•For years I have commented that S&P500 profit margin is one of the best mean reverting series of economic data there is. The final stock market peaks of 2000 & 2007 coincided with turning points when profit margins began retreating from their peaks.

•Notice -like all mean reverting series- the larger the area above the average (green area), the larger the area below the average that follows (red area).

•It is particularly worrisome that:

•the profit margin series is now at an all-time high and there’s as much area over the median (green area) as there was before the previous melt-down in 2007. Call that crash fuel.

•the fact that the end of the graph looks like Bart Simpson’s head. Those large wiggles represent the swing in profit margin from the beginning to end of each earnings season (3 months). It captures the gap in profit margins of the financial sector and the rest of the economy. This is because the first 2 weeks of earnings season are heavily weighted with financial companies – and they have the fattest profit margins by far. Bank profits are the easiest to fudge, and they’re about to be sliced — courtesy of our friends at the Fed flattening the yield curve and therein taking away the profit from the carry (the difference in interest rates between long term bonds and short term bonds). Aye carumba!

•The Nasdaq is at 11-year highs! Woohoooo! Now if it manages to gain another 70% over the next 4 years it will be all the way back to where it was in 2000 — that would be 16 years to break even. The Dow is back to where it was in early 2008 (and 1999), and the S&P500 is where it was in April last year (and 1999). This makes the 3rd time in 3 years that the stock market has priced-in a rosy future on the basis of central banker-supported monetary candy. Each time previously, things blew apart once the candy was taken away. There’s no reason to expect anything different this time either.

•The list of metrics indicating the stock market is extremely frothy is growing quite long. Yet the bond market is holding up fairly well during the latest bear market rally. Better than it did during the previous two. More importantly:

•the mini greedometer appears to be going through the set-up routine that would indicate April-May would be a secular stock market top again (much more details in the private client weekly letter).

•and the greedometer is also ratcheting-up the risk to the point where April-May will likely see redlining again.

•The Economist Magazine estimated this week that the planned removal of fiscal gimmicks and goodies at the end of this year will amount to a nearly 4% drag on GDP. I was thinking 2-3% (ouch). And this is from a starting point of what is likely to be roughly 0% GDP growth this year. I don’t see November’s election results changing this outcome.

•If the Republicans win, they’ll do what all politicians do when they take the helm: allow reality to creep in and the economy to soften, and blame it on the previous guys. An ugly 2013.

•If the Democrats win, we get more of the same but with higher taxes (needed) and minor spending cuts (much more needed). Picture 2011 but with a 3-4% GDP drag. Now consider that GDP growth was only +1.6% in 2011. D’o! Ugly 2013.

•4Q 2011 earnings season is now all but done (90%).

•60% of earnings results beat, 29% missed, 11% met lowered earnings expectations. Tepid. Profit margins continued to soften with this week’s data. There are more retailers reporting next week, and that pretty much wraps it up. With the US consumer slowly hitting the wall and pulling back on spending, I’m not sure how profits and profit margins will stop dropping. Yet “The Street” continues to pen estimates of growing profits through 2012 and 2013. Exactly what they said in 2000 and 2007. Food for thought.

•Moody’s is threatening to lower the credit rating on 17 megabanks. That news is being digested with a yawn, so far.

•Congress approved extension of another unfunded tax cut: the payroll tax cut and extended unemployment benefit are going to be extended through the end of the year. More life support. This economy rocks! 2012 is going to see a $1T deficit and 0% GDP growth. Sure the punditocracy is forecasting 2.5% GDP growth for Q1, but that’s not going to happen. It will be in the 1% range for reasons explained in the last GDP report letter. This time bomb will show up at the end of April when the BEA releases their first guess at 1Q GDP. (mind you they have a history of over-stating it then reducing the estimates later).

•Consumer Spending is the main driver of GDP as you know. Check this out:

•December seasonally adjusted retail sales were adjusted down to a reading of zero growth (again, now that December is ancient history, the bad news is released). •January seasonally adjusted retail sales were up 0.4%. Good, but half of what was expected.

•Here’s my favorite: the raw/ non-seasonally adjusted January retail sales data saw the biggest monthly decline since 2006. Yup. Worse then what we saw in 2008-2009.

•Recall in my 4Q 2011 GDP letter (3 weeks ago) I wrote that consumer spending is going to be very weak on 1Q 2012, and that the other major contributors are going to be on their back. This is starting to be supported by the data coming out now.

•US Housing. The health of the US housing industry is captured in a diffusion index by the National Association of Home Builders (NAHB). This week saw a 29 — the highest reading since May 2007. It has been up for the past 5 months! Great! Now, look at the graph below to see how good this is.

•Home builders sentiment is picking up. Its almost all the way up to average recession levels. The overall series has an average of 49, so 29 has a long way to go to represent happy days. Home builders are feeling better about their prospects. Good. But understand that virtually all the homes being built these days are far smaller and cheaper than 5 years ago. No HGTV-inspired McMansions anymore. More reversion to the mean.

The President proposed a budget for the fiscal 2013 year. You can read the details elsewhere. All I’m going to say is — it is a silly budget. Any federal budget that fails to begin to dramatically reduce the deficit (Now!, not in 8-10 years time) is silly at best. $4T in planned deficit reductions over 10 years is a joke. OK, I have to ridicule 1 thing— the assumed GDP growth: 3% GDP growth this year; 3% next year, then 4% growth after that? This kind of brown-ink math from every White House administration for the past decade contributed to our current predicament.

In Europe:

•The Euro area saw a GDP contraction of -0.3% in 4Q 2011. If this were the end of it, we could call it a speed bump. And that’s how it is being priced-in by equity markets so far. But its a warm up act. Austerity has barely begun being implemented.

•Industrial production was down 1.1% month-over-month in December. That makes 4 months of contraction in a row.

•Moody’s downgraded the debt ratings on 6 sovereigns this week, and threatened more to come.

•Greece.

◦On again, off again…. Monday will likely see the latest agreement for yet another mega bailout for Greece.

◦The leader of one of the political parties not currently in charge says he pledges to renegotiate the bailouts after the April elections. That’s got to make Germany feel good. I can hear it now… No! we don’t accept merely having to pay you back 50 cents on the dollar. You should not have loaned us all that money! How about 10 cents on the dollar or we default and drag Portugal down with us?!

•France. Much the same thing. The leader of one of the political parties not in charge says a renegotiation of treaties will be top of the list, after the April election.

•Portugal: 4Q 2011 GDP dropped at a 5.1% annualized pace. The 5th quarter in a row of declines in GDP. But no one cares. Yet.

•Italy. Despite seeing its sovereign bond yields fall over the past 2 months — thank you ECB LTRO program — Italy’s economy saw its second straight quarter of GDP decline in 4Q 2011.

•Let’s take stock. Greece, Portugal, Belgium and Italy are already in recession, and several other countries have seen a 1-quarter GDP contraction. And most of the fiscal pain from budget cutting (austerity) has yet to be applied. Sure, this is just a speed bump.

