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Why The Stock Markets Are Collapsing

GaryHalbert — Tue, 10 Mar 2009 20:46:56 GMT

IN THIS ISSUE:

The Economy Continues To Slump Badly

US Stock Markets Continue To Plunge

Obama's Multi-Trillion Dollar Spending Spree

Obama's Budget – The First $2 TRILLION Deficit?

Obama's Plan To Nationalize Health Care This Year

Obama's “Cap-and-Trade” Environmental Proposal

Conclusions – Why The Stock Markets Are Collapsing

Introduction

Economic news continues to worsen week after week. As I will discuss below, Gross Domestic Product contracted at almost twice the previously reported pace in the 4Q of last year, and most analysts now expect a similar or worse slowdown in the 1Q. Many forecasters now believe the recession will last all year, with a modest rebound beginning in 2010. We will look at the latest economic data as we go along.

The stock markets continue to plunge, even as trillions of dollars in bailouts and government spending have been announced. The Dow and the S&P 500 fell 33.8% and 38.5% respectively in 2008. So far this year, the Dow and the S&P 500 are down another 25+%. Both indexes are down more than 50% from their peaks in October 2007. While the equity markets are grossly oversold, there is still no evidence of a bottom, although I fully expect that we are close.

Investors around the world are stunned, not only as a result of the collapse in the US and global equity markets, but also due to the continuing severe credit crisis. More and more analysts and politicos are calling for the US to nationalize the major money center banks that are teetering on the brink of insolvency. Clearly, people around the world are preoccupied with the economic and financial crises.

In the following pages, we will recap the unprecedented spending that President Obama has proposed over the last six weeks, including his first federal budget proposal totaling a record $3.55 trillion for fiscal 2010. Obama's 2010 budget projects a record deficit of $1.75 trillion, and I believe it will be even higher as I will discuss below. No wonder the markets are not happy!

It is also clear now that President Obama has decided to use these crises as an opportunity to cram down all of his big liberal plans for the country this year. In addition to spending trillions of dollars, he is also moving forward with other major plans including “Cap & Trade” (carbon emissions), “Card Check” (expanding unions) and nationalized health care – just to name a few, all of which will eventually mean higher costs for American consumers.

When Mr. Obama was elected, most political analysts believed that he would attempt to enact these major liberal plans over the course of his four-year presidency. Yet it is obvious now that he wants them all this year, while Americans are preoccupied with the economic and financial crises. If he gets his way, it will dramatically change the face of America. More on this as we go along

The Economy Continues To Slump Badly

It will come as no surprise to readers of this E-Letter that the US economic numbers continue to falter. But by far the most shocking number released over the last several weeks was the latest 4Q GDP report released in late February. In late January, the Commerce Department's advance estimate for 4Q GDP was -3.8% (annual rate), which was the worst in well over a decade.

Then on February 27, the government revised this number to -6.2%, the deepest quarterly decline since early 1982. I have been watching US economic data for over 30 years, and I have never seen the Commerce Department miss the GDP number this badly over just a one-month period of time. Clearly, this economy is contracting severely.

The US unemployment rate continues to ratchet up rapidly. On Friday, the Labor Department reported that unemployment rose to 8.1% in February, up from 7.6% in January. Many forecasters predict this number to rise to near 9% by year-end, and some even project the jobless rate to reach 10% by the end of this year.

The Consumer Confidence Index plunged again to a new record low in February of 25.0, down from the previous record low of 37.4 in January. Consumers' appraisal of overall current economic conditions, which was already bleak, worsened much further in February. Those claiming business conditions are “bad” rose to 51.1% in February from 47.9% the prior month.

On the manufacturing front, reports are equally grim according to the reports for January (latest data available). Durable goods orders plunged 5.2% in January following a drop of 4.6% in December. Factory orders fell 1.9% in January following a plunge of 4.9% in December. Industrial production fell 1.8% in January following a drop of 2.4% in December.

The nation's factory operating rate fell to 72.0% in January, down from 73.3% in December. Elsewhere, the construction spending rate fell another 3.3% in January, down from 2.4% in December. This is the worst manufacturing downturn in decades.

On the housing front, the numbers continue to worsen. Existing home sales fell to 4.49 million in January from 4.74 million in December (again, latest data available). New home sales fell to 309,000 in January, down from 344,000 in December. Housing starts in January fell to 466,000, down from 560,000 in December. Meanwhile the median home sale price continues to fall, sliding to $170,300 in January, down 15% from a year earlier.

In summary, we find ourselves in the worst economic slump since 1981-82, and many would argue something worse. A growing number of forecasters are coming to the conclusion that we may be headed into a depression. But as I will discuss as we go along, Obama has authorized over $3 trillion in new spending, the Fed will spend up to $2 trillion and Congress has just passed more new spending projects. So, that much money should start to show up in the economy before long.

US Stock Markets Continue To Plunge

As noted in the Introduction, The Dow and the S&P 500 fell 33.8% and 38.5% respectively in 2008. So far this year, the Dow and the S&P 500 are both down over 25%. Both indexes are down more than 50% from their peaks in October 2007. The Nasdaq Composite Index fell 40.5% in 2008 and is down another 17.6% so far in 2009, down over 55% since the peak in late 2007.

Stocks have been battered with a steady stream of bad news so far this year, as noted in the latest economic reports above. In addition, there has been report after report of faltering banks. The government now owns 36-40% of Citigroup, which saw its share price fall below $1.00 last week. The 30 companies that make up the Dow Jones Industrial Average are commonly referred to as “Blue Chips” or the strongest of the strong. Over the last year, however, the number of Dow stocks trading under $10 per share has increased dramatically.

In addition to Citigroup, other beleaguered Dow stocks include General Motors at $1.50 per share, Bank of America at $3.00, General Electric at $6.00 (down 60% this year alone), and Alcoa at $5.00.

