A Look at 2006 - Up-to-the-Minute Financial Commentary about Money, Investing, and How It Affects the Average Investor

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Today's Commentary: 01.01.06
Like a Blind Horse Knee Deep in Corn: Our 2006 Outlook

Alan Greenspan once said: " It's very rare that you can be as unqualifiedly bullish as right now."

Andrew Carnegie once said: "Put all your eggs in on basket and then watch that basket."

President Bush once said; "We are heading into a new year with an economy that is the envy of the world and we have every reason to be optimistic about our future."

To put those comments in perspective, it must be noted not only when they were spoken but what happened after these sage prognostications were made. Greenspan made his financial pronouncement on January 7th, 1973 just before the worst two years for the markets since the Great Depression. Carnegie on the other hand was doling out advice concerning the concentrated investment goals one should have in one company or one sector with the claim that this was how the rich became rich and as a result, it was the only way to prosper. And Mr. Bush, that hapless fellow who has taken the first half of this decade and made some of the worst economic decisions of a President in modern times and explained them as worthy of envy.

As we close to 2005 we need to understand that the forces that have shaped this economy have been coming from opposite directions. Much like the moon pulls on the orbit of the earth, which by the way is why we get that pesky atomic second added on New Year's Eve, the financial information many of us and the markets has had to digest over the past year has twisted any sort of rational thought and decision making. We are confident, then we are not. We are prosperous and then we are not. We are in debt and then we are, well, not so deep in debt.

Barron's, the weekly financial magazine, has a market sentiment chart at the bottom of three other charts plotting the plodding pace of the markets this past year. Perhaps most telling observation about the grouping of these four charts is the way they seem to change course about mid-year with the markets gaining ground while the sentiment drifted away. The S&P 500 gained 3% for the year with the caveat that sans energy, the group would be down 10%. The Nasdaq had a plus year as well but the blue chip industrials, the benchmark for how well the economy is doing was down slightly for the year, divided by outrageous gainers and dismal losers. Depending on how well you could pick the markets, you could fold any good news into bad and vice versa. Investors stayed away. Companies decreased liquidity.

How often have heard that the consumer is key to the success of the economy? A full two-thirds of the economy rests on the shoulders of the average spender - since we are no longer savers with our negative 1.5% savings rate, we may as well call ourselves what we are.

Our 'spending' habits have become legendary both here and abroad. Our thirst for goods is unparalleled on the world stage. Even China's economy whose GDP was doubled recently due to an accounting error does not consume what we do. Every country capable of producing a trinket has sought access to our marketplace. And on the backs of our home equity, a new source of wealth for Americans, we consumed everything the markets had to offer and then some.

Now that 2006 has arrived, there are subtle signs that our home cum ATM machine will no longer capable of providing the necessary cash to purchase these goods. Unless, of course, the outgoing Federal Reserve Chief insists that his interest rate mongering in the name of inflation method was the right one and successfully encourage his successor, Ben Bernanke to follow with more rate hikes.

And he probably will raise them at least once. He might do so to appease the inflationary gods in March, but then he will abruptly change course. It is important to keep in mind Mr. Bernanke's brief stint as the President's economic advisor. That indoctrination in the Bush way of thought will not allow new top banker to be his own man for long. By mid-summer, rate for the short term overnight loans will begin to fall and with it, the mortgage industry will rejoice.

(The two rates have absolutely no correlation. One is short term while the other is traditionally long term. But with so many loans being crafted with much shorter time horizons to much riskier borrowers, rate watchers like low Federal rates more for their sentimental value than actual worth.)

This new era of loose money and low (creditworthy) qualifications will be enough to keep the economy growing for the upcoming year. Between you and me, I wish it wouldn't happen. .

The current housing market, as was pointed out recently in the New York Times, is more affordable that it was a quarter century ago. Our income seems to be able to provide more room for housing in the household budget than in decades past but the comparison is flawed.

While the month-to-month affordability of home ownership is definitely a plus, the number of homes being 100% financed has increased significantly. Very creative financing has allowed many people who could not otherwise afford to buy a home, purchase one, and those who could, purchase larger ones. But much of this affordability is generated from growth of the home's value more than an actual increase in household income.

Because of that, if those equity estimates drop, and history has proven this can and will happen, the pressure of owing more than the property is worth will have a negative effect on the homeowner. many of these first time buyers did not ante up a down payment the way many of us did just a decade ago. And, as a result, far too many are unprepared for any economic shifts because of those dubious financial arrangements

There was a time when the average home was purchased primarily for shelter and recently tax purposes. Now it is considered to be an active asset in a diminished overall portfolio that may even lose its tax advantages in the coming year.

