The final 4Q GDP report came in at +1.7% (annual rate), versus 1.6% reported earlier.  The first estimate of 1Q GDP will be released on April 28, and the latest Wall Street Journal survey of leading economists has a consensus estimate of 4.6% for the 1Q.  That figure comes as a surprise to me since most of the economic reports we’ve seen so far this year have been mixed.  In this issue, we will review the latest economic reports.  As you will see, I don’t find evidence that the economy grew by 4.6% in the first three months of this year.

Many economists are reducing their economic forecasts for the 2Q and 3Q, to 3.3% and 2.9% respectively according to the latest WSJ survey.  If the economy starts to slow down, as BCA has predicted, this should pave the way for the Fed to end its rate hiking cycle, either at the May 10 FOMC meeting, or at the latest the June 28/29 meeting.  It remains to be seen if the Fed will go too far and risk a recession.

Most of the major stock indexes have risen to new recent highs this  year, or even new all-time highs in some cases.  This strength could continue later this year, especially if it becomes clear that the Fed has stopped raising interest rates.  Thus, investors may want to remain fully invested in equities.  But the risks are high and rising, and this is why I recommend having most of your equity investments with professionals who use “active management” strategies that can exit the market or hedge positions if conditions change.

In this issue, we also focus on the housing market which has clearly peaked, at least for the time being.  Housing starts in February were 13.4% below yearago levels.  New home sales were down 10.5% in February.  The question is, how bad will things get in terms of home and real estate prices?  BCA thinks it will be only a modest decline, but others think it will be a lot worse.  Interestingly, the Chicago Mercantile Exchange is about to introduce new housing futures and options for the first time.  As a result, you will soon be able to hedge the value of your home and real estate in general.  This should be interesting.

Introduction

Last month I wrote about how disappointing the economy was in the 4Q of last year.  But since then, all we’ve heard about is how strongly the economy rebounded in the 1Q of this year.  As I will discuss below, the latest survey of leading economists suggests that GDP surged ahead by well over 4% in the 1Q.  But did it really?

As long-time clients and subscribers know, I keep my ear tuned to trends in the economy at all times.  I subscribe to numerous publications that track economic data and make forecasts for the future.  I feel it is important to gauge the economy due to its effects on the investment markets, stocks, bonds and commodities in particular.

Over the past 20+ years, the US economy has surprised on the upside, as predicted by The Bank Credit Analyst back in late 1981/early 1982.  Since then, we have only had five "recessions" - defined as back-to-back quarterly declines in Gross Domestic Product.  With the exception of the 2000-2002 recession, sparked by the technology meltdown, the other four recessions were very mild by historical standards.

Yet as we look ahead to the second half of this year and to 2007, the economic outlook is quite puzzling.  Americans, we are told, are tapped out with record large household debt, so consumer spending which accounts for over two-thirds of GDP is bound to dry up any day now.  Yet consumer spending continues to surprise on the upside year after year.  But is it now finally about to dry up?

Then there is the Fed which last week raised short-term interest rates for the 15th consecutive time to 4.75%, under the leadership of new Fed chairman Ben Bernanke.  The Fed also hinted that it's not done raising rates just yet.  Another hike to 5% is all but assured at the next FOMC meeting in early May.  Concerns are rightfully rising that the Fed will go too far and push the economy into a recession.

Next we have the surprising slowdown in the economy in the 4Q of last year.  The Commerce Department released its final report on 4Q GDP, showing a rise of just 1.7% (annual rate), following the gain of 4.1% in the 3Q and 3.5% for all of last year.   Most analysts agree that the shortfall in the 4Q of last year was largely due to the hurricanes and soaring energy prices.  But what does that mean for the future?

Next on our worry list is the housing bubble.  Has it burst, as suggested by numerous reports over the last couple of months, including February new home sales which fell by 10.5%, the largest monthly drop in nine years?  Or is it alive and well, as suggested by the February existing home sales which rose by 5.2%?  I suggest the former, as I will discuss below.  So, the question on my mind, at least, is how much home prices will drop, and how much will that impact the overall economy.  No one knows for sure, by the way.

And finally, we can’t forget about inflation.  The Consumer Price Index rose 3.5% for the 12 months ended February, while the Producer Price Index rose 3.7% over the same period.  The Fed has made it clear that inflation above 3% is not acceptable.  So analysts are now fretting about whether there is more than just one more rate hike in the cards. 