The government has also increased its equity stake in AIG, now reportedly owning over 80% of the insurance giant. Speaking of insurance, I am hearing from sources inside the industry that we could be hearing announcements soon that some major insurers are in serious financial trouble.

Investors around the world want to know what is driving the equity markets down so dramatically. Certainly, the credit crisis and the economic recession are weighing heavily on stock prices. But I believe there is much more to it than that. As I will discuss later on, I believe that the markets are voting NO on the massive spending Obama has authorized in his first 40 days in office.

Obama's Multi-Trillion Dollar Spending Spree

In sheer size, the economic measures announced by President Barack Obama to address “a crisis unlike we've ever known” are remarkable, rivaling and in many cases dwarfing the New Deal programs that Franklin D. Roosevelt famously created to battle the Great Depression. Here is a list of the massive spending that Obama has gotten passed or is proposing:

1. In February, Congress passed and Obama signed into law a record $787 billion stimulus bill, which is mostly new federal spending along with aid to struggling states and tax incentives.

2. Treasury Secretary Geithner announced last month that the government would make available up to $2 trillion on top of what has already been spent or promised in a rescue effort for banks and other financial institutions, including credit card companies and those who make student loans. We have yet to see the details on this massive rescue plan. Clearly, the lack of a detailed financial rescue plan for the banks is spooking the stock markets.

3. The president pledged up to $275 billion in federal aid to help stem the tidal wave of home foreclosures. Here, too, the details are unclear as to how it will work.

Add it all up and the total for these three spending proposals alone is over $3 trillion in new government debt over the next 2-3 years. In all, the plans noted above would raise the federal portion of the US economy to some 31%, more than twice the level after eight years of FDR's historic New Deal spending.

This does not include the remaining $350 billion in TARP money that Obama will get to spend this year. Plus, there is also talk of a second stimulus package later this year, one supposedly aimed at consumers directly.

And let's not forget that the Federal Reserve has purchased over $1 trillion in troubled assets and related securities over the last year alone. Fed chairman Bernanke told Congress recently that the Fed is prepared to double that amount this year.

President Obama and Bernanke tell us that all this massive spending is necessary to avoid a “catastrophe.” Yet no one knows if these huge spending programs will work. No wonder the stock markets are tanking.

Obama's Budget – The First $2 TRILLION Deficit?

President Obama unveiled the largest federal budget in history in late February – a whopping $3.55 trillion. With the economy in recession, the Obama administration projected that the budget deficit for fiscal 2010 would be a record $1.75 trillion. However, there are reasons to believe it will be even higher.

For example, Obama's budget plan assumes that Gross Domestic Product, the sum of all goods and services produced by the nation, will shrink by only -1.2% this year and rebound to about 3.2% by next year. Given that GDP plunged by 6.2% (annual rate) in the 4Q, and the likelihood that the 1Q will be just as bad or worse, we would have to see a huge rebound in the second half of this year for GDP to average only -1.2% for the year overall.

Furthermore, none of my trusted sources expect GDP to rebound to 3.2% in 2010. The point is, federal tax revenues in 2010 will almost certainly be lower than the assumptions in Obama's $3.55 trillion budget, so the deficit is almost certain to be larger than projected.

Obama's budget plan also assumes that the US unemployment rate will average 8.1% this year and get slightly better in 2010. The US unemployment rate stood at 7.2% for December 2008. It has since risen to 7.6% in January and to 8.1% in February. Most economists now expect the unemployment rate to reach 9% by year-end. That does not average out to 8.1% for the year.

Here again, the unemployment realities will mean that federal tax revenues in 2010 will almost certainly be lower than the assumptions in Obama's $3.55 trillion budget. As noted above, the Obama administration projects a budget deficit of $1.75 trillion for fiscal 2010. But it will not surprise me if the deficit is $2 trillion or more in 2010. No wonder the markets are tanking!

$410 Billion Omnibus Spending/Pork Bill

The Senate is expected to pass the huge $410 billion omnibus spending bill that will finance the government through the end of September any day now. This is possibly the most pork-laden spending bill in history. It is widely reported that the bill contains over 8,500 “earmarks” (pet spending projects for lawmakers' states and districts).

The omnibus spending package ran into trouble last week when several Democratic senators opposed not only the pork-barrel spending in the bill, but also the shear size of the bill - $410 billion. That is an 8% increase over the prior omnibus bill. Among the Democrats in opposition was Senator Evan Bayh of Indiana who told the Wall Street Journal:

“The omnibus increases discretionary spending by 8 percent of last fiscal year's levels, dwarfing the rate of inflation. Such increases might be appropriate for a nation flush with cash or unconcerned with fiscal prudence, but America is neither.”

During the presidential campaign, candidate Obama promised that he would wholly change the budget process in Washington by going line by line through spending bills, picking out the wasteful earmarks, vetoing the bills, and telling Congress to send them back stripped of the pork. President Obama has echoed that promise since he took office - but just not for this bill. Since this omnibus bill was largely negotiated last year when Bush was still in office, Obama labeled it “unfinished business,” which he says he will sign and “start fresh next year.”

So, it is politics as usual in Washington, only the numbers are much bigger! These historically huge spending programs and bailouts that Obama and the Democrats in Congress have authorized have really spooked the stock markets. And the Democratic spending machine isn't finished yet. Using the “never let a crisis go to waste” doctrine, Obama has made it clear that he plans to pursue massive spending for other pet liberal programs over the next couple of years.

Obama's Plan To Nationalize Health Care This Year

President Obama recently convened a health care summit at the White House, which was attended by “experts” across the health care and insurance industries. The Washington summit is to be followed by regional meetings across the country in the weeks and months ahead.

