Welcome to the Room - December 15, 2006
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Last Updated December 8, 2006
Dear Reader,
My apologies, but this week’s edition is going to be a bit rushed as it is late in the day and I have just now walked back in from a business trip, capped off by a much delayed flight from hell.
To be more specific, after a rather late and wine-sodden business dinner, I arose at 6:00 am, grabbed a quick bite in the hotel restaurant and rushed to the airport. Where I discovered my plane was delayed for 2 hours. In time, crammed into a small, overheated prop jet and feeling a touch queasy from the convivial imbibing of the night before, we sat on the runway for an extra 40 minutes before bumping into the windy skies. It went downhill from there, with a scheduled forty-minute flight turning into 90 minutes, all of it in rough air, but every second of the last 30 minutes in a holding pattern over La Guardia in some of the most turbulent air I have ever experienced. It was as if some deity, mildly annoyed at my intemperance, decided to punish me, or at least toy with me for amusement purposes, by shaking me till my teeth rattled and my stomach begged me to put it out of its misery.
In any event, the work I had planned on doing while traveling (including my Argentine update) was left undone. And I am still none too chipper.
However, before I find a nice couch to plop down on, no doubt gasping “TGIF” as I do, I did want to share the contents of a useful email I found waiting for me from our untiring and ever diligent numbers watcher, Bud Conrad, reporting on some of the news that hit his radar screen this week.
The Steady Element
The big number this morning is that non-farm payrolls jobs increased 132,000, better than the consensus 112,000. This more positive view will bring the “soft landing” crowd out to give their blessings to the economy and tell people everything is fine. “Goods Producing” jobs were off 40,000, of which 29,000 were from the ill-fated construction trades. Professional and Business services, Education and Health, Leisure and Hospitality, Retail, and Government were all up, in that order. In other words, the hollowing out of American manufacturing continues, with the slowing housing sector beginning to be felt. October jobs were revised down and September up. Unemployment rate increased a tick to 4.5%.
This good news left stocks muted, being basically unchanged.
[Ed Note: A reminder that, as revealed in the current edition of the
International Speculator, unemployment in America hit its all-time low just before the crash of ’29.)
The Dollar
But we at Casey Research have been worrying more about the dollar than government-manipulated proclamations of good economic numbers. Confidence in the economy has been lifted by the 13% rise in the S&P 500 index so far this year. That looks good in dollar terms. But dollars don’t buy what they used to, especially if you travel to Europe.
For Europeans (and many other foreigners), who invested in the U.S. stock market, their returns were decidedly unexciting… just 1.6% after conversion to the currency they spend, the euro. So they essentially get all the risk with almost no return… and as the dollar slide gains momentum, eventually bleeding over into the stock market, potentially a seriously negative return.
It’s not a game many would presumably want to stay in for very long. To wit, stocks rise a bit on a price basis, but the decreasing dollar leaves stock holders with dollars that buy less. If they cash in the stock profits, they have to pay taxes on the increase in the dollar price of the stocks, even if they can’t buy more with the dollars.
Lest you think this is just a recent phenomenon, triggered by comments from China that they may rebalance their $1 trillion of foreign currency reserves away from the dollar, below is a chart of the stock market in both dollar and euro terms. The green line shows returns as Europeans would see U.S. stocks.
What isn’t shown above is that the euro is also eroding, and probably more than their government is letting on, just as in the U.S., so the real stock returns are anemic at best, and after tax almost certainly not worth the risk.
Whither the Asians…
It seems like everyone these days is catching on to the theme we’ve been playing around here for many months… that the dollar weakness is just beginning.
In the latest salvo out of Asia, the New York Times quotes Masahiro Kawai of the Asian Development Bank as saying “We believe that some U.S. dollar depreciation would be necessary, and collective joint appreciation of the East Asian countries could be needed.” Various of China’s ministers have recently gone on record about changing the composition of dollar holdings.
