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Market Outlook
Dow Jones–
A New All Time High... Or Is It?
A quarterly newsletter published by M.L. Ballew, III and T. Doug Dale, Jr., Ballew/Russell advisors
The Dow Jones Industrial
Average is comprised of 30 of
the largest companies in the
United States and Wall Street
has recently cheered the fact
that the Dow has gone into
levels higher than those
achieved in January 2000
(11750).
The same stocks in the
Dow in 2000 are not what
comprised the Dow Index in
2006. Thus, the calculation to
determine the level of the Index
is very misleading since only
eight of the 30 stocks have truly
hit new highs in price.
Presently, two of the 30
stocks remain below their all
time highs by between 3% and
6%. Five of the 30 are down
between 10% and 30%; 13 of
the 30 are down between 30%
and 50% and two (General
Motors and Intel) are down
over 50%.
In a recent Market
Outlook, I discussed the impact
of the inverted yield curve on
economic growth within nine to
12 months after interest rates
have stopped rising. The U.S.
negative savings rate, which has
been present for two full years
in the U.S. (the first time since
1934) and the fact that the total
credit market debt (which is
more than double its all time
average as a percent of GDP
and has doubled since 2002)
cannot be sustained, leads to the
fact that the consumer will have
to cave and start rebuilding his
nest egg.
I've never claimed to know
when assets would be repriced
to reflect value, debt and
negative saving but I know that
if you ignore the valuation, any
day could be the day you begin
facing a surprising reduction in
net worth. Another way of
saying that is the risks are high
but are being ignored or
misunderstood by most
investors.
To make a simple analogy,
using the S&P as our example
and considering 20 times
earnings expensive, 15 times
earnings as fair value, and 10
times earnings cheap, then an
investor in the S&P 500 today
has a potential upside gain of
11% versus a loss between 16%
to 44% (-16% is fair value and 44% is cheap). This leaves the
investor with what I consider a
poor risk/return ratio.
The Market Outlook has
new readers each quarter so I
am asking that each of you
indulge me as I explain to them
our long term thesis. We are in
a secular long term bear market,
which can last 15 to 20 years
(starting in January 2000) and
during this secular long term
bear market, there will be
cyclical bull rallies followed by
significant drops like the 20002002 time frame. Past time
frames of secular bear markets
were from 1929 to 1954, 1966
January 2007
spending until he has to and
to 1982, and currently 2000
now I feel like we are getting
through the present and
close to that time frame since
counting.
the stock
We had a
market has
stock market
bubble that
"...the risks are high but are had a lengthy
cyclical bull
was pricked in being ignored or
run and the
2000 leading
misunderstood by most
housing equity
to drops
investors."
extraction
between 36%
game appears
and 80% in
to have run its course.
the Dow, S&P 500 and
The balance of this Market
NASDAQ 100. The Fed
Outlook will be devoted to the
stepped in to save the day
U.S. housing market giving our
creating massive amounts of
readers an update as to why
liquidity through low interest
home equity extraction may not
rates. This coupled with fiscal
be a source of consumer
stimulus from Congress from
spending in future years and
massive tax cuts brought the
market back. It also created the could finally be the catalyst for
real estate bubble, which started flat to downward markets over
in 2002 and ran through August the next two or three years.
(Giving credit where credit
2005. It now appears to be
going the way of the 2000 stock is due - I am paraphrasing much
of Barry Ritholtz's comments.
market peak albeit at a slower
Mr. Ritholtz is chief market
pace. And, finally, for new
strategist for Ritholtz Research
readers, we have had an
and Analytics in New York.)
average savings rate in this
It is unlikely that there is
country for over 40 years of
anyone left in the country who
about 7.5% which has dropped
doesn't know about the huge
to negative territory for eight
run up in home prices during
full quarters (since the first
2002 - 2006, and the
quarter of 2005) for the first
subsequent “correction.”
time since the Depression. An
Since the recession in
increase in savings back to
2001, real estate has been
7.5%, which is ultimately
crucial in enabling enormous
necessary, means reduced
consumer spending and helping
spending and, therefore,
to create many new jobs. These
reduced economic growth at
two factors have been the
some point in the future.
primary drivers of the post
It has been my belief that
crash economy. With this
the U.S. consumer won't quit
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economic expansion now
such an extended period.