The summit concluded without specific details as to what an Obama health care system would look like. We do know that Obama's 2010 federal budget calls for the creation of a $634 billion health care reserve fund to cover reforms over the next 10 years. The President's remarks at the summit included the following:

“To the liberal bleeding hearts hoping for universal health coverage, I don't think we can solve this problem without talking about costs. And to those obsessed with costs…[we will] not slash the social safety net. I just want to figure out what works. We don't have a monopoly on good ideas. We've got to balance heart and head.”

For those fearing a total socialization of health care, this is at least some good news. By all accounts, President Obama is resisting the liberal calls for a “single-payer” socialized health system of the type that exists in Canada and Europe. So what can we expect? No one knows for certain just yet, but two of the ideas being floated are: 1) an expansion and retool of Medicare; and 2) some variation of the health plan that members of the federal government enjoy.

It is abundantly clear that Obama intends to enact his massive health care reforms this year, and unlike the Clinton administration, Obama appears to have the votes in Congress to get it done. So, now the question is, how to pay for it? As noted above, his 2010 budget includes $634 billion over 10 years to help fund his health care “reforms.” But where does this money come from?

The Obama administration says that $318 billion of it will come from tax increases on the “wealthy.” Another large portion will supposedly come from “internal reforms” to the Medicare system. Specifically, Medicare Advantage would be placed into a new competitive biding system that will supposedly do away with federal subsidies paid to these private medical plans, which is projected to save $175 billion over 10 years.

They say another $37 billion could be saved as home health care payments to Medicare are reduced, and a further $20 billion could come from higher rebates from drug companies for drugs sold to the Medicaid program. All of this only adds up to $550 billion. Where will the other $84 billion come from? I have no idea, and at the moment, neither does the Obama administration.

The Obama plan does not seem to be in danger of going the way of the ill-fated Hillary-Care proposal in 1993. House Representative Joe Barton (R-TX) was on hand for Obama's health care summit last week. Barton was pivotal in derailing Hillary-Care, but he told those assembled at Obama's summit that he largely supports the health care reforms that President Obama has outlined thus far.

Barring some big surprises, President Obama is going to get his massive reform of the health care system, whether we like it or not, possibly before the end of this year. While it may stop short of socialized medicine, the government will be in charge of our health care system, and we all know how well the government controls spending, costs and quality. Again, no wonder the stock markets are tanking!

Obama's “Cap-and-Trade” Environmental Proposal

The “cap-and-trade” concept is not a new idea. The type of cap-and-trade program that President Obama wants is very similar to that of the European Union. Yet, the EU's cap-and-trade program is in near-collapse, which demonstrates the weakness of this strategy.

Under a cap-and-trade system, polluters (think power generation plants, steel mills, etc.) are given a cap on greenhouse gasses they can emit into the atmosphere. If they exceed their limits, they can either make their process more environmentally friendly by upgrading technology and equipment, or they can buy credits from other entities that produce fewer emissions than their caps. The goal is that, as the overall emissions caps are reduced over time, industries will find that reducing emissions is more cost efficient than buying credits.

The cap-and-trade idea is often confused with a “carbon tax,” but the two are different. In a carbon tax, the government charges a fee for the production, distribution or use of fossil fuels, rather than creating a system of emission credits that can be traded among companies. Whatever the structure, virtually all agree that any program to curb greenhouse gasses will increase prices as higher costs are passed on to consumers. Even President Obama admits this.

President Obama's recent $3.55 trillion budget proposal calls for a cap-and-trade system to be implemented by the year 2012. The government would auction credits to power plants, industrial plants, etc., with some of the proceeds over the cost of administering the program to go back to taxpayers (I wouldn't count on it).

The Congressional Budget Office (CBO) estimates that a cap-and-trade system will cost middle-income families as much as $880 to $1,500 per year in added costs. Thus, Obama's plan to offset these increased costs through a payroll tax rebate ($400 for individuals, $800 for families) won't cover all of these costs. Plus, the liberals in Congress have not yet had their say. The final bill may concentrate the rebates on lower income families, possibly leaving many middle income and high income families out entirely. Of course, the rationale is that higher-income families will reduce their costs by lowering their energy bills through conservation. …Right.

Also, it is important to recognize that certain areas of the country will be hit much harder by cap-and-trade, especially those that rely heavily on coal for electricity. I have included a link to a very good article on which areas will be hurt the most in Special Articles below.

Here again, Obama's cap-and-trade plan serves as yet another tax on higher income folks who create most of the new jobs in this country. Critics also say that a cap-and-trade program could lead to the loss of as many as four million jobs and reduce the US GDP, but still may not effectively reduce emissions. Again, no wonder the stock markets are tanking!

Obama's “Card Check” Proposal To Strengthen Unions

It is no secret that Obama has long been an advocate for the organized labor unions. As a senator, he co-sponsored the “Employee Free Choice Act of 2007,” which was very favorable to unions but was fortunately never enacted. As a presidential candidate, he had a very pro-union agenda, including repeated promises of making “Card Check” the law of the land.

Card Check, considered one of the most sweeping revisions of labor law since the 1930s, would allow unions to do away with secret ballot voting by workers who are deciding whether or not to unionize. Instead, workers would be required to vote in public by signing a card signifying their desire for, or against, union representation.

Secret ballot elections have been the law of the land for a very long time, and even many union members do not want this to change. Critics of the Card Check system say that a secret ballot election is the only way to insure that employees are not faced with undue coercion when making their decision. Card Check changes all that, since union organizers can place a card in front of a worker and know exactly which box they check. Liberal union leaders have wanted Card Check for a long time, since it makes unionization much easier.

Union membership has been steadily declining since the 1950s when an estimated 35% of the American workforce belonged to a union. Today, the Bureau of Labor Statistics reports that only 12.4% of wage and salary workers belong to a union. By far, government employees are the most likely to be unionized, with a membership rate five times that of private employees.