•I’d like a job at the IMF. They forecast Greece’s economy will stop collapsing this summer, turn the corner and begin growing again. Are you kidding me? The so-called austerity programs of bailout #1 have not been fully implemented, and none of the austerity from bailout #2 has been implemented. In what world does this mean Greece bounces back this summer? I think the IMF economic forecasters had the same math teachers as the White House economic forecasters.

In Asia:

•Japan.

◦The latest GDP report was a disappointment. GDP shrunk at a 2.3% pace in the fourth quarter. So let’s see…. that makes 3 of 4 quarters in 2011 in the red.

◦Japan announced plans to do more QE of their own — to the tune of another $130B.

•China.

• Apparently the latest wooing efforts by European leaders has failed once again to charm China into agreeing to buy-up their toxic debt. As I’ve said before, why should China (or anyone else outside Europe) be expected to throw good money after bad in Europe? Chinese leaders are many things, but idiots is not on the list. They’ll wait for terms to be much more favorable, then buy-up some bonds to show they care. But their real money will be held in reserve to support their own economy. As Europe goes deeper into recession, China’s GDP growth is going to slow down quite a bit. Potentially to the 5 – 6% range. Growth this slow is perilous with so many poor clamoring to be pulled into the middle class. Evidence of this is already showing up:
  • Because the economy is slowing, the People’s Bank of China (PBoC) is backing away from the tightening over the past 2 years.
  • Plus, the PBoC is playing extend and pretend with local governments. Half the $1.7T stimulus loans made in 2009 are coming due over the next three years. . Local governments don’t have the money, so the central bank is extending the terms to allow the losses to be realized over a longer period of time. Come on, soft landing…..

In the US:

A single reading on its own doesn’t provide a lot of insight. Context is needed. That’s contained in the weekly private client letter. With that said, here’s a view of how the greedometer warned in 2007 and again in 2011.

In Europe:

• The ECB is poised to do LTRO 2 at the end of the month. It then intends to sit back and watch how things work out.  This time around it will lower the quality of debt that national banks accept from their commercial banks as collateral when they borrow from the feed trough. With this move, the Bundesbank is chiming-in.  Finally!  It is not pleased with the lowering of credit accepted and an attempt to increase the size of LTRO 2.  Sooner or later LTRO is going to noticeably de-value the euro and spark inflation. (let’s see….we’ve seen this movie before somewhere…….)
  • The impact of LTRO so far:
    • It has done nothing to encourage commercial banks to make loans to people or businesses.
    • It has not improved the willingness of banks to lend to each other. I wonder why that is.
    • It has provided a means for commercial banks in PIIGS countries to borrow from the ECB at 1%, buy their own country’s short term bonds yielding several times this, and post turd-quality bonds as collateral.   How does this end well?
    • But it has lowered interest rates on Italian and Spanish sovereign bonds from extreme levels to merely unsustainable levels.  
• Greece.   Bailout agreement deadlines missed. Fiscal targets missed. More good money after bad. And more riots. Tomorrow (Sunday) the parliament votes (yet again) on the batch of austerity measures attached to the latest bailout.
  • The Greek government claims there was an 11.3% slide in industrial output in December from the previous year. Ouch.  The Greek economy is in a depression and will remain in one for years regardless of tomorrow’s vote.
  • From the time the ink was dry on the current bailout plan set in October to now —– Greece’s economy has slid faster and further than the assumptions in the bailout.  This is a death spiral. 
• Greece vs. North Carolina. (some perspective on debt)
  • Greece: 
    • population :  a little over 11M
    • in 2008 Greece had a GDP of $250B. This year it will likely fall to  approximately $200B (that’s a depression!).
    • debt load $450B.  So debt:GDP is well over 200%.
    • result: Greece is beyond saving. 
  • North Carolina:
    • population : almost 10M
    • GDP is approx $440B
    • combined state and federal debt approx $500B (90% of that is federal).  Debt:GDP of 114%. 
    • result: by traditional banking standards North Carolina (and the rest of the US) is a financial basketcase that needs to begin a budget cutting diet immediately.
• UK.  More QE is on the way. The latest round of QE will bring the total printing to roughly half a $T.

4Q 2011 Earnings season is roughly 58% done — as of Thursday’s most recent data from S&P.

•57% of earnings results beat, 32% missed, 11% met lowered earnings expectations. Again, this is below the 65% average beat rate for sandbagged results. Why do I refer to earnings estimates as sandbagged ? Because there’s a pattern of earnings estimates being lowered as a quarter approaches (so they may be easily beat). Here’s a graph from S&P on earnings estimates for 4Q 2011 (the current earnings season) at different points in time. It troughs within days of earnings season kicking off. No, this game’s not rigged….

•Profit margins -though still very strong — have begun to compress from last quarter’s records. (mean reversion beginning…)

The January employment report from the BLS was encouraging. Well, no actually.

•Headline: the initial claims rate dropped to 8.3% and 243K new jobs were created.

•The January 2012 BLS report incorporated new census data. The results make a massive distortion of the change in readings from December. Here’s the unadjusted data regarding January’s figures versus the previous month:

•There were 1.7M more civilians. Ordinarily, this would increase the labor force by slightly over 1M, and increase the number employed by slightly less than 1M. Not this time…….

•737,000 fewer had a job. You read that right. (not 243,000 more)

•849,000 more claimed unemployment insurance.

•the initial UI claims rate actually rose by 0.5%, not dropped.

•But after some season adjustments and population adjustments, the BLS tells us 243,000 new jobs were created, fewer people were looking for work, and the UI rate went down? Not just no, but hell no!  Here’s the table of unadjusted stats from the BLS….

I think there are 1 too many letters in the BLS acronym. 

Housing. The latest Case-Shiller housing report (for November) was released. National prices fell 1.3% from October, and represented a 3.7% drop from the previous November. This was a slightly larger price drop than the pundits expected, and a smaller price drop than I expected. Let’s make this easy. This picture says it all… (my estimate of home prices are included for the next couple years. This is where prices need to go in order to clear the inventory glut. The fact that it also would represent a reversion to the mean for the data series is all the more reinforcing….

One or two of you may be thinking so what? Other than the fact that in 2-3 years time US housing will have gone through 14-15 years of no appreciation end-to-end — and the impact that will have on psyches towards real estate, there’s one very important data point to bear in mind. Close to 40% of home owners with a mortgage will be under water. That’s several $T in mortgages aka bank assets. You think this might be a systemic risk to the banking system at some point?

•The Fed announced it plans to leave short term interest rates in the current 0 – 0.25% range until late in 2014. And an explicit 2% inflation target was set.