As a result of these concerns and others, many economists are dialing back their forecasts for the second half of 2006 and 2007.  While preliminary data suggest that the 1Q of 2006 was very strong - an estimated 4.6% jump in GDP by the 50 or so economists surveyed by the Wall Street Journal - these same economists are scaling back their forecasts for the rest of this year.  The average forecast is for the US economy to slow to a 3.3% annual rate in the 2Q and 2.9% for the 3Q.  This projected slowdown over the next few quarters, we are told, is a good thing since it should cause the Fed to go on hold after a final rate hike in early May.  Or maybe not.

In the pages that follow, we'll survey the latest economic reports and see if we can draw any meaningful conclusions.  We’ll also see what the smart guys at The Bank Credit Analyst had to offer in their latest report for April.  And we’ll analyze the troubling trends developing in the housing market.    Let's get started.

Latest Economic Reports Send Mixed Signals

As noted above, the government reported that 4Q GDP rose by a meager 1.7% (annual rate), up from 1.6% in its previous report.  For all of 2005, the economy grew at an annual rate of 3.5% in GDP, despite the poor showing in the 4Q.  Yet the economy seems to have rebounded strongly in the 1Q of this year.  The consensus expectation is a rise of 4.6% in GDP in the 1Q, as noted above.

Based on the economic reports I saw during the first three months of this year, I think a 4.6% jump in 1Q GDP is a bit optimistic.  As of this date, we have only seen economic reports for January and February.  Only a few reports for March numbers are  out yet.  Let’s look at the reports we’ve seen so far this year and see if you find them as mixed as I do.

Let’s start with the Index of Leading Economic Indicators (LEI) which fell by 0.2% in February after rising modestly for the four preceding months.  Keep in mind that the economy grew only 1.7% (annual rate) in the 4Q, even though the LEI was slightly positive during the previous four months.  In my view, the LEI is not telling us much about the economy at present.  It does not suggest that the economy soared by 4.6% in the 1Q.  But that remains to be seen.  The Commerce Department’s first estimate of 1Q growth will be released on April 28.

Next we look at the Consumer Confidence Index published by the Conference Board.  The report for March was released on March 28, showing a jump of 0.4% last month.  That puts the confidence index to the highest level in almost four years.  But in January, we saw a decline of almost as much as the index gained in February and March.  Here again, this index isn’t telling us much, in my view, but it does not suggest a 4.6% jump in GDP in the 1Q. 

The US unemployment rate, which fell to 4.7% in January, rose slightly to 4.8% in February.  While a number under 5% is generally considered “full employment,” the uptick in February doesn't suggest a barnburner 1Q.

Retail sales were up 2.9% in January, but then fell 1.3% in February.  For the 12 months ended February, retails sales were up 6.7% - a healthy number.  Industrial production was down 0.3% in January, but up 0.7% in February.  For the 12 months ended February, industrial production was up 3.3%. 

Capacity utilization - the factory operating rate - has been steady between 80% and 81% for the last several months.  You would think it would be higher if the economy grew by 4.6% in the 1Q.  That may be explained by the fact that factory orders rose a less than expected 0.2% in February, after plunging by 3.9% in January, the largest monthly drop in more than five years.

Durable goods orders (big ticket items) fell sharply in January and recovered modestly in February, but are still well below levels seen in the 4Q of 2005.  Orders for new motor vehicles fell 3.3% in February, after falling 3.2% in January.  Auto sales fell another 2.9% in March in a report released on Monday.

Construction spending was up marginally in January and February and rose 7.4% for the 12 months ended February.  A big part of that increase was due to housing construction.  But as I will discuss at length below, there are clear signs that the housing bubble is coming to an end, or at least a significant slowdown, and this will negatively impact construction spending in the months ahead.

Might We Be In For A Disappointment?

When I consider all the economic reports we’ve seen for January and February, and a few for March, I don't get the impression that the economy grew at an annual rate of 4.6% in the 1Q, as suggested by the most recent Wall Street Journal survey of leading economists.  Since the Commerce Department doesn’t release its advance report on 1Q GDP growth until April 28, we may well see those estimates revised downward over the next 2-3 weeks.  But that remains to be seen.

As noted earlier, these same economists are not as optimistic about the next two quarters.  The consensus estimates are that the economy will grow by 3.3% in the 2Q and 2.9% in the 3Q.  Those estimates seem more reasonable to me based on what we’ve seen so far this year.

Corporate executives, on the other hand, are more optimistic about the remainder of the year.  The Business Roundtable reported that its quarterly CEO Economic Outlook Index rose 0.8 point to 102.2 in March, it’s second highest reading in the survey’s history.  I would note that this particular survey is almost always positive.