Unions hope that the new Card Check rules, which are almost assured to pass and be signed into law, will help to put them back on a growth path. The economic consequences will be higher labor costs for producers, lower productivity and higher prices for goods and services to consumers over time. Just look at the big three carmakers and see how beneficial increased unionization is likely to be for the US economy.

Conclusions – Why The Stock Markets Are Collapsing

I now firmly believe that President Obama and his top advisers have made a calculated decision to try to ram through the largest parts of his liberal agenda this year, while the American people are preoccupied with the economic and financial crisis.

I recently wrote that Rahm Emanuel, Mr. Obama's new Chief of Staff, told a Wall Street Journal conference of top corporate executives late last year (comments he almost certainly probably wishes he could take back):

“You never want a serious crisis to go to waste. Things that we had postponed for too long, that were long-term, are now immediate and must be dealt with. This crisis provides the opportunity for us to do things that you could not do before.”

So Obama's liberal policy agenda that would have been considered aggressive over the full four years of his presidency is apparently going to be crammed down the American peoples' throats this year if possible.

Obama's massive emergency spending/bailout plans announced in just the first 40 days of his presidency total over $3 trillion, something never before remotely seen. Obama's 2010 federal budget of $3.55 trillion will likely result in a budget deficit of $2 trillion next year, and over $1 trillion in each of the next 2-3 years.

Meanwhile, the Fed is in the process of printing and spending another $2 trillion in debt to fund banks and buy toxic assets. Where this Fed printing and spending will stop is anyone's guess, unfortunately. The implications for inflation down the road are ominous.

And let's not forget the Congress which is about to pass a $410 billion omnibus spending package to keep the government running through September that was 8% higher than last year at this time, and included over 8,500 pork-barrel earmarks. Obama obnoxiously broke his campaign promise to veto earmarks by saying this enormous omnibus spending bill was “unfinished business” left over from the Bush administration, and promises to sign it into law.

On top of all this, Obama's liberal policy initiatives such as nationalized health care, cap-and- trade and Card Check (just to name a few) will add hundreds of billions in cost to American consumers over the years ahead. And despite what Mr. Obama says, taxes at all levels will have to eventually be increased to pay for this massive spending. It will change the face of America as we know it, but that is a story for another time.

The long-term implications of these unprecedented multi-trillion dollar spending plans are unknown. No one knows for sure if all of these huge spending efforts will work to revive the economy and unfreeze the credit markets. If they do, then there is the prospect for spiraling inflation in the years to come.

Investors around the world are watching their stock portfolios being decimated – down over 50% in just over one year – and are asking WHY is this happening? Sure, the subprime mortgage debacle was the catalyst. But in my view, the radical changes that President Obama is pursuing – sooner rather than later – are in large part why the stock markets are in a freefall collapse instead of a normal bear market.

Fortunately, the professional money managers I have recommended to you in this E-Letter over the last several years have done their jobs admirably. Their active management strategies that have the ability to move to cash or hedge long positions have limited losses to less than half what the stock markets have lost. Some have even made money in this historic bear market. As always, I must add that past performance is no guarantee of future results.

As always, I invite you to call us at 800-348-3601 so we can help you make sense of this frustrating investment environment. That is all for this week, depressing as it may be once again.

Wishing you the best in tough times,

Gary D. Halbert

SPECIAL ARTICLES:

Deception at Core of Obama Plans
http://www.realclearpolitics.com/articles/2009/03/a_dishonest_gimmicky_budget.html

The Anti-Stimulus Plans
http://weeklystandard.com/Content/Public/Articles/000/000/016/249nhfrg.asp

Winners & Losers in Huge Congress Spending Bill (who got what in pork)
http://www.foxnews.com/politics/2009/03/09/winners-losers-proposed-massive-spending/

Who Pays for Cap and Trade?
http://online.wsj.com/article/SB123655590609066021.html

The Room 3/31/08

DavidGalland — Mon, 31 Mar 2008 20:08:36 GMT

Dear Reader,

I am writing to you in the pre-dawn from a soft chair in a Starbucks in Scottsdale, a vast improvement over the small desk in the cluttered toy room that I usually write you from on Fridays. 16 inches from my left hand is a "vente" (in the Starbucks' nomenclature, that means super sized) Americano (four shots of espresso with a dash of water to hold them all together) that I will be consulting with throughout this correspondence. I do so in an attempt to sterilize the effects of a glass of wine or two too many following the close of what I felt was another excellent Crisis & Opportunity Summit.

For those of you unfamiliar with the concept of sterilization, at least as the word is used in the discussion of modern economics, a topic that occasionally slips into these paragraphs, I will elaborate. Sterilization refers to the notion that a central bank can, upon spotting a storm cloud gathering on the horizon, unleash a flood of loose money - the amount is almost irrelevant, as long as it is enough, in their studied opinion, to re-juice the economy and keep the consumers consuming. Then, once the danger is passed, the same central bankers simply cut the supply of money, thereby "sterilizing" the prior injection of cash before the ill and otherwise inevitable effect of price inflation kicks in.

It all seems so logical, this fundamental underpinning of fiat economics. Sense a threat - unleash money. Threat passed - tighten up.

Yet, as you may have noticed, it apparently doesn't work. At least if you use the value of the dollar as the metrics of success, the staunch defense of which is supposed to be job #1 of the Fed. If you are looking for further proof of that contention, your contemplations need extend only far enough to notice that the greenback has lost some 80% of its purchasing power since its link to gold was broken in 1971. There is another side effect of the flawed foundation of the fiat system, at least as it is pursued in the U.S., namely that American consumers, encouraged by the loose money to make a hefty dose of spending a part of their daily activities, are now up to their nostrils in debt and many are underwater.

Over the last day and a half here at the Summit we have heard much about these and other consequences of the government's failed jiggering of the economy and, in particular, the depth and breath of the current crisis. Regrettably, I don't have time to go into great detail in this week's edition, as attempting to do so would result in my missing the plane back home.