•Bond markets are interpreting the news something along these lines: the economy is sufficiently weak and likely to remain that way for several years. So the Fed is going to commit to trying to jump-start the economy for three more years. Obviously the Fed has not the slightest whiff of inflation. Indeed it probably is forecasting an extension of the recent slowing of core CPI and PPI. The yield on the 5-yr note dropped to a record low of 0.74%. But the yield on the 10yr & 30yr are not dropping much. The 10yr & 30yr yields need to drop in order to move mortgage rates lower (To clear the overhang of housing inventory. You’ll see what I mean on Tuesday when the Case-Shiller housing report for November comes out.). The current interest rate spread in long vs short term US Treasuries is 3%. The long term average spread is 2%, and the short end is nailed to zero. With no inflation on the horizon, it would appear the 10 yr & 30 yr yield are poised to drop lower on the next stock market dip. This summer & fall should be a good time to refi into a 2.5% 15 yr mrtg. (too bad the interest deduction is going to go away…. but that’s at least 2 years away and will be phased-in…)

•Stock markets interpreted the news (at least for the hours after the announcement) as the punch bowl would not be taken away anytime soon, and that it might be spiked (with QE3) later this year. Don’t hold your breath.

•4Q 2011 Earnings season is moving along nicely – and about as I thought. With 39% of companies reported (as of Thursday), the score is: 54% beat, 34% missed, 13% met lowered earnings expectations. That’s not great (quite a lot below the 65% average rate of beating sandbagged estimates). Revenue and earnings are coming up sequentially lower for the first time since….. let’s see…. oh yes, since the Great Recession began. Hmmm. And don’t look now, but profit margins have started to compress. Darn that mean reversion! After next week, 65% of companies will have reported. It will be hard to keep the equity market suspended. Those of you that receive the private client letter know there’s a lot more to this story and that risk assets are pretty frothy right now. There’s no major melt-down immediately infront of us, but the dips after April, July, and October earnings seasons are not going to be fun.

•The BEA’s first estimate of 4Q 2011 GDP is +2.8% (annualized growth rate, seasonally adjusted). Street expectations were for a 3.0% number. I remind you this will be fine-tuned at the end of February and March, and coarse-tuned a few years from now –when nobody cares. Here’s how the major components of GDP stacked up in 4Q 2011:

•GDP = Personal Consumption + Private Investment + Government + (net of exports -imports)

•for 4Q 2011, that was: +1.4%(PC) + 2.4%(PI) -1.0%(G) + 0.01(E-I) = +2.8%

•What to take away from this:

•The US consumer carried the quarter again by lowering their savings rate. How long can that continue as the economy slows?

•The investment contribution (PI) was strong. But a less generous tax code for 2012 will lower the PI portion of GDP for the rest of the year. Plus half of the contribution came from a fairly large build up in inventories. That won’t continue.

•All levels of government were subtracting from GDP at a net 1% rate.

•Exports & imports were roughly balanced.

•1Q 2012 is likely to see a flat GDP number outside of what the consumer does. I suspect 1Q 2012 is going to be very similar to 1Q 2011 (+0.4% GDP growth). Flat.

•As it stands now, the BEA estimates the US economy grew +1.6% last year. Not enough to generate any / many jobs. This despite the statistical illusion represented by a lowered initial claims rate that ignores roughly equal numbers of people falling out of the UI system without a job. In 2012, look for more of the same from this incomplete unemployment view from the BLS.

•The ECRI WLI has been indicating the US economy is on the verge of a recession for the past 3 months. Mind you it has bounced back a bit over the last month. It remains in a range indicating flat (0%) GDP growth. So this remains my view for 1Q 2012 GDP.

•Tuesday will see the Case-Shiller housing report for November. I expect to see national home prices decline 5% from the same month a year previous. The next three months will see reports with new price lows that gradually alarm US consumers and add fuel to a recession here in the US. Fear not! Apparently the Fed stands ready to launch QE3. Higher mortgage rates and higher inflation. Yeah, that’ll help. (go to www.noQE3.com)

In Europe:

•The EFSF (Europe bailout fund #1) has 200-250B euro left and will be replaced by the 500B euro ESM (Europe bailout fund #2) in July. The ECB, IMF, and pretty much everyone except Germany, Finland, and the Netherlands, want to throw the remaining EFSF money into the ESM. Germany has steadfastly held to a “NO!” position on this. Though like everything else over the past 2 years, this is true until it’s not. Last week saw Germany suggest it would go along with a merged bailout fund, but it wants (can you guess?)…. more fiscal austerity.

•LTRO. Last month’s back-door QE 3 year feed trough line of credit was a nearly 500B euro offering:

•33% was vacuumed up by Italian commercial banks.

•17% by Spain

•16% by Ireland

•9% by Portugal

• What did LTRO round #1 succeed in doing? Commercial banks in PIIGS countries have been buying short term bonds of their own sovereign in order to profit off the free money from the carry trade (borrow at 1% from the ECB, buy bonds paying many times this). But so far, that’s about it. There remains very little interest in longer term PIIGS bonds. LTRO #1 will be put to the test on Monday and Tuesday next week as Italy tries to sell 5 year & 10 year bonds.

•LTRO #2 is going to be launched on February 29th. No word yet on how big it will be. It could be as small as 200B euro or as large as 700B. How big LTRO #2 is — and where the money goes — will be very important. If we find that by early March there is a Trillion euro in commercial bank cash parked at the ECB, we’ll know the game is over. The financial system in Europe will begin to melt down as Italian bond auctions begin to fail.

•Greece: Wow! Things might just (finally) fall apart in the next few weeks. The EU is forcing Greece to give up sovereignty over its budget. As a condition for the next bailout loan (130B euro), the EU is insisting upon Greece submitting to an EU appointed external “Budget Commissioner” with authority to veto Greek budgets. Furthermore, the EU is insisting that Greece pay its debts in full and on time (after this latest 65-70% haircut) BEFORE putting any money towards whatever needs Greece has. Northern Europe has reached the end of its patience with Greek budget deficit intransigence and wants to ensure Greece can’t continually hold it over a barrel via default. I guess the economic progress in Greek deficit reduction is even worse than I thought. I’ve got news for you northern Europe. You are going to get back no more than 20% of the $Bs you loaned Greece, regardless of the haircut you cook-up next week.

•Negotiations continue on a haircut for Greek bond holders. There is yet another Eurozone conference on Monday, and they’d like to be able to trumpet they’ve saved the day (yet again). None of it matters. This haircut is only a stall tactic. Much more needs to be slashed. And it will.

•Sure Greece and Portugal don’t matter. Just like seemingly insignificant Thailand didn’t matter in 1997 (the Asian financial crisis began with the collapse of the Thai boht).

•Portugal. The yield on 10-yr sovereigns continues upwards to new records (now over 15%). Bond traders are increasingly pricing-in a default. This is the same path taken by Greece 9 months previously. The CDS market is pricing a Portuguese default at 70% (and 90% for Greece). Too bad those CDSs may be rendered useless!

•UK: 4Q 2011 saw the economy shrink at a 0.8% annualized rate. 2011 overall saw the economy grow by 0.9%. Stall speed.

•Are things coming unglued? 7 months ago, 54% of buyers for the EFSF (bailout fund #1) came from east Asia and the middle east. That dropped to 12% earlier this month. If Europe can’t rely on Asian money to fund its bailout, it is out of luck. We’re not going to do it.

•Fitch Ratings agency lowered the sovereign debt ratings for: Italy, Spain, Belgium, Cyprus, Slovenia. This news was lost in the noise. US investors are tired of hearing about ratings downgrades in Europe. Be complacent at your peril.