At the moment, CEOs have good reasons to be optimistic.  On March 30, the Commerce Department reported that corporate profits soared by over 14% in the 4Q of last year to $185.8 billion.  That compared to a drop of $54.4 billion in the 3Q of last year when hurricane related insurance settlements slammed results.  Corporate profits in the 4Q accounted for 11.6% of GDP, the highest level ever.

There were some very positive reports in January and February, as well as some negative ones.  I would call it a mixed bag so far this year.  As a result, I would expect to see the consensus estimates on 1Q GDP coming down a bit in the weeks ahead.

Inflation Still Above Fed’s Threshold

As noted above, inflation continues to run above the Fed's comfort zone.  The Labor Department publishes the Consumer Price Index and the Producer Price Index (wholesale prices).  In the latest report for February, the Labor Dept. reported that the CPI rose 3.5% over the last 12 months, while the PPI rose 3.7% in the last year. 

These numbers are supported by the inflation figures in the latest GDP report.  The Commerce Department reported that the price index for gross domestic purchases by US residents (formerly the GDP price deflator) rose at an annual rate of 3.7% in the 4Q and 4.2% in the 3Q.  Both sets of figures are higher than the Fed wants to see.

However, the “core rate” of inflation - minus food and energy - is reportedly the inflation figure the Fed monitors the closest.  For the 12 months ended February, the core rate of inflation was 2.1%.  Supposedly, the Fed wants to keep the core rate below 2%.  This is another reason why analysts are convinced the Fed will hike rates at least one more time at the May 10 FOMC meeting before stopping.

A lot will depend on how strong (or disappointing) the GDP estimate is for the 1Q.  That report will be released on April 28, well before the next FOMC meeting on May 10.  That report could also influence whether the Fed will raise rates a 17th time at the June 28/29 FOMC meeting.

BCA’s Latest Forecasts

The latest April report from the editors at The Bank Credit Analyst is consistent with what they have said in recent months.  They believe that US economic growth will "decelerate" in the second half of the year, with growth averaging 3% or less in GDP.  They do not, however, believe the US is headed into a recession, barring any major negative surprises.

BCA believes that the slowdown in the US economy will prompt the Fed to end its rate hiking cycle, either at the upcoming May 10 FOMC meeting, or at the latest, the June 28/29 meeting.  They do not believe it will be necessary or wise for the Fed to raise rates above 5%.  They believe the slowdown in the US economy will keep inflation in check.

While BCA expects 2-3 quarters of slower growth in the US, they believe that the economies of Europe and Asia will continue to strengthen over the same period.  For this reason and others, they expect the US dollar to resume its long-term downtrend.

BCA remains positive in its view of the equity markets, and believes investors should have slightly above average holdings of stocks and/or equity mutual funds.  While not raging bulls, the editors believe stocks could get a significant boost later this year when the Fed stops raising interest rates.  

As for bonds, BCA feels that yields will come down when it becomes clear that the economy has slowed down.  However, because the 1Q was a relatively strong one, they would not be surprised if bond yields move somewhat higher in the near-term.  Thus, they recommend below average holdings of bonds for now.

As always, I highly recommend subscribing to The Bank Credit Analyst.  Visit their website at www.bcaresearch.com.

Has The Housing Bubble Burst?

The much-ballyhooed slowdown in housing is now more than a prediction as February and March reports show a housing market that has, at the very least, peaked.  While existing home sales increased 5.2% in February, new home sales dropped 10.5% in February, the largest monthly drop in nine years.  Sales were also down in January. 

Housing starts were down 7.9% in February when compared to January, but remember that January’s starts were abnormally high because of good weather.  The more pertinent statistic was that February 2006 housing starts were down 13.4% from year-ago levels, definitely something to be concerned about.

The median sale price of new homes fell in February for the fourth consecutive month to $230,400.  That was down 1.5% from January and 2.9% from yearago levels. 

The slowdown in sales pushed the inventory of unsold homes up to a record of 548,000 at the end of February.  At the February sales pace, it would take 6.3 months to sell all of the homes on the market, up from 5.3 months in January.  Analysts believe that the growing backlog of unsold homes will start to put more pressure on home sellers to reduce prices in the months ahead.

Making matters worse, it is not uncommon for builders to continue to crank out supply even after demand has peaked, especially given the development and permitting process required, so it is likely that the level of inventory backlog will continue to increase. 