To move things right along, I'm going to take the short cut of inviting others to join me on the page. Starting with John, a subscriber who earns his daily soup by serving as a professional real estate appraiser in Northern California. John kindly agreed to candidly answer a series of questions we sent him in our attempt to get a clearer picture of what's going on behind the scenes and under the hood in the all important real estate market.

Real Estate, the Insider's Perspective

Before we get to John's interview, I'd like to share some observations on just one of the many great presentations held at this Summit, that delivered by Andy Miller, one of the most substantial real estate investors in these 50 states (for Andy, a typical day's labor might involve the buying or selling a hundred million dollars worth of real estate or loans connected with same). Andy accepted our invitation to Scottsdale to share his perspective on the outlook for real estate going forward. While Andy used far more sophisticated language than I, I will summarize his outlook as thus:

RUN FOR COVER!

To be more specific, his view on real estate - and remember, Andy is as "inside" as inside gets - is that we are nowhere near the bottom and that some segments, commercial and condos especially, are going to fall off a cliff.

While there is little in the way of specific actions you can take to invest for a short-term profit from this unfolding situation - mainly because the stocks of almost all the publicly-traded real estate firms have already been crushed - Andy does believe that as this crash occurs it will create the opportunity of a lifetime. If nothing else, in six months or a year down the road you should be able to pick up that dream condo on your favorite beach for an off-key song. As to when the market might bottom, Andy's take is that it all depends on the actions of the government. If it stands aside and lets the market take its righteous toll on the overextended mortgagees and those who hold those mortgages, then the worst of the damage could be over in a couple of years (at least that was my sense of the timing Andy suggested). However, if the government, as it is prone to do, rolls up its sleeves and sets about fixing the many dislocations in the real estate market, then, like the Japanese before us, the real estate fiasco and attendant damage could stretch out for a decade or more. Hot tip: watch the politicians carefully (always good advice, in my opinion, especially if you find yourself in a tightly packed elevator with one).

Another of Andy's many insightful comments was that you should not trust appraisals. That's because, as the bubble inflated, loan officers, looking to make as many loans as possible, and the bigger the better, naturally gravitated toward the most liberal appraisers. By contrast, the more cautious appraisers soon found themselves in an un-enviable position portrayed so convincingly by the MayTag Repairman: sitting at an uncluttered desk, staring forlornly at the silent phone.

As is human nature, a great many, if not most, of the appraisers swallowed their ethics, put away the textbooks they studied when learning their trade, and as a basis of their appraisals began to use the amount of money they felt would evoke a smile on the thin lips of the loan officers.

The task of over-inflating the values became increasingly easier as the "comparables" available to appraisers began to reflect the new reality. To wit, if the shack down the street actually sold for $650,000, then who could dispute that the lovely fixer-up, lacking only in a little TLC (read: "new plumbing") was worth $1,000,000?

Which brings us, finally, to our guest interview with John, a residential real estate appraiser in California. As he described himself in the correspondence leading up to our interview... "I've been appraising in California for 18 years, and deal with the gamut of lenders, borrowers and developers, and see every story, scheme, and scenario possible. I have lots of anecdotal stories and evidence, as well as research and conclusions, from the extremely overbuilt new tracts, where builders are still building—because they're committed—and competing against first generation foreclosures in their earlier phases, and losing money on every sale, to small projects dead in the water or upside down, to the very rural, to the very upscale still paying cash."

With that introduction, here is our interview...

1. Have you ever seen things in the real estate market this bad?

In terms of the all-around uncertainty and worry being felt by borrowers, lenders, buyers and sellers, nothing this bad.

I was in southern California in the mid-1990s downcycle. Things had gotten overheated there especially, but the decline was much more orderly, over maybe 3-5 years, than this one has been in just two or so. In retrospect it was a fairly normal and not surprising correction. People and borrowers got hurt and became wary, but there wasn't the pervasive worry about the bottom falling out. And it wasn't as widespread. That is, while most everyone lost value in their homes in the mid-1990's downturn, fewer people were as directly impacted or in such a critical situation. There wasn't nearly the breadth and depth of indebtedness then. Today there is a much higher percentage of borrowers with a much higher level of debt because, in this run up, so many people continually ran up debt and sucked out their equity.

The frenzy of borrowing and lending up until a year or so ago was far greater than that which led to the escalating prices, and subsequent correction, in the early to mid-1990s. I see instance after instance of someone with say a $300,000 loan taking out a second mortgage or an equity line for $50,000 a year later, followed by an all new mortgage that consolidates the previous two plus tacks on another $50,000. So now they've got a $400,000 loan. Ten months later they get another $60,000. And, in 2004 through 2006 especially, there was a lot of 100% financing, usually a first and a second mortgage, often with the same lender.

The downtrend is not as steady as the mid-90s. It goes in real fits and starts. In cases of some very overbuilt communities I've seen the bar lowered by $30,000 in a single month in a $300,000 to $400,000 neighborhood. It's usually caused by sellers -- often banks -- unloading after a period of waiting or stagnating sales. All of a sudden what was thought of as a competitive asking price is now overpriced by $30,000 or more.

[Ed Note: Andy Miller said the best time to buy properties, when the time is right, of course, is at the end of quarters when the institutional holders dump properties in an attempt to clean up their books.]

2. Are appraisers under any pressure to give rosy valuations?

Not as much at this time, because the lenders are more deeply affected and truly reigning in. Mortgage brokers, who don't fund their own loans, will still try to put some pressure on, but the lenders—the ones actually putting out the money—are saying "tell us what's really happening in the market." They want to know because they've got lots of exposure and want to know the real story. In fact, where before, in the 1990s downturn, FNMA and most lenders encouraged appraisers to call the market "stable" versus "declining" even if everyone knew they weren't stable, this time around they expect to see the declining box checked, unless you make a very convincing case that values are in fact stable (not too common here in California). So, at this point lenders are really tightening. So even the magic cure of lowering interest rates won't help much when lenders are increasingly risk averse.