In Asia:

•India: The governor of India’s central bank is telling parliament to cut government spending in light of inflation concerns. The combined federal and state government budget deficit is likely to reach 9% of GDP this year. This will force India to offer higher interest rates, and begin to choke economic growth.

• Warning: The mini greedometer (tactical risk indicator) is displaying readings previously only seen when the S&P500 was within 5% of a secular (long term) top. The greedometer (strategic risk indicator) is approaching dangerous risk levels as well. There is very little upside and a great deal of downside to risk assets (stocks, junk bonds, commodities, REITs) at this time. A much more detailed view was presented in the private client letter.
• My book is progressing and will be out in the second quarter. It will be called: Greedometer. Dow 5000 in 2013. Why no one saw it coming.

(This week’s letter is longer than we’ll see for a while as I spend less time on the economic letter and more on the book. There will be no change to the time/ effort spent on analysis and trading.)

A Primer: Why will stock markets crash in 2012-2013?

Recognizing that this note is meant for a wide audience -including some new folks that receive it via social media – it might be helpful to summarize the case for risk assets (stocks, high yield bonds, commodities, REITs) to crash. Longtime clients will know these points well …….

• Earnings are going to head lower, and expectations of earnings will compress P/E multiples as investors lose faith in the “cult of equities”. Having been burned badly in 2000-2002, and 2007-2009, retail investors are now more apt to run for the lifeboats when markets breach intermediate-sized losses (say 25-30%).
• S&P500 profit margins are at all-time highs (last week). As they mean revert, this puts downward pressure on earnings.
• US Consumers have just stretched their credit / reduced savings again (4Q 2011). The consumer will sober-up very shortly when they realize their largest financial asset (their home) is a boat anchor. US home prices will continue to slide for 3-4 more years to re-balance supply with demand.
• Over a century of US stock market data shows secular market bottoms have a P/E south of 10. 7-8 is more common. Slap an 8-handle on what is likely to be $75-80 in 2012 S&P500 earnings (as-reported, not operating), and $50-55 in 2013. (FYI: 2007 saw $66, 2008 $15, 2009 $51, 2010 $77, 2011 $89)
  • for reference purposes, please read the blog posting – Which type of history will repeat?  http://www.triwealth.com/?s=history+Repeats&x=0&y=0  
• Stopping the S&P500 at 666 last time (March 2009) required mammoth fiscal and monetary ammunition that is not available now. So the 500s (my estimate) is the right ball-park.
• 2012 sees a GDP headwind from budget cutting and tax raising in Europe. Recession.
• 2013 sees a sobering US GDP headwind from fiscal reality finally coming home. Higher taxes and spending cuts — courtesy of the bond market. Recession.
• Plus wildcards:
  • when does the European sovereign debt crisis finally implode via a Greek default initiated a credit crunch?  March?  June?
  • when does Japan’s mounting debt load cause it to dramatically increase the amount of int’l buyers for JGBs?  In so doing, doubling or tripling the debt burden. Causing Japan to print or default. Probably 2013.

In the US:

• The latest US consumer sentiment report saw the highest readings since May last year — when the US stock market had just peaked for the year. Mind you, on an absolute basis, the reading remains at recessionary levels.
• The latest sentiment indicator of US retail investors hit the least bearish point in seven years. There’s a contra-indicator for you. When retail investors are extremely bullish / extremely unbearish, the stock market is frothy and primed for a fall.
• Manufacturing perked up 0.9% in December — the fastest pace in a while.
• Citigroup reported disappointing results this week. Though results were even lower than expected despite earnings assistance from lowered loan loss reserves. It posted $0.38/share net income, falling short of recently lowered estimates of $0.49. In the spirit of highlighting the sandbagging that Wall St does, three weeks ago, there were analysts with net income estimates as high as $0.76 (2X what was posted!!!).
• Goldman Sachs and Morgan Stanley reported disappointing results this week as expected. Due to more accounting tricks and a recently lowered expectation (sandbagging), their share prices held up well this week.
• Builder confidence rose to the highest levels since June 2007. Wow. They’ve risen from depression levels almost up to average recession levels. The wind is going to be let out of the sails to this story in a few days. The next Case Shiller housing report (next week) will show US homes dropped 5% in price over the past year. And they’ll drop another 5-8% this winter to 2002 levels. (rinse and repeat…).
• The latest inflation reading shows it gained 3% in 2011 -the highest in 4 years. Core inflation (ex food & energy) was up +2.2% over the past 12 months. Some view this data as alarming — and are buying TIPS. Indeed, this week saw the first ever TIPS auction with a negative yield. A guaranteed loss unless inflation goes higher than it currently is.
  • But dig into the data and you see that all of 2011′s inflation was during the first half. It was caused by our old friend QE2. The inflation rate was 1.5% in December 2010 -when QE2 was just getting started. By the end of QE2 in June, inflation had risen to 3.6%. It continued to rise marginally higher shortly thereafter, then rolled over. The last quarter saw inflation drop from nearly 4% to 3.0%. So in an era of stagnant wage growth, the Fed caused inflation to rise – and mortgage rates with it. Thanks for the help. Still think we’ll see a QE3?  Still want QE3?
• 4Q 2011 Earnings season is well under way and the results are mixed. Of 59 companies reported so far, 29 beat lowered expectations, 20 fell short, and 10 met. So 49% of companies have managed to beat sandbagged/lowered expectations. That figure is usually well into the 60%s, and has average 70% for the previous year. Profit margins are at all-time highs. Mind you, retailers haven’t started reporting yet.
• I’ll be watching to see how revenue is fairing (harder to manipulate than earnings). Plus, pay attention to the spread between operating vs as-reported earnings. As this widens over the course of the coming year, that’s a signal “earnings quality” is weakening. This means more tricks are being played to bury more bad stuff.  

South America:

• Brazil: Protectionistas R Us. Last month Brazil implemented a 30% tax increase on cars sold with less than 65% local content. This was in keeping with a trend of other protectionist actions last year. These actions are aimed at China –its largest trading partner. Trade with China is up 17-fold since 2002. (you read that right). What Brazil needs is a way to depreciate its currency relative to China. Good luck with that. As the global economy softens this year, look for protectionism to spread.