To say the least, demand for new housing is starting to wane.  Bloomberg reports that the mortgage application index has plunged in recent weeks, with the four-week average back to levels not seen since November of 2003.  The National Association of Homebuilders also reports that its monthly survey shows a marked drop in buyer traffic and sales expectations.  It has also been reported that it is taking longer to sell homes, and there has been an increase in the number of people walking away from contracts to buy new homes.

The various reports noted above make it clear that the housing bubble has peaked.  The question is, how bad will it get?  One thing seems certain, that different parts of the country will be affected more seriously than others.  But how bad the housing market gets in general is anyone’s guess. 

While the gloom-and-doom crowd is calling for a catastrophic drop in housing prices (don’t they always), the editors at BCA see the housing market softening mildly in some areas and merely leveling off in others.  They say: “A major drop in house prices is not in the cards, assuming we are correct that interest rates will soon peak.”

There are obvious effects that a softening in housing prices might bring about, not the least of which is a drop in consumer spending.  However, you can see stories about this everywhere in the financial press.  Instead, I’d like to point out several things I think we can take away from the latest housing statistics that might not make the other media outlets.

First, is that the experts were right when they said housing prices could not continue to rise at double-digit levels forever.  This reminds me of the late 1990s when some investors and analysts thought stocks would continue to deliver double-digit returns indefinitely. 

The same goes for housing.  No prices can continue to increase at double-digits forever without a commensurate gain in income, which has not occurred.  Thus, when housing becomes unaffordable, prices will stagnate, or even decline.  That appears to be happening now.  As noted above, the median price for a new home is still $230,400.  With mortgage rates increasing, fewer individuals will be able to afford houses at this price. 

A second thought in regard to housing is to not expect the housing industry to wilt away quietly.  Investors Business Daily recently reported how homebuilders are pulling out the stops in their efforts to woo buyers, including throwing in a variety of upgrades such as kitchen upgrades, landscaping and in some cases, even swimming pools. 

These items don’t necessarily show in the housing data, since the homebuilder supplies these perks, often at no additional cost.  Thus, the homebuilder makes less on the house, but can still count it as a sale.  Increasing the cost of homes sold, however, will have a definite effect on the bottom line of homebuilders, and this is already becoming evident.  Several of the nationwide homebuilders have already issued profit warnings.

As noted above, BCA does not feel that the housing market is in for a bust, but rather a slowdown.  Interestingly, the editors at BCA feel that a softening in housing prices could actually be the catalyst for a gradual rebuilding of the personal savings rate.  You may ask how this could be, but BCA explains:

“There is no avoiding the fact that housing wealth has been largely used as a substitute for incomes, leading to a sharp drop in the saving rate.

A cooling in housing should be the catalyst for a gradual rebuilding of the personal savings rate.”

There is no question that many homeowners have refinanced their mortgages (several times in many cases) and have used the equity in their homes to supplement their incomes and spending.  This has resulted in what is commonly called a “negative savings rate.”

BCA reasons that, as housing prices continue to soften, the ability to tap an increasing equity will go away.  If so, the negative savings rate should also gradually go away.  Taking it a step further, BCA suggests that if homeowners begin to worry about falling house prices, they will begin to save more of their incomes.  We’ll see.

Unfortunately, this potential for a rise in the savings rate will be at the cost of consumer spending, which makes up two-thirds of the US GDP.  If consumer spending falls off too much as a result of a leveling off (or decrease) in home equity, the overall economy is likely to suffer.  Just how much the economy will suffer and how hard GDP will be hit is anybody’s guess.  BCA continues to reject the gloom-and-doom scenario, staying with their expectation of a rather benign mid-cycle slowdown in the economy.

Conclusions: Risks Are High

The consensus is that the economy rebounded powerfully in the 1Q - up 4.6% (annual rate) according to the latest Wall Street Journal survey of economists.  Yet if we look at the various economic reports we've seen over the last three months, we don't see such a rosy picture.  I will not be surprised if 1Q GDP is well below 4.6% when the report is released on April 28.

Inflation for the 12 months ended February was still above the Fed’s comfort zone.  The Fed raised short-term rates for a 15th consecutive time in late March, and hinted that it's not done yet.  A 16th consecutive hike is widely expected on May 10, and analysts are increasingly expecting a 17th hike on June 29.  The question is, will the Fed go too far and push the economy into a recession?  The gloom-and-doom crowd certainly thinks so.