3. When a property doesn't sell in two or three times the normal time span, why doesn't the seller face facts and slash the price?

I've seen some slashing, and some sellers chasing the price down, but always a step behind. What they'd settle for now, but can't quite get, they could've gotten last year when they were asking $60,000 more. Reductions are more frequent and often sizeable. It used to be that you'd see a token $5,000 reduction, more just to get your listing visible again. Now large reductions are common. This is especially true in the high-end and custom spec homes. Every contractor and contractor's brother was building a spec home, getting bolder in how big and fancy they'd build them. After all if you can make $60,000 on a 2,000 square foot $400,000-value home, why not build a 4,000 square foot home with all the bells and whistles...it'll cost more and take a little longer but the market's just going up anyway. I watched one 6500 sq ft very high quality spec home go from a $2.5M asking price a few months prior to completion in 2005, slowly down to $1.9M, then $1.6M and so on, eventually to $1,200,000. In the end it sold for around $1,150,000. The guy must have lost money because I'm sure that quality cost him close to $200/sf just to build, not to mention the land (probably $200,000+) and the enormous holding costs for 2-3 years.

The other sellers are, of course, banks, whose motivations vary greatly. I've seen a few put money and effort into a home and try to hold out for reasonably close to market value, but most often they want to get them off their books as quickly as possible. Sometimes they're competitive and sometimes they blow them out. I had one agent who handles REOs (Real Estate Owned) for several lenders tell me sometimes they'll get word to get two sold in the next two weeks. He said that a decision was made, for example, to clear 100 properties nationally off their books in the next 30 days, so that meant orders were going to Region A to unload 12, Region B to unload 15, etc.

He said it was sometimes the case of regulators requiring them to reduce their REO units. In one case, the agent reduced a small home on 5 acres with a 3600 sq ft barn with additional 2BR apartment from $569,000 to $400,000, overnight. It was contracted in three days, and closed a few weeks later for $392,000. Someone had paid $710,000 for it in 2005 with 90% or maybe 100% financing. In another case a lender was asking $325,000 and accepted a cash offer of $175,000. The house was dumpy but sound and livable, and reportedly not a major fixer. It was just not worth $325,000 and the bank was tired of looking at it, and took the offer. Until then nothing in a 3BR/2BA in that neighborhood went below $275,000 or $250,000. Of course these are exceptional cases, but the downward pressure is very real, and very intense still. There are many properties for sale, and buyers are wary, or waiting. Some sellers, those fortunate enough not to have to sell, pull out of the market. Those that have to sell usually have to reduce their expectations.

4. Are there sellers who have been in denial for months about what their property is worth but who are about to come out of denial and make a big cut in the price? Are there many of them?

See #3 above. Again, there are always those that must sell. And, there's another category that falls in between the regular homeowner and the bank. It's the owner/borrower who's in trouble and must sell, or lose the house. This is the "short sale" situation, where the borrower owes more than the property is worth, and is engaging the bank in the selling process to have them accept less than the outstanding loan balance. The bank is involved in negotiations and must approve the final sales price. They're fairly agreeable, because the alternative is going through the entire default process, sinking more time and money into it, and likely losing more. And here we're just speaking about the first mortgage (trust deed in California) holder. Often a second mortgage holder will lose their entire loan amount; after all why would they step in and pay off a first mortgage that alone is more than the value of the collateral?

5. How is the market for buildable lots? More depressed than for houses? How much more difficult has it become to get financing for a buildable lot?

The market for lots has completely dried up. In this area (semi-rural northern California) land was on fire for several years, as contractors bought up nice lots and not so nice lots to build homes on. For a while everything turned to gold. People were selling land held in the family for a long time (just like silverware in the late 70s!). Developers, many inexperienced, were getting in to subdivide land to make 4 parcels, 12 parcels, or whatever zoning allowed. But it is a long and expensive process.

The craze and demand peaked probably in 2005-2006, and I still see some of these projects just coming to market. People have spent two years, and more money than they expected, to get their golden little subdivision, all finalized and ready to go to market...and the market is not there. The demand is so low for unimproved land now, but I haven't yet seen the capitulation I expect. I've seen small and medium sized subdivision projects, which are completely upside down. A friend of mine owns a commercial appraisal firm and specializes in large subdivisions. He's been the bearer of bad news too. In the frenzy, national builders were buying farm land in the middle of nowhere, some two plus hours from metro areas, to create new subdivisions and planned communities. Many of the tracts and phases that never got built now have a residual value of less than zero! That is, taking the estimated value of a proposed completed house (times 20 or 200 or 2,000 depending on how big your plans were!) and backing out the cost to build the house and all your infrastructure, bond obligations, etc., the land is worth less than zero. Of course, it is worth something, but only to speculators willing to sit on it for a long time. There's a reason it was farm land in the middle of nowhere to begin with. Some can't even go back to farming because of zoning and general plan changes and new houses now adjacent. [A whole other topic is farmers selling water rights to new developments and municipalities, resulting in what is an increasing amount of fallow land that's apparently not farmable now. Lots of unintended consequences, and unfolding opportunities?] It's going to be very interesting to watch the market unfold.

6. Based on what you are observing, how much further do you think prices are going down?

My answer would have to be anywhere from "some" more, say 15-20%, should well grounded optimism magically set in before year-end, to a lot more, possibly 30-40%, should news and conditions (and perceptions) worsen and snowball, or there be some unexpected large macro event that shakes things up on top of the underlying situation.

This, of course, is the unknown and unexpected, but these things happen. It could be a natural disaster, a military showdown, somebody doing something big and stupid in the Middle East, political correctness of "Olympic" proportions (what if the Tibet situation goes south, Richard Gere and fans get half the world to boycott China this summer and cause them to lose face in an epic way, and they decide in turn to boycott our dollar...), or simply some confluence of events, in the US or elsewhere, that ratchets up fears and concerns here.