In Europe:

• The IMF is passing the hat and trying to raise another $ half trillion to save Europe. It has $387B available, and Europe says it can scrape together another $200B. $1T seems to be the target. And this is in addition to the EFSF and ESM. We’re closing in on $2T in bailout loans altogether. That’s in the right neighborhood. The US & UK are not interested in throwing good money after bad, so it is pretty much back to China they go. As I wrote over a year ago, China is going to play the trump card: removal of arms sanctions applied after the 1989 Tiananmen Square massacre.
• Not content in merely lowering the ratings on sovereign bonds, S&P lowered the rating on the EFSF bailout fund. This came as no surprise. After all, there’s another bailout fund-the ESM scheduled for early arrival in 5 more months. Surely they can make the 250B euro remaining in the EFSF last until then?
• More records! Commercial banks parked over 520B euro with the ECB — yet another all-time high in a string of highs. This means despite the ECB’s LTRO feed trough, banks still don’t trust each other. Hmmmm.
• Greece:
  • Apparently, we’re close to an announcement that will see a 68% voluntary (no default, no CDS trigger) haircut to Greek bond holders. That should goose the risk-on trade. But it will be short lived because the bond holders with CDS protection were not likely part of the negotiations. Because they bought CDSs to indemnify them against default they will not accept a large haircut that does not trigger a CDS payout. Besides, 68% won’t be enough. It would buy more time for banks to build up their balance sheets and prepare for the real thing — an 80% haircut. I wonder what Portugal and Ireland are thinking about all this. And if Greece applies a collective action clause retroactively – thereby cramming a 68% haircut to all bond holders – there will be a nuclear winter in the CDS market. The unintended consequence will be bond buyers will demand higher interest rates since they no longer can count on CDS insurance against default. There’s a silver lining here for US banks. If CDS don’t have to pay-out, big US banks benefit as much as Greece does because large US banks are on the hook to pay-out on some of those CDS contracts. (but happens to the bank on the other side that was counting on that pay-out ?)
  • In the coming weeks we’ll get an update on Greece’s economy. The numbers will come up short again. Having seen its economy shrink 12.5% since the 2008 peak, it will be seen to have shrunk 6% last year. And it will shrink a similar amount this year as tax increases and budget cuts are ramped up. The debt : GDP will exceed 180% this year without a haircut. And the proposed haircut level will still leave Greece with a 120%+ debt:GDP that will continue worsening. Basically, Greece is in a death spiral. There’s no chance it can outgrow the interest on its debt. Assuming more good money after bad will continue to be thrown at it before the March debt repayment and probably again in June, Greece will hold an election in July. A mish-mash of parties will form a coalition Parliament, but won’t be able to pass any legislation involving spending cuts for fear of running amok of one of the coalition members. An unstable situation becomes more unstable.
• Portugal. The 10-year note saw yields climb to 14% — the highest since Portugal joined the euro. If this does not reverse soon, it will be hard to argue against contagion spreading from Greece to Portugal.
• Germany: December saw investor sentiment rose the most it ever has. Granted it rose from near-depressionary lows. But bear in mind that stock market tops always coincide with high investor sentiment readings. (sorry to burst the bubble) Egan Jones (a US ratings agency) lowered Germany’s sovereign rating 1 notch last week.
• Italy: Looking forward to next week’s test: a large auction of 10-year notes.
• Spain: Had a successful 10-year bond auction this week. The yield (interest rate) dropped 1.5%. A sigh of relief all over Europe. 

In Asia:

China:

• Q4 2011 saw the first time since the Asian financial crisis of the late 1990s that Chinese foreign exchange reserves dropped. No panic button yet, but it is significant nonetheless.
• Q4 2011 GDP grew at +8.9% — the slowest rate since summer 2009 — but more than anticipated. Slow down? What slow down? Not yet — at least not if we are to believe the data from China (always taken with grain of salt).
• China’s central bank is likely to keep softening monetary policy to stop the GDP growth rate from dropping under 8% since that seems to be the threshold at which civil unrest ramps up.

Japan:

• Last year, Japan had a trade deficit –its first in nearly half a century. By my estimates, Japan’s current account will follow into deficit within the next 2 years. Translation: Japan will become importers of cash like we are here in the US. With Japanese household savings rates dropping over the past 20 years to roughly 2%, corporations became buyers for Japanese government bonds (JGBs). That’s about to change because corporations have paid down their mammoth debts and rebuilt their balance sheets (it only took 20 years). Profits are being squeezed by the high-priced Yen, and taxes can only go up. So, where does this leave us ? There’s an explosive moment (failed bond auction) in Japan’s future. Foreign bond investors will not settle for the current JGB bond yield. A 1% rise in the cost of borrowing will double the cost of servicing Japan’s debt. And if you think interest rates will only rise 1%, I have a bridge to sell you. 

The balance sheet recession continues here in the US, and in Japan and Europe. As Reinhart & Rogoff suggested in their book – This Time Is Different – we can expect recessions to come more frequently and economic growth to be more shallow than we’ve come to expect over the past several decades.

The greedometer and mini greedometer are showing some very interesting readings. In some respect, current risk levels are similar to those seen when the US stock market reached the all time high in 2007, and again at the April 2011 peak. (much more in the private client letter next Tuesday.)

In the US:

• 4Q 2011 earnings season kicked off this week. A solid read on 4Q 2011 earnings will be in place by the end of the month.
• You may recall that last quarter’s earnings season saw large banks book profits as a result of their own bonds losing value over the third quarter (yes, you read that right). That process will have been thrown into reverse as large US bank bonds saw price gains in 4Q — forcing banks to account for the increase as losses. This is because those bonds are a liability to banks. Thus, if a given bank’s own bonds rise in price, its balance sheet will have weakened since its debt became larger. Rest assured, the bank will play down the loss as accounting gimmickry. Funny though, you didn’t hear banks downplay the paper gains they made when the reverse was true last quarter — when they booked gains from accounting tricks.
  • case in point: JP Morgan. Last quarter (3Q 2011), JP Morgan added a $1.9B accounting gain to their bottom line — because of their bonds losing value. That was 44% of the profit! Remove that $1.9B, and throw another $1.9B to account for a reversal of the previous quarter’s bond accounting gain and you’ve got a $3.8B headwind to overcome. Given that 3Q saw $4.3B in earnings, a reasonable earnings guess would have been $0.5B for 4Q. So how’d we get to $3.7B this time (and on $2.2B less in revenue!)? You guessed it. More accounting gimmickry. JPM only accounted for a $.57B loss from the gain on their bonds (nowhere near a $1.9B loss). And loan loss reserves were lowered again by $.73B. By the way, I wrote this paragraph before 4Q earnings came out and left blanks to be filled in for the numbers. I was expecting these games to be played. It’s nice to have a few $B to slosh around when you need it to “make your numbers for the quarter”. Much the same thing was done at the beginning of the Great Recession. I would not expect these numbers to make investors happy.
  • Here’s a wider & simpler view. 2011 saw $5B less revenue and $1.7B higher expenses than 2010. Yet net income miraculously grew by $1.8B. If it weren’t for loan loss reserves being slashed, JPM would have seen net income drop by $9B — a 50% drop from the previous year.
• Speaking of sandbaggers…… As is the case immediately before earnings season begins, CFOs are busy lowering guidance on the quarter with an earnings report immediately infront of us in order to help drive the stock higher when announced (& masterfully manipulated) earnings are reported that beat the recently lowered estimate. Shameless sandbagging. With this said, the ratio of negative to positive pre announcements is very high right now at 3.5. (the average being around 2.3X)
• The wildly overpaid column: Investment Analysts. Not once in the past quarter century has the consensus forecast by analysts at the start of the year called for a decline in earnings in the aggregate. Yet almost a third of the time earnings fell! You’d have to be a sucker to rely on consensus analyst forecasts.
• The Fed was the most profitable bank in world history last year by earning almost $77B in profit. This comes as a result of QE2 and operation twist. 2010 saw the Fed earn $81B in profit on its bond portfolio because of QE1 and QE2. While this is good news, keep in mind the size of the Fed’s balance sheet. It owns a staggering $2.8T in Tbonds and mortgage backed bonds. At some point, US Tbonds will be shunned by investors (because the US Congress continues to fail to produce a credible debt reduction plan). When this happens, the losses could easily exceed $100B.
• Small business sentiment improved in December — for the 4th month in a row. Nice. But readings remained at recessionary levels.
• If you have not already, you’re going to hear plenty of squawking from the Wall St hype machine over the currently low P/E on the S&P500. According to the hype machine, the forward P/E is 12ish. The more sane Shiller P/E remains around 21. Supposedly anything south of 15-16 means it is time to buy. Let me remind you that the Shiller P/E will drop to the 7-9 range at some point this year or next because this is where a secular bottom has always gone. Other things being equal that means the S&P500 will be more than sliced in half from where it is now.
• 4Q 2011 US GDP is likely to be in the 2.8 to 3.2% range, giving 2011 an end to end 1.6% GDP growth rate. Not enough to generate job growth. We’re told 1.6M new jobs were created in 2011. That’s not enough to keep up with population growth. And what do you know, roughly the same number of people left the workforce in 2011. In short, 2011 was a zero sum game for job growth in the US. Mind you it was the fourth year of wage deflation. I don’t believe that has happened in the US since the 1930s.
• 4Q 2011 also saw disappointing US retail data in December, and a marked increase in the trade deficit. This is not going to help support GDP at all.
• 1Q 2012 is likely to see 0 US GDP growth and contractionary numbers in the eurozone, the UK, and Japan. It is going to be very difficult to stop there. It remains my view that 2012 will see recessions in the developed world, and depending on how Europe’s financial crisis shapes up, the developing world will either stagnate or contract since it remains heavily reliant on exports to Europe and North America — and since it is also heavily reliant on funding from Europe’s banks. (how would you like to be reliant on them right now?)
• There’s a crunch coming. The latest estimates on November US home prices is as I expected: bad. We are going to see prices accelerate downwards in November 2011 through March 2012. This erosion of net worth is going to force a reversal of last year’s savings rate reduction. Combine this with a reversal in gasoline prices and we have an economic crunch in the making that is going to squash any economic growth in the second half of 2012 (regardless of what happens in Europe).