entering its fourth year, the
Dollar denominated asset
cooling real estate market is
classes were “repriced.”
increasingly presenting new
Because money was so cheap
risk. The peak of the boom,
and plentiful, anything priced in
long since past (August 2005),
dollars (oil, gold, industrial
the current housing inventory
commodities, etc.) increased
build up, sales slowdown, and
dramatically in nominal price.
price decreases are starting to
This brought on a new round of
take their toll on economic
inflation in just about every
activity. Given how
item in the production pipeline extraordinary the boom was, we with the exception of labor.
may not be in for a run of the
The U.S. consumer
mill downturn. When the U.S.
aggressively used cheap debt
economy was under the weather financing on whatever he
in 2001, the government
possibly could. This led to his
prescribed big tax cuts, lots of
savings rate promptly dropping
deficit spending, increased
below zero. And, consumer
money supply, military
financed purchases - primarily
spending for two wars, and
homes and automobiles - saw a
significant interest rate cuts.
huge spike in sales.
Despite the massive
Post Crash Recovery
stimulus, nothing much
When viewed from a
happened at all. Following the
historical
perspective, the
Tax Relief Act of 2001, plenty
expansion
and the massive
of deficit spending in 2002,
stimulus created were:
lower rates and even more tax
1. Light on job creation.
cuts in 2003, the economy was
2. Heavy on inflationary
still barely limping along. Real
pressures.
GDP was barely positive in
3. Overly dependent on
quarter four of 2002. The
real estate.
possibility of a “double dip
In most recoveries, the
recession” was very real and
economy
drives real estate.
that was making the members
Interest rates are
of the Federal
important but it is
Reserve very
usually job creation
"It has been my
nervous
and growth that are
belief that the U.S.
especially in
the key metrics for
light of the fact
consumer won’t quit
that the Federal
spending until he has residential demand.
That is not how it
Reserve had
to and now I feel like
happened this time.
watched Japan
we are getting close
Statistics for nonget caught in a
to that time..."
farm payroll
decade long
growth and wage
recession,
growth
were
anemic to flat, all
compounded by a nasty case of
of which compare very
deflation.
unfavorably to prior recoveries.
Unwilling to take the
In fact, during this recovery,
chance of a Japanese-like
new job creation has been the
deflationary spiral happening
worst on record since WWII.
here, the Fed got panicky.
The explosion in
Their response was that of a
residential
real estate can best
doctor whose patient was not
be
explained
by the level of
getting better despite taking his
Mortgage Equity Withdrawal
meds: they upped the dosage.
That meant more rate cuts. The (MEW) that has occurred. A
number of risky forms of
FRB took rates down to 1% - a
financing, such as adjustable
46-year low. Then, just to
rate mortgages, no credit-check
make sure the patient did not
loans, interest-only mortgages,
slip back into a coma, the Fed
120% financing, piggy-bank
left rates at 1% for a full year.
mortgages, and all other
Since 1954, the Fed has never
manners of creative financing
had this degree of stimulus for
for sub-prime borrowers more
than replaced the typical drivers
of real estate demand.
Obviously, if job creation or
wage gains were actually
driving real estate, the
dependency on high-risk exotic
loans would have been totally
unnecessary.
Real Estate Driven
Economy
The primary gains from
real estate were three fold:
1. Job creation.
2. The wealth effect.
3. Consumer spending.
Job creation
Job creation from housing
covers a wide swath of
industries - not only developers,
builders and sub-contractors but
also real estate agents, mortgage
brokers and designers. In
addition, it brings about
increases in employees at stores
like Home Depot and Lowe's
resulting in a disproportionate
percentage of new job creation.
How disproportionate?
According to a study by
Northern Trust, from 2001
through April 2005, 43% of
private sector job creation was
housing related. Even more
interesting is that once the Fed
began raising rates from those
ultra low levels, real estate
related job creation plummeted
68.2%.
Housing Wealth Effect
In addition to the actual dollars
extracted from housing through
refinancing, one shouldn't
underestimate the psychological
impact feeling flush has on
spending.
A recent study quantifies
the outsized impact and
multiplier effect on wealth that
housing has. According to the
study, an increase in housing
wealth of $100 will boost
spending by $9. A similar
increase in stock market wealth
only creates $4 more spending.