In other words, if the stars line up, and lots of things go well, or appear to go well, throughout 2008, things may stabilize with maybe only a 15% haircut, from here, in general real estate values in the US. To predict less than this just calls for too much precision with all the variables and uncertainty, unless you really believe the downturn is about over, which I don't see. Under current conditions 5-10% can potentially whiz by in a month or a quarter, and is really just noise, between commissions, negotiating skills, fear and uncertainty, and the varied motivations of both buyers and sellers.

On the other hand, if things continue along with the same pressures as I see now, we'll likely see drops of 15% to 20%. If conditions fail to improve in the next 6-18 months, or are exacerbated in some way, then I think we could see larger drops in value, and a more prolonged decline.

Of course, there are many markets and sub-markets throughout the country, and some are more volatile and some more insulated than others. There will be some exceptions and some extremes. In general, though, I believe we're in for some more decline.

7. How long do you think it will be before we see prices come back to the levels they were before the crash? Are we talking months, years or decades at this point? We know this is pure conjecture, but what is your gut feeling based on many year's experience?

That's a long way to go back up, especially since we're still going down at this point. I'd have to estimate as much as a generation, at least for the areas that are being most impacted. It got so overheated with lenders, buyers and borrowers making mutually terrible decisions. Everyone is going to be wary for a long time, especially because this became such a speculation-driven run up.

Besides lots of average homeowners forgetting common sense (and forgetting that even attractive loans still require repayment) and assuming (speculating) that values would keep going up, there sprang up a whole class of everyday people that became speculators, and actually went out and bought second and third homes to turn over. These were people who otherwise don't do real estate deals, because the market doesn't normally afford that kind of opportunity. There was a huge disconnect from what typically drives a real estate market. Most people probably won't go near real estate speculation again, will be careful in their future borrowing, and will be wary of buying more houses than they need and can afford. So, until they're no longer the primary buyers and owners of real estate, and their kids and grandkids stop taking their advice, we probably won't again have conditions that will lead to a rapid increase in values.

Of course, natural growth and demand do cause values to rise, but it could take 10-20 years of typical appreciation (1-3% per year in traditionally less volatile areas, to maybe 3-6% in more active markets like California, the East Coast and Florida) to cover the ground of 4-8 years of frenzy. And that will be after the current downturn stabilizes, meaning oversupplies are absorbed, foreclosure and defaults have run their course, indebtedness is at normal levels, and healthy market conditions are back in place. That in itself will probably be another year or two at best. It doesn't seem likely that the down cycle will last only 2-3 years, considering the last one lasted 3-6 years when the underlying problems were not as bad. To summarize, to get back to where we were at the peak, at least in the areas hit the hardest, we'll need the time it takes to stabilize, at least a year or two, and then, depending on where things do stabilize, likely a decade or two of healthy and typical appreciation.

David again... my sincere appreciation to John for taking the time to work with us on this interview. Correlating his remarks with those of Andy Miller, and taking into account the sheer magnitude and importance of the real estate markets to the U.S. economy, I think the picture painted is fairly bleak.

That said, per Andy, when this wildfire eventually runs its course, it will create the opportunity of a lifetime for investors who have avoided the worst of the losses and have their capital intact.

As an aside, if you are, like John, an insider in a business with experiences that you think other subscribers would like to hear about, drop me a line at david@caseyresearch.com.

Democracy Versus Republic

As you may have noticed, I am no big fan of the idea of democracy because, in time, democracy inevitably devolves into a fight - with votes - at the public trough. Today, over 51% of the populace of the U.S. are net recipients of money from the U.S. government (read: their fellow citizens).

But if not democracy, what? In my view, it is a republic... a form of government whereby the government is limited to specific functions and no more, and where rights are inviolate and not subject to tampering by whichever gang of powerseekers have captured the flag.

On this topic, one of the participants at the Summit wandered over to me to share the following illustration of the difference between the two forms of government:

In a democracy, two wolves and a sheep get together to decide who they are going to eat for lunch.

In a republic, eating the sheep would be outlawed.

Universal Health Care Anyone?

At this point, given the high cost of health care, the high levels of indebtness which makes those costs unbearable to so many Americans, and because changing the system is as easy as voting in the Democrats, it is my opinion that universal healthcare is a sure thing for the U.S.

Given my time constraints, a more detailed discussion of the wisdom of adopting this large-scale giveaway will have to wait. But I would like to share a couple of anecdotes that will give you a hint as to my general views on the topic.

The first came out of a newspaper I picked up on a recent trip to Canada. The first paragraph, about patients in Ontario, pulls back the peel on the rest of the story, and reads as follows:

"More than 400 Canadians in the full throes of a heart attack or other cardiac emergency have been sent to the United States because no hospital can provide the lifesaving care they require here."

In the same newspaper (the Globe & Mail if I recollect correctly), I also noticed large ads paid for by the Canadian government, couched in a pleading language, for doctors. Given the sheer volume of red tape and effective income restrictions doctors in that country are saddled with, it is no wonder so many of their best and brightest now practice their professions here in the U.S., and there are shortages up north.

My second anecdote comes from a fun service I subscribe to called "This is True" (thisistrue.net). Here it is...

"PLEASE HOLD: More than 43,000 patients had to wait outside in ambulances for at least an hour last year before they could be seen in Britain's National Health Service emergency rooms. Standards require that patients must been seen within four hours when they arrive at an emergency room, so when busy, patients must wait outside so the clock doesn't start ticking."

Who knows, maybe the government in the U.S. will learn its lessons from the various universal health care systems being employed around the world, and won't let politics or demands from constituents drive the creation of a system that destroys the few remaining positive aspects of the U.S. medical system... or beggars the country any more than it already is... but that is a long-shot hope at best.

