loan analyst then, and it turned me forever skeptical on builders and financial intermediaries. I did buy warrants on Fannie Mae that traded on the American Stock Exchange, but I waited until Paul Volcker relented on interest rates. For a while, Fannie's five-year debentures traded at a 15% yield.

What I remember about the spring and summer of 1982 is the subtlety in the bottoming-out process. People weren't looking across the valley as they may be right now. We had a pool going in the office as to which month an automaker would file for bankruptcy. And yet, I began to detect within the foggy malaise specific sectors of the market resisting further erosion. First it was utilities, and then the oil sector held the line. After all, utilities are allowed a reasonable return on capital by the regulators, and the value of oil reserves in the ground is quantifiable.

Today, systematic inflation is not a policy issue, just a worry. But nobody's paying attention to the Commodity Research Bureau's U.S. Futures Grain index, which recently broke out from a base dating back to 1998. Meanwhile, the U.S. Spot Foodstuff index spiked above its previous high set in 1996. Farmers are getting rich and ethanol is capturing the attention of economists. It's the motive force for food inflation starting with corn. Deere is scaling up tractor production worldwide.

If there is a mini-recession brewing, my last column "Buy the World" is irrelevant. Yes, I believe growth stocks will outperform cyclicals, but both sectors will decline absolutely. The exception could be health care, reasonably valued today and impervious to the economy. My money is on Celgene and Gilead, rapidly growing mid-sized drug houses.

The call on commodities and aerospace, so far on the money, is a no-no if you believe world growth is shaved by our economic contraction. I'm sticking with Boeing. Rio and Freeport-McMoran, which act better than Google and Apple combined. I recently lengthened the duration of my bond portfolio with Federal Agency paper going out 20 years. Nobody wants to sell me low-grade corporate debentures anywhere near their bid price.

Oil, nearly off the chart on the upside, perplexes me. Service operators like Schlumberger still hold some profit margin leverage, but the exploration and production properties like ExxonMobil are seeing rapidly rising operating costs. They need $80 oil just to maintain present earning power.

The clearing cost to produce copper is so much lower than present quotes, over $3 a pound, that it takes all my courage to hang in with Freeport, up 40% in the past two months. When Nelson Bunker Hunt tried to corner the market for silver decades ago, he drove the price from $5 to $50 an ounce. Then, the housewives in India shed their bracelets and everyone melted down their silverware. One of my friends, a commodities trader, made a large fortune shorting silver. Commodity prices can spike, then crash. There is no residual intellectual capital like you find in tech-land--just a big hole in the ground. Iron ore contract pricing could rise 30% next year if China's healthy. That's the Rio bet.

Bottom line, I'm talking about a plus 5%, minus 5% bracket for the market over the next 12 months. Mark down your co-op or four-bedroom colonial by 20%. The Fed can't bail us out of 20 years of asset valuation buildup. Let's hope it contains the carrying costs for debt-ridden families. That's the real world.