Considering how
widespread home ownership is
in the United States, this is
quite significant. About 68% of
American families live in their
own home while ownership of
stocks is near 50%. The typical
American family has a
relatively small percentage of
their net worth in equities.
Indeed, in most cases, stocks
are their second or third largest
asset. Therefore, it would
appear that the wealth effect of
home price appreciation is not
only greater, it is much more
widely distributed.
Consumer Spending
While the boom had a positive
impact on jobs and the income
and spending that goes along
with it, the wealth effect it
created was very real. The
most significant impact to the
economy was MEW and the
consumer spending it enabled.
This has been the single biggest
element of the economic
expansion. Without it, the
nation would have had a flat to
1% GDP growth rate over
recent years and be on the verge
of a recession.
If a comparison is made
between the most recent
mortgage equity withdrawals to
those in the past, it helps drive
home the point. For most of the
1990s, the new equity pulled
out by homeowners - either
through sales or through home
equity refinancing - was fairly
modest. It amounted to about
$25 billion per quarter and was
about 1% of disposable
personal income. After
slumping in the late 1980s and
early 1990s, homes prices
began to rise modestly. By the
late 1990s, gains had returned
to the historical mean. That
allowed some withdrawal of
equity. But, even then, it
remained a relatively modest
amount at $25 to $50 billion per
quarter - about 2% of
disposable income. Given the
total GDP of the U.S. is $12.3
trillion, this amounted to only a
small blip on the economic
radar screen.
The impact of MEW began
to accelerate once the Fed cut
rates so spectacularly. By mid2002, the quarterly average
MEW was north of $100
billion. That is greater than 4%
of disposable income, up nearly
400% since 1997. By 2003,
those quarterly numbers were
$150 billion and 6%.
Then, things exploded in
2004, as quarterly withdrawals
were almost $250 billion and
the MEW hit a peak - it was
over 10% of disposable
personal income. To put that
into context, that is a 1,000%
increase since 10 years before
in 1995. The MEW was
essential to the expansion.
Without it, the economy would
have been expanded at a 1%
growth rate or worse. The
psychological impact of this
anemic growth could very
likely have caused that double
dip recession the Fed had
feared.
In the second half of the
1990s, equity extraction
contributed approximately 25%
of GDP growth. Using a
method developed by former
FRB Chairman Greenspan, the
MEW impact on the economy
since rates hit their lows in
2003 has been nothing short of
breathtaking. MEW has been
responsible for more than 75%
of GDP growth.
Now, MEW is falling. As
rates have ticked up, two things
have happened: MEW has
trended downward (it fell to
113.5 billion in the third quarter
of 2006, a drop-off of 50%
from the 2004- 2005 peaks) and
GDP growth has trended
downward with MEW.
So, in review, our post
stock market crash post
recession economy was nonresponsive to the usual
economic stimuli. It took the
Federal Reserve slashing rates
to levels not seen in nearly half
a century and then leaving them
below inflation for a year
before the economy actually
showed signs of life and
responded. The response was
enormous affecting everything
from commodities and real
estate as well as corporate
profitability.
Despite all this, U.S. real
incomes remain flat. However,
MEW allowed the consumer to
keep on spending, even as their
savings rate went negative and
their compensation as a
percentage of GDP dropped to
multi-decade lows.
Now, it seems that things
are ending and the housing
boom with its accompanied
MEW is beginning to unwind.
The decline in housing has been
well documented in spite of
some recent signs of
stabilization. It doesn't appear
to be anywhere near a bottom.
Housing starts have plummeted
and inventory remains at
extremely elevated levels.
According to research from
Goldman Sachs, over the past
three cyclical declines since
1960, new home unit sales have
dropped on average by over
50% over a 26 to 53 month
period. The statistical top in
housing activity was only 15
months ago; housing starts are
off by only 20%. From this
historical perspective, we could
still be very early in the
downturn. We still are near 15year highs in terms of existing
home inventory.
Indications that the housing
market is beginning to take its
toll on the rest of the economy
are as follows:
Transportation Index
Leaders in the transportation
industry seem to be saying that
they see problems
ahead. The American
Trucking Association
plunged 3.6% in November
following a 1.9% drop in
October. The Index has
decreased 8.8% compared with
a year earlier, marking the
largest year over year decrease
since the last recession.