Inflation? What Inflation?

Last week I shared the story of my mother's childhood residence, in Mont Clair, New Jersey, purchased in 1929 for $45,000, and sold below that price almost 20 years later.

My friend of long standing, Ian McAvity, the editor of Deliberations, an excellent service for those of you who lean toward technical analysis, dropped me an email with the following message.

David,

You might be amused that Zillow.com estimates the value of 10 Sutherland Road, Mont Clair, NJ at $1.24 million currently.

Ian

So, $45,000 to $1.24 million in about 63 years. But it is worse than that, because the former family homestead was, according to my mother, subdivided into a number of lots, so the actual current value of the property is likely closer to twice that value.

I said to my wife the other day, following an expensive meal, that I need to recalibrate how I think about money. Simply, $20 is no longer the $20 I remember from my youth, but is actually more like $2.00, or even $1.00.

Thus, a dinner bill of $200 for a family of four at a decent restaurant should not evoke a reaction such as "$200! This is ridiculous! How does anyone manage to survive these days, let alone save any money!".

Rather, recalibrating my sense of value to the brave new world whose air we now breathe, my reaction should, going forward, be nothing more than, "Nice dinner, and look, it was only $20."

A self-delusion, or the new reality? You decide.

Bearish Questions

Ed Steer, the hardworking contributing editor to our Daily Resource Plus, sent along an article from Reuters on the Bear Stearns buyout, which I thought you would find of interest. I certainly did. Here's an excerpt...

NEW YORK -- Stunned Bear Stearns shareholders who saw investments virtually wiped out overnight when a takeover deal with JPMorgan Chase was unveiled are demanding to know how it was put together in the first place.

For instance, they -- and Washington lawmakers -- want answers on how the deal was arranged, and gained government approval and financing, all in a few hours, and seemingly without alternative bidders being canvassed.

They also have a host of questions about the role of the Federal Reserve and the Treasury Department in engineering the emergency deal.

So far some crucial details remain murky.

"Under the circumstances, shareholders should be entitled to know just about everything," said James Melican, chairman of shareholder advisory firm Proxy Governance Inc., which is expected to make a recommendation to investors on whether the deal should be approved.

"There needs to be full disclosure of exactly what happened over the weekend," he said. Investors have "an absolute right to know whether there is any other alternative mechanism that could either keep Bear Stearns in business or at least have them get a more appropriate price for their shares."

Billions of dollars in shareholder value have been wiped away in the last week. Based on current market prices, the takeover is valued at $2.41 a share, a shockingly low offer compared with Bear's $159 stock price last April.

Another highly unusual aspect of the deal is the way JPMorgan Chase & Co. has been allowed into the Bear Stearns Cos. Inc. to provide "management oversight of its operations."

If shareholders were to reject the JPMorgan offer, JPMorgan still would have been in a position to understand everything about Bear's trading strategies, staff quality and assets.

JPMorgan even has an option to buy the Bear Stearns' building if the deal collapses.

Congress also wants answers, particularly on the involvement of the Federal Reserve in pushing the deal, which came as Bear Stearns faced a sudden cash crunch and possible collapse. In an unusual move, the Fed agreed to lend $30 billion to fund illiquid Bear Stearns assets to help seal the takeover.

Among the unanswered questions are:

-- Were other parties asked to bid on Bear Stearns, or did the government solely approach JPMorgan about the takeover?

-- Were any overseas banks or private equity firms asked to consider a bid, or did the buyer have to be a large U.S. bank?

-- How did the Federal Reserve arrive at the $30 billion figure and did it discuss with Bear whether it was preferable to arrive at a quick sale or explore a bankruptcy filing?

-- How could due diligence be done and the deal approved in the space of a few frantic hours on Sunday?

-- And how can a party taking over another be allowed to run the target before the deal has gone through?

With so many unknowns, the Senate Finance Committee is reviewing the sale and particularly what implications it may have for taxpayers. On Thursday afternoon the committee's top Republican, Iowa Sen. Chuck Grassley, said he wanted details of the Fed's financial support of the deal, as well as how Bear insiders were being treated under the buyout.

In the House of Representatives, the chairman of the House Oversight and Government Reform Committee also wants to know more. The committee is conducting a "preliminary review" of the deal, an aide to Democratic Rep. Henry Waxman of California, who chairs the panel, said on Thursday.

A decision on whether to launch a more formal investigation or to hold committee hearings could take several weeks, said the aide, who declined to be identified. The aide added that the Bear Stearns developments dovetailed with separate hearings that Waxman's committee has conducted on compensation packages for top executives at troubled firms.

Here's a link to the full article.

And That Is It For This Week...

As usual, I have so much more I would like to discuss. But unusually, I have almost no time to dive in further.

I will leave off, however, by saying that I was pleasantly surprised while idly looking through a discarded copy of USA Today, while waiting for yet another jolt of caffeine to be delivered, to find the front page article of the Life Section of that publication dedicated to a glowing discussion of the town of Cafayate and the surrounding wine country, where my own favorite partner of all times is building out his own version of Galt's Gulch. (You can view more at www.cafayateliving.com).

Doug has always had a spectacular eye for moving into the right real estate markets at the right time, and it looks like he's done it again.

In any event, it is time to wrap these weekly musings and rush madly for the airport. Next week I will be writing from the forebodingly named Jekyll Island, Georgia, where Doug and I will be spending a few days in good company further pondering the world as we know it.

Until then, thank you for reading and for subscribing. And a special tip of the hat to all of you who attended our Summit. I have said it before, and I'll say it again, our subscribers are a remarkably philosophically sound and interesting lot. It is always a pleasure to spend time with you, and the Scottsdale Summit was no exception.

Very sincerely,

David Galland
Managing Director
Casey Research, LLC.