One last note about this shift in housing. Even though the portion of total budget set aside for the mortgage has dropped in many markets and may seem inexpensive in comparison to income, the quality of buyer has changed. They now consider themselves investors. .

Carnegie, when he made the quoted statement at the beginning of this piece was referring to business owners of great means who owned large blocks of their own companies, homeowners should take heed. Time is not a friend to those that do not diversify. And so many homeowners, leveraged to the hilt and with their fortunes tied up tightly in their humble abodes, there is a good chance they will feel those words ring true in 2006. ( I have mentioned this before but it begs repeating once again: $500 billion adjustable rate mortgages will be revalued in 2006, almost all are owned by sub prime borrowers. No savings and with a considerable amount of their dreams tied up in their homes, these poor souls will feel the brunt of an investment turned sour.)

To counteract, the U.S. needs to readjust its way of thinking. Something needs to change and that changes needs to come from an increase in the savings rate. It won't happen in 2006 but the idea will gain momentum.

Let's take a look at businesses in the upcoming year, those hollowed institutions that put their shares on the open market for purchase and are responsible for supplying the GDP with the numbers that so many investors watch. Trouble with those numbers comes only upon closer examination.

As one staunchly Republican and outspoken reader asked recently - someone whose vitriolic phrasing is indicative of the many blind horses knee deep in corn that are running this country - what is so bad with share buybacks? His claim that they increase shareholder value is simply untrue. Although 2006 will best answer that question, 2005 definitely gave it the old Wall Street try.

Share buybacks are an accounting game played by companies flush with cash. That cash came compliments of repatriated funds, unbelievably low borrowing rates and a consumer who was willing to buy goods that were once made here on American soil but are now made more cheaply overseas by American companies.

Last year, companies bought back a record amount of their shares. $456 billion worth of shares to be exact. This created the illusion of growth and it can be seen in retrospect as deceptive on every level. The bottom line is altered when the actual earnings are calculated against the outstanding shares. Take a couple of million shares or more off the market and you decrease the number divided into earnings. Using those numbers relative to the outstanding profit margins that ended the year (11.5%) and you will find the actual growth of US companies have been overstated by four basis points.

So which economy is the President referring to as one that is so globally envious. Foreign investors and their zeal to park those hard earned trade dollars somewhere, have skewed the Treasury markets. Without these investors pouring money - and they do so because, for now, there is no better place - the yield on the ten-year Treasury would be as much as three points higher and there would be no talk of inverted yield curves.

(Inverted yield curves are not good. They simply refer to the belief that interest rates paid by short term notes are worth the investment dollar more so than the longer term bonds. When short term rates are higher, the curve is inverted. And yes, it has been a reliable precursor of recessions in all but one of the last eleven times it has happened. Remember those creative mortgages I mentioned earlier?)

2006 does not look all that good. Wishful thinking wishes it were not all so gloomy but wish we will.

Housing will take a few overdue missteps. The Fed will try, under its new leader to fix an economy once propped up by low interest rates, forced to slow down with rate increases even as the acceleration was considered questionable, and do battle with inflationary pressures and the possibility of a recession all at the same time. Businesses will not begin recapitalizing the United States no matter how much money they claim to have. And the deficits, both trade and fiscal will expand even more. Easy enough guesses to make, you might quip and you would be right. 2005 has done a very good job at setting up 2006 for the fall.

Wishful thinking also hopes that voters are observant enough to realize that all branches of government held by one party creates economic detachment. At least when the responsibilities of governing are shared, we have stagnation.

If the first five years of the President's term are any indication of the final three, we are headed for a seriously difficult path to 2008.

Now its resolution time. Avid readers (and critics) of this column will find the new year somewhat different it terms of what this column offers. We will no longer focus on the blunders of the President's economic policies, the missteps of the economy or the fact that the numbers that are reported seem to never add up. Instead, this column will take a more investor friendly approach.

In the coming year, we will be looking for specific opportunities for the average investor, some of the portfolios we track, and how to find successes in the marketplace using common sense. We will not be making specific recommendations however. Instead, we will look at the investor psyche and attempt some sort of crowd control, wonder aloud about stocks and bonds and their place in your portfolio, and otherwise provide you some sort of survival guide to the coming years.

With that thought in mind, we will search for prosperity in a landscape that is both dangerous and decidedly bearish and wish you the very best in 2006.