The question is whether Asian central banks can recycle their U.S. foreign reserves into other assets without destroying the dollar?
As has oft been commented on, the Chinese want to help keep the dollar afloat because it’s in their own best interest. One way the Chinese might attempt to achieve their new goal of currency diversification without killing the golden (sorry, paper) goose, might be to establish a government-owned investment company to manage investments using dollars. This company would raise capital by issuing yuan-denominated bonds, using the proceeds to buy foreign exchange from the Chinese central bank and thereby invest in foreign assets. This way China can buy the assets of the west without damaging the dollar. Asian markets are rising, and so the next bubble could be in Asian assets.
Another reason for dollar weakness is that, over the last few months, Iran has started replacing the dollar with the euro in the majority of its crude oil exchanges. Iran's objective is an obvious encroachment on dollar supremacy in the critical international energy markets. Europeans will not need to have as large U.S. dollar reserves to buy the oil. This also allows China to accumulate fewer dollars. The U.S. attacked Iraq shortly after it started trading oil in euros. Could Iran be next?
Housing
Since real estate accounts for almost 30% of employment growth from 2002-2005, housing is central to the economy. The exotic mortgage wave of 2004-2006 could unravel with ARMs resetting, delinquencies rising, spreads widening in the CDO market and foreclosures skyrocketing. At a minimum, these dynamics put further pressure on supply, and more severely could tighten mortgage liquidity for the consumer.
Anecdotal evidence of the housing slowing in key areas is extreme: Here are a few news clips:
More than 115,000 properties across the country were in the foreclosure process in October – up 42 percent from the same month a year earlier, according to RealtyTrac, a California company that tracks foreclosures.
Foreclosures in Georgia are up a stunning 99 percent in the past year.
In the Denver metro area, foreclosures have now reached a record high.
Sub-prime mortgage lender "Own It" informed its broker network that it will cease funding loans. Own It was probably the tenth-largest sub-prime mortgage lender with approx $1.5 billion of originations per month. Merrill Lynch owns 20% of Own It.
Wells Fargo just announced that they are shutting down mortgage operations for their wholesale sub-prime in the Florida and Arizona locations.
Official numbers on house prices probably understate the decreases in price. The statistics keepers say prices have either continued to rise, albeit modestly, or have fallen slightly over the last year. But they are based only on homes that have actually sold. The numbers overlook all those homes that have been languishing on the market for months, getting only offers that their owners have not been willing to accept.
Gold stocks
Gold stocks in the S&P 500 Gold Index are more dearly priced than the broad averages at over 20 P/E multiple compared to the S&P 500 at 15. This is because earnings in the S&P 500 Gold Index are projected to grow 50% in the next 12 months, while the broad measure may be closer to flat. That leaves gold stocks a better buy even at this P/E level.
Tying things together
Since we are talking of housing and gold, it is interesting to compare them, thus eliminating the dollar in the ratio. Here are housing prices shown in ounces of gold:
Of course houses are usually bought on leverage with mortgages, increasing returns, but there are ways to leverage gold as well. Leverage in either market adds risk, such as witnessed by the ARM market discussed above, or in derivatives for gold.
Consumers are feeling less confident, as shown in today’s University of Michigan’s survey coming in at 90.2 in December compared to 92.1 in November. The forecast of Wall Street economists was 92.4.
Returning to today’s jobs numbers, manufacturing is declining, with the continuing offshoring of jobs and construction in decline reflecting the slowing economy. The contrary move in the goods-producing sector is that mining jobs increased by 4,000. Jobs that we can’t export, like health and government, are rising.
The scenario we have been talking about is rolling out as expected with housing troubles leading to economic slowing, but the dollar weakness is hiding the problems, making investors feel okay about stock gains that are relatively less than they realize. In a dollar-weakening market, gold is the steady element.
That’s it for this week…
And that’s it for this edition of the Room.
Thanks for reading, and for subscribing! TGIF!