In Europe:

• S&P ratings agency poured water on the rally on Friday. It lowered the sovereign debt ratings by 2 notches for: Italy, Spain, and Portugal. France & Austria were lowered 1 notch from AAA. This move was telegraphed a month ago so markets took the news in stride. The ramifications for the EFSF bailout fund are not good though. There’s no chance it can remain a 440B euro AAA-rated fund now that France and Austria have been dropped out of the AAA club.  If the EFSF is no longer AAA-rated, pension funds will stop buying it.   Fear not!  The EFSF might now be marketed as a AA+ fund instead, and see an expansion.  This is after-all the same rating as the US.
• Greece: After two years of wrangling, arguing, and dodging, Greece continues to fester and pose a risk to the European banking system. Perhaps the saga is coming to a close. Private bond holders are apparently on the edge of agreeing to a 60% haircut. The IMF wants it. Greece wants it. But Europe’s creditor nations remain luke warm to voluntarily taking large losses (go figure). March 20th is the date for Greece to redeem a 14.4B euro payment. It does not have the money to get this done and needs the next bailout tranche. More good money after bad. Sooner or later this will reach a breaking point. Without doubt, that will be this year. But when? 
• A new record (high) for bank deposits with the ECB was set last week. Yup. There’s confidence. No credit crunch here. It’s all good.
• The euro currency is plumbing 16 month lows against the US Dollar. This is going to help reduce the pain of a recession in Europe. But! (you know what comes next…) This same process is going to bring pain to the US economy — not least because 20% of S&P500 company profits come from Europe. A more expensive US dollar hurts that profitability. This will begin showing up in 4Q 2011 earnings reports (now).
• Spain. Thursday saw a successful auction of 3 and 4 year sovereign bonds. I could hear the sigh of relief across the Atlantic ocean.
• Italy. Same story as Spain. Thursday & Friday saw successful debt auctions. But Friday’s was a squeaker. And the yield on the 10-yr remains around 6.7%. Not sustainable.
  • UniCredit — the largest bank in Italy – has been pummeled recently and has seen its stock lose roughly 80% of its value just in the past couple weeks (though it bounced back after the Italian sovereign debt auction). UniCredit announced a hefty discount on a share rights issue that spooked investors.
  • The share of Italian debt held by the ECB has sky-rocketed in the past 6 months. A quarter of the ECB’s holdings are now Italian bonds. It is well known that Italy’s bond refinancing calendar is brutal in 2012 and that it can overwhelm the ECB.
  • Thank you ECB. Per the bond auctions in Italy and Spain this week (noted above), Europe managed to dodge a bullet this week. The ECB’s recently implemented back-door QE feed trough (called LTRO) seems to be working. Banks are borrowing on the cheap from the ECB (money it created from thin air). Then they’re using that money to buy PIIGS debt, and parking that debt at the ECB as collateral. If this continues, Europe’s banking system crisis may be kicked down the road. After a couple years of this, banks will have mountains of cash from an immensely profitable carry trade, and they’ll then be able to write-off massive losses on PIIGS debt against their mountain of cash. This is what the Fed & Treasury manufactured here in the US 3 years ago. The fly in the ointment is European banks are under immediate pressure to increase their cash positions and improve their balance sheet to meet near term targets. The LTRO program represents a large increase in risk and could (should) be seen as weakening the balance sheet.
  • Germany. Weak German industrial data caused some stress this week — and drove many investors to buy the ultimate safety — short term German Bunds. The yield was driven into negative territory. Translation: Investors loaned their money to Germany and accepted a guaranteed loss.
    • Apparently the German economy contracted at a -1% annualized rate in 4Q, leaving it with 3% GDP growth for 2011. Not bad at all. A weaker euro should help German GDP stabilize in 1Q 2012. But the rest of the year does not look good.
  • France: Since the beginning of the year, the ECB has expanded the list of assets it will accept as collateral (it lowered its standards / increased risk). Roughly 80% of the newly acceptable assets are bonds from French banks. Is this a pre-emptive move prior to a loss of AAA rating in sovereign French bonds? Perhaps. One thing is for sure: it is a desperate move. Absent the latest ECB feed trough and lowering of standards, it is likely that several large French banks would be collapsing right now.

In Asia:

• China:  The most recent trade data (December) shows a much larger trade surplus. Hence China continues to grow at a nice clip. But! Much of this came from a weak showing in imports — a year low. On the whole, 2011 saw a $155B trade surplus –the third consecutive annual decline and the lowest trade surplus in six years.
• Inflation dropped to 4.1% –the lowest in rate since mid 2010. This will provide more room for the PBOC to lower bank reserve ratios and stimulate the economy. Maybe China will pull-off a soft landing. It is far too soon to tell. Trade with its largest partner (Europe) is going to be worsening all year long.