Our friends at The Bank Credit Analyst, on the other hand, have a more benign outlook.  They believe the economy is in for a mid-cycle correction, with slower growth over the next 2-3 quarters, but no recession.  As growth slows, this should bring down inflation by enough to convince the Fed to end its rate hiking cycle, either after the May 10 FOMC meeting, or at the latest after the June 28/29 meeting.  In 2007, BCA expects the economy to rebound strongly again.

The housing bubble has peaked, at least for now.  Median home prices have fallen for the last four months, although not dramatically in most markets.  The inventory of unsold homes has risen to more than a six-month supply, and is likely to rise more in the next month or two.  How far home prices will continue to fall is anyone's guess, although BCA does not expect a huge drop in house prices.  In any event, the era of refinancing homes every six months or so to cash-out ever increasing equity is coming to an end.

While the economic outlook is probably benign, with only a temporary dip in growth over the next 6-9 months, there are plenty of “wild cards” at play.  Will the Fed go too far in hiking rates?  Will home prices and real estate in general drop a lot more than is currently expected?  Will energy prices soar to new highs?  Will consumers go into a funk and cut spending significantly?  Will we drift into a recession?  What about the war in Iraq?

As noted above, the editors at BCA believe we will avoid most of those things and a recession.  They see another 2-3 quarters of slowing growth, with the economy improving again in 2007.

The stock markets seem to agree with them, and several of the major market indices have risen to new highs this year.  That, too, would seem to suggest we are not headed for bad times just ahead, as promised by the doom-and-gloomers.

With that said, it is also clear that the risks are high, especially for the next 6-9 months.  As noted above, there are several things that could go wrong, and thereby dash consumer confidence and spending.  While BCA believes it is not the most likely scenario, we cannot rule out a recession.

This is why I have most of my investments under the direction of experienced professional money managers who use “active management” strategies, which allow them to exit the market and/or “hedge” their positions if economic or market conditions turn negative.

Currently, all of the equity managers we recommend are profitable for the year.  Several of the programs are up double digits this year and are beating the S&P 500 Index.  Of course, past results are not necessarily indicative of future results.

If you are out of the stock markets, or if you are under-invested, now may be the time to check out the professional money managers Irecommend.  To do so, you can visit www.profutures.com or you can call us at 800-348-3601.  We will be happy to send you information on how to get started.

Housing Futures & Options

Sometime over the next couple of months, the Chicago Mercantile Exchange (CME) will introduce new housing futures and options markets.  While other industries, such as agriculture and the financial markets, have access to a wide range of financial risk management tools, such tools have not been available to the housing industry – until now. The CME is continuing its tradition of innovation with the creation of the first comprehensive products to hedge risk in real estate.

The CME housing futures and options will  provide opportunities for protection in down markets, and extend to the housing industry the same financial tools that have been available in many other commodities for years.  By providing a means of hedging exposure to home prices, they can diffuse the potential impact of sustained declines in housing prices.  According to the CME, the new housing futures and options markets will:

1.  Create a new means of risk transfer to a broad range of investors;

2.  Have the potential for fostering stability in the housing industry; and 

3.  Provide an innovative way to participate in the real estate market without having to buy and sell properties.

The new futures markets will be based on the S&P/Case-Shiller Home Price Indexes.  The  housing futures and options are cash-settled to a weighted composite index of US real estate prices, as well as to specific markets in 10 major U.S. cities:

Boston, Miami, New York, San Diego, San Francisco, Washington, D.C., Chicago, Denver, Las Vegas and Los Angeles.  Other cities are expected to be added in the future.

Karl Case and Robert Shiller are two widely-known economists at Yale.  Some 20 years ago, they began developing various indices to measure home values.  They believe their so-called Case/Shiller indices are the most accurate indicators of residential real estate values around the country.

While the new CME housing futures and options are targeted mainly at institutions and large homebuilders, they may prove attractive to individual homeowners and rental property owners and investors in general.

Home and rental property owners will be able to hedge their property values by shorting housing futures and protect from a downward move in prices.  Investors who believe that housing prices will continue to increase will be able to go long in housing futures and benefit if prices do in fact go up.  Of course, they can also lose if prices go down.

A spokesman for the CME told me in late March that the new housing futures and options will begin trading “sometime in the second quarter.”  He also indicated that each futures contract would represent apprx. $70,000 in value.  See my April 11 E-Letter for more details on the new housing futures.

It will be very interesting to see how these new markets are accepted, especially with home prices starting to soften in many parts of the country.  As a warning, I would not recommend that most investors get in this market.  Remember, futures trading is very risky, and risks can be even higher in a new market such a this.  I’ll keep you posted.