Holiday Retail Sales
According to Master Card
analytics, holiday sales
increased only 3% this year.
That is the weakest since 2002.
With inflation running about
3%, this means that real retail
sales were flat year over year.
Durable Goods
Orders fell by 1.1% in
November, which was the
second consecutive monthly
drop, and the fourth decline in
the last five months.
Manufacturing Indices
ISM Manufacturing Index
slipped below 50 for the
November reporting period.
Data below 50 reflects
contraction. The ISM Index
rebounded in December so we
will see what January brings.
Mortgage Foreclosures
Foreclosures have been
accelerating in the sub-prime
area with no signs of slowing.
In fact, the interest-only and
variable mortgages issued in
2003 and 2004 “reset” in 2007
and 2008.
Automobile Sales
The “dealer doldrums indicator”
suggests that the economy is
cooling rapidly and this
indicator in previous cycles has
a good track record forecasting
recessions.
Business Caps Spending
Many of the forecasts for a soft
landing scenario are relying on
business spending to pick up as
the consumer begins to slow.
So far, there has been little
evidence of this happening as
business investment in new
Page Three
equipment and software fell in
quarter two for the first time
since the recovery began.
Earnings
S&P 500 earnings generally
revert to the mean over long
periods of time. At the current
time, it is experiencing what
would be referred to as peak
earnings after three solid years
of earnings expansion and a
slowing of earnings growth
should be expected. With the
S&P 500 trading at a price
earnings ratio of about 17, the
market is fairly valued. In the
event any of these issues
worsens, we cannot imagine
how corporate revenue and
profits won't be impacted in a
negative way. Any appreciable
spending slowdown by either
consumers or business will not
bode well for equities.
Presidential Election
Cycle
Contrary to all the above, the
year before election years is
universally an up year typically
because those in office will do
whatever they can to stimulate
the economy to help the coming
election. 2007 could be an up
year but I don't expect a
barnburner, as we have had
nothing but stimulus for four
full years.
My best guess is that we
should have at least a “V-like”
pull back in stock prices since
the slowing has already had a
major impact in commodities
and in spite of the rate hikes
starting in June 2004 through
June 2006, long interest rates
have drifted downward
forecasting a slowing or
recessionary economy.
– Matt Ballew, JD, LLM, CPA
OUR BOTTOM LINE ––––––––––––––––––––
• MEW (Mortgage Equity Withdrawal) has been responsible for more than 75%
of GDP growth.
M.L. Ballew, III
[email protected]
T. Doug Dale, Jr.
[email protected]
• The decline in housing has been well documented in spite of some recent signs
of stabilization.
• We should have at least a “V-like” pull back in stock prices.
Page Four
Need a Speaker?
Matt Ballew and T. Dale are available to
speak to your professional organization,
employees or civic group. We will be glad
to provide a complimentary informative
talk regarding the market and preparing
for the future.
To schedule a speaker for your group,
please contact Lisa Tate at 368-3500 or
[email protected].
4800 I-55 North, Suite 21
Jackson, MS 39211
Post Office Box 14888
Jackson, MS 39236-4888
The Market Outlook is a quarterly publication for
the benefit of the clients of Ballew/Russell, Inc.
Pursuant to the provisions of Rule 206(4)-1 of the
Investment Advisors Act of 1940, we advise all readers
to recognize that they should not assume that
recommendations made in the future will be profitable
or will equal the performance of past
recommendations. The contents of this letter have been
compiled from original and published sources believed
to be reliable but are not guaranteed as to accuracy or
completeness.
M. L. Ballew, III and T. Doug Dale, Jr. serve as
portfolio managers at Ballew/Russell, Inc., a registered
investment advisor, a subsidiary of Security Ballew, Inc.
Ballew/Russell, Inc. is affiliated with Ballew
Investments, Inc., a fully-disclosed introducing
broker/dealer and NASD/SIPC Member. All securities
are cleared and executed through Pershing, LLC.
Ballew/Russell, Inc. and Ballew Investments, Inc. are
both subsidiaries of Security Ballew, Inc. Clients of
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from time to time make purchases and sales of
securities mentioned herein.