(with thanks to the Financial Times for this)

2012 began with a bang. The first day of trading saw some of the largest gains for a first day of the year in decades. Too bad all those gains occurred before markets opened on Tuesday. Indeed the entire US stock market gain for the week happened before the 9:30am opening bell on Tuesday (no, of course this game is not rigged).   Volume was low on equity markets all week, and some of the junkiest assets saw the most gain. Doubtless some short covering was going on.  Next week is the beginning of 4Q 2011 earnings season. Look for this one to show a stagnation in earnings growth and profit margins, and very weak earnings from the financial sector in particular. Sure, no shortage of tricks will be employed to make the income statement look better. But pay attention to the balance sheet. It is much harder for CFOs to manipulate.

The US:

• Over the last 12 months, 1.5M Americans left the labor force. Our population continues to grow, but the labor force continues to shrink. Add those 1.5M Americans back into the data and you find the headline UI rate rose from 8.5% to 9.5%. Or you could add them to the more inclusive U6 rate and have 16.2% unemployment.   Pathetic.
• The average duration of UI claims continues to hold at record-setting bad levels: nearly 41 weeks. As I’ve been writing for years, we’re not in a typical recession. Balance sheet recessions are an entirely different animal.  Here’s an update to the chart for this data set going back over 60 years.

Europe:

• Spain’s unemployment rate (23%) is 3X that of Germany! Does this sound like a stable union?
• Spain’s banks are being forced to set aside 50B euro ($65B) to accommodate future losses on real estate loans. That’s 4% of GDP. That’s a lot. And you can bet that bank CEOs are going squawk about it. Given the extent of the real estate meltdown in Spain, I’d say 50B euro is about half-way there.

Asia:

• China:
  • The most recent manufacturing data (for December) shows the manufacturing industry marginally growing.
  • Land sales are drying up. This is a key source of revenue for local governments. And they’re going to need it since over half the debt they accumulated comes due this year and next.
• Korean manufacturers are warning of a rough economy in 2012.
• India is opening up its stock market to international investors. This should have been done years ago. Better late than never.

And certainly last but not least…….. Iran is ratcheting up the stakes in warning the US not to re-deploy a carrier to the gulf. Not surprisingly, futures contracts are pricing higher oil costs – essentially a tax on global economic growth (when there’s not much growth to spare).

• There needs to be a longer and more pronounced follow through in order to confirm (we should know by the end of January).  If so, risk assets would have a good first quarter (the S&P500 would rise to 2010 peaks –  a 10% gain), and we would see another redline reading from the greedometer. This would be without precedent.   
• If there’s no follow through on the mini greedometer in the coming weeks, down we go. The rubber band will have been stretched that much further. The mini greedometer will have topped-out another hump in the sequence.  A new leg down would begin, and it would be at least as abrupt as the previous one — that saw the S&P500 drop 18% in 3 months. A 25% drop (S&P500 around 1000) by the end of March would be a reasonable estimate.  That would not be the end of it –not by a long shot!

The end of the year is special for those in the investment business. It is a time to reflect on the past year, and a time to lay out a chart for the coming year. And as is the case with previous year-end letters, I struggle to condense the letter to a 15 minute read.  Off we go…

What can we say about 2011….  The S&P500 began the year at 1257. And it ended the year at 1257. A virtual carbon copy of 2007 in terms of end to end return, and volatility. You may recall what came next.  2011 saw global stock markets shed $6.3T in wealth. Global bond markets made a lot of those gains back. Yes, the ever maligned bond market managed to outperform the equity market again. Sorry Wall St.   

2012 Forecast: 

The consensus Wall St 2012 forecast is pretty much the same as it always is:

• 10% (or so) earnings growth for US companies — (to $108 for the S&P500 in 2012),
• the S&P500 will finish the year 10-15% higher,
• bonds will lose money as yields climb because of economic growth (because no one ever forecasts a recession)

Triangle Wealth Management 2012 forecast:

• The baseline view for the 2012 global economy has the developed economies sliding into a deep recession and pulling developing economies along because of their reliance on exports to consuming developed countries. Hence the 2012 forecast is for risk assets (common stock, commodities, high yield bonds, REITs) to have a very bad year with losses in the 30-40% range (Dow 8000). This assumes Congress continues extending the “temporary” fiscal treats through 2012, then is forced -at gunpoint- by the bond market to take an axe to the deficit. 2013-2014 is not likely to be pretty (Dow 5000).
  • But if Congress fails to extend the fiscal support past February, things break down faster. Dow 5000 in 2012 comes into play.  
• US Treasury bonds continue to gradually turn Japanese and see yields fall further (prices rise) on the middle & long end of the yield curve. Not a good environment for bank profitability.  

The list of issues that may bite us in 2012 continues to be those identified and discussed in 2005 and 2006 (and every year since).  Let’s get an update….

Europe’s debt crisis:

• Several countries are insolvent and will have to eventually hand losses to bond holders in the 25% range (Italy) to 50% range (Portugal) to 75% range (Greece and Ireland). Some will have to leave the euro currency union in order to regain competitiveness (Greece and Portugal). To a lesser extent Spain and Belgium are also risky bets. Spain is still contending with a bursting housing bubble that is even larger than the one seen in the US -on a proportional basis -  and zombie banking system sitting on piles of bad commercial and residential mortgages.     
• Most of Europe’s large banks are insolvent. They own piles of sovereign bonds not worth face value. Because of the leverage employed, a 25% loss across the board on PIIGS debt would make Europe’s banks and financial system insolvent and probably initiate a global depression.
• Having spent the past 2 years denying the problem then minimizing it, Europe’s leaders have finally admitted the problem is large enough to initiate a depression.
• Two weeks ago, the European Central Bank (ECB) held a nearly half trillion euro back-door QE exercise. This 3-year loan program will probably stop banks from melting down the European financial system in the first quarter. Their bond roll-over needs in the near term are now met.  But it remains to be seen whether banks will use this money to refinance the PIIGS sovereign bond roll-over calendar in 2012. And that is exactly what is required in order to stave-off a sovereign bond induced meltdown.
  • The initial test case was this past week. Several Italian sovereign bond auctions were held. The most important was the 10-year auction. Despite the ECB buying  bonds in the background and a massive half trillion euro liquidity facility, the 10-year auction yielded interest rates nearly 7%. More importantly, the 10-year traded over 7% after the auction.  This is far too high for the world’s third largest bond market. (Japan -the world’s 2nd largest bond market-  pays 0.99% for 10year bonds)  Italy cannot sustain interest rates at these levels. This is why the new Prime Minister made an appeal on Thursday for yet another enlargement of the bailout facilities.  If this is the reception Italy is going to get from the bond market, some point in the first quarter will see a failed bond auction. There are several outcomes after that point, ranging from bad to awful.
  • And with this new ECB loan facility in place how confident are Europe’s banks?  Last week saw a record high — 450B euro in bank cash parked at the ECB.  
• 2011 saw red numbers across the board for Europe’s equity markets. And their bonds trade with the same volatility as stocks, so why bother?   I still so no reason to deploy capital there. (unless we’re shorting it)

Japan’s debt crisis:

• Japan’s debt/GDP is 200%+. Its aging population is only increasing the ongoing burden on government spending. In short, Japan’s economy is going to suffer a head-on collision in the not distant future.  Mind you, many a career has been ruined betting on a collapse in Japan’s bond market. And judging by the strength in the yen this year, Japan may yet be able to find buyers of its bonds for a while longer. The yield on the 10-year JGB is a mind-numbingly low 0.99% ! (the advantage of having a society of savers to buy your debt) 
• But the increasing scrutiny by bond rating firms and bond investors everywhere, combined with Japan’s worsening debt structure is going to hasten the day of reckoning. If the sovereign debt rating of the US, UK, France, and Germany come under pressure in 2012 -and they probably will- how would Japan be able to dodge the axe ?  
• Once the data is in, it will be clear Japan’s economy saw no net growth in 2011. 2012 will be worse as its export-heavy economy is kicked in the shins by a deflationary and de-leveraging US & Europe.  
• Having lost 17% in 2011, Japan’s stock market remains somewhere to avoid. 22 years later, it remains down 78% from the late 1989 peak. 

The US debt / housing / banking crisis:

• The US debt load relative to GDP has been exploding since year 2000, and entered an even worse phase in 2008 that continues today. Congress is intent on continuing to shirk their responsibility in solving the debt problem by punting to 2013. I doubt the bond rating agencies will let it slide that far.
• Here’s a chart of our past and extrapolation. We’re almost a basketcase now, and will be one before this decade is out. Please note: this is not a forecast. The bond market will not allow this forecast to transpire.

•  
  • Legend: 
  • Black line = total value of US home prices
  • Blue line = total value of US home prices with a mortgage
  • Red line = value of mortgages
  • Green line = total net equity of home owners with a mortgage
• This week’s Case-Shiller housing report shows US house prices for October were down 3.4% from the same month the previous year and are where they were in 2003. Anticipate a further 5-7% drop from October 2011 through March 2012. That will translate to 2002 prices in 2012 and a 38% national drop in house prices. Hold onto your hats though. This is likely to repeat next year.  With luck, that will be the extent of the drop. My best estimate (and largely the same as last year’s year end note view) is for house prices to drop to year 2000 levels in 2013. That would translate to national house prices seeing a 45 – 50% drop from their bubble peak in 2006. There’s 4 years worth of inventory and a slowing rate of household formation preventing this story from ending rosier than this. 
•  The continued slide in house prices is going to impact the American psyche — probably beginning this winter. Savings rates will increase to historic normal levels for recessions (9-10% range). Combined with a state & local government in spending retreat mode, it is difficult to see any GDP growth for the US economy in 2012. In total, the US economy is likely to contract 2 – 2.5% in 2012.  I don’t think I’ve seen any Wall St forecasts like this. And this assumes Congress continues to extend the temporary fiscal candy through 2012. If not, add another 1 – 2% GDP drop.

China. Does it manage to avoid a rapid collapse in real estate prices?

• At the top of every asset managers list (after Europe) is China’s slowing economy. China’s economy in 2011 is more heavily reliant on real estate and infrastructure spending than ever. The hope is for Chinese real estate to gradually drop 20-25% in price during 2012. This would still leave real estate massively overpriced, but it would wring-out some of the speculation and make a small dent towards making home prices affordable.
• You know their banks are sitting on bad loans made in haste in 2008-2009. But how much is going to end up being flushed?   Fitch thinks roughly $2T of the $4T in bank loans since 2008 will go bad.
• China’s stock market (the Shanghai) lost 22% this year, is back where it was in early 2009, and remains an unattractive place to deploy capital. 

India, Australia, Canada, Brazil, Turkey, and Norway continue to be on the radar screen for potential places to invest equity positions.   But until there are substantially lower prices and appropriately lower readings from the greedometer, this remains on hold. Emerging markets and some out of the way international localities pose interesting opportunities for bonds. 

Gold: Assuming the European mess continues to fester and eventually break in 2012, and assuming the ECB eventually caves to the pressure to print, gold has a lot of upside. But it may first have to continue to give back some of the past gains until there’s a clearer read on money printing. Gold at $1400, $1300, $1200 may happen before $2200, $2300, $2400.     

Other Commodities: A slowing global economy and continued rising dollar will continue to put downward pressure on commodities.   

US Residential & Commercial Real Estate:  I continue to see no reason to own these assets until there’s a credible reckoning of the   

Wildcards. Topics that may take center stage in 2012:

• Growing civil unrest in Russia. Now that Russia has been granted accession to the World Trade Organization (last week), will it become a more civilized trade partner? 
• Growing civil unrest in China.
• Growing civil unrest in the middle east (Arab spring part II).
• When in 2012 does Greece decide to hand 75% losses to bond holders.
• Does Italy make it through the 1st quarter of 2012. (who buys their bonds?)
• The US Presidential Election. Does it matter who wins? Either way, the bond market is going to bring the pain in 2013 (if not earlier).
• Do we get yet another Persian gulf war — this time with Iran?
• Does the new leader of North Korea act crazier than the last leader?
• Will new regulations make a flash crash less likely?
• Now that the US has pulled out of Iraq, will there suddenly be peace? Mesopotamia has been the intersection of Persians, Arabs, Turks, and Kurds for centuries. The odds favor increased instability and strife with the exit of “the Great Satan”.      

• There’s more evidence of residential property prices dropping. The People’s Bank of China is going to have to step-in in Q1 if this continues. After the European financial system crisis, China’s property bubble is the number two strategic investment issue to track.
• How is China’s stock market?  Down over 60% since the peak in 2008, and down nearly 30% from this year’s peak. 

India:

• The news continues to worsen out of India. Inflation remains high at +9.1%.  GDP is still the envy of every developed country at +6.9% (annualized rate). So on net, the economy feels recessionary. This partially explains why the Indian stock market has been tanking.
• Last week, India’s central bank decided to stand pat and cease raising overnight interest rates charged to commercial banks at 8.5%.

Germany: Business confidence for early December was considerably higher than expected. The same report suggested German GDP growth would be lower in Q4 than Q3. (no kidding)

Ireland:  Austerity is in full swing. The Irish economy posted a -1.7% drop in Q3 –this is a -6.8% annualized rate (what we track here in the US). It will be exceedingly challenging to limit economic decline in Ireland while the rest of Europe heads into recession.  

Italy:  The latest austerity budget was approved by yet another confidence vote in parliament. How many confidence votes have there been this year?  I’m confident I don’t know, and that there will be another one coming along in Q1.  Last week saw a successful 5-year Tnote auction, but it came with a hefty price. The yield was roughly 6.5% — a euro era high.    

Spain:  Last week and this week are seeing a noticeable drop in Spanish bond yields. With luck, Spain will be able to put some distance between it and Italy — in the eyes of the bond market.