David Rosenberg's letter to private clients

The equity market appears to be buying into the consensus view that we will see the last negative real GDP print in the second quarter, and then revert to +1.3% in the third quarter and +1.8% in the fourth. This is like deja vu all over again, as it was this same time last year that the consensus was calling for the fourth quarter of 2008 to be the best quarter of the year because of the lagged effects of Fed easing. The forecast was for +2.6% annualized growth. Not only was the fourth quarter not the best, it was the worst, and actually looks set to come in at nearly a -6% annual rate.

Market not discounting that recovery will take more time. We have enjoyed a big equity market rally in the past six weeks that seems to be discounting a very quick end to the economic contraction with the arrival of the new administration and all of its political capital. However, I'm left wondering what the market reaction will be when it becomes clear that the recovery will require a lot more time, because history shows that it is not at all unusual to see the entire period of extremely weak economic performance last between two and three years in the aftermath of a busted asset and credit bubble of the magnitude we have just seen.

At the same time, what I see is a forecasting community that continues to make predictions based upon linear data that have been completely interrupted by the secular change in the credit cycle. And I think because this is all so far beyond our own collective experience, the tendency has been to underestimate the role that asset deflation and debt repayment plays in the economy.

For example, we estimate that the cumulative loss of household wealth as of the fourth quarter was probably north of $13 trillion, based on what home prices and equity valuation did since the end of September, which would bring the total loss to over 20% from the peak of mid-2007. This is unprecedented in the post-war era.

So far, the impact to the household balance sheet is double what was created by the 2001-02 tech wreck, and half the loss incurred during the Great Depression. By any measure, this hole that has been created in the household balance sheet is huge, and history shows there to be a 90% historical correlation between household wealth and the personal savings rate, which is now on a discernible uptrend. The lagged impact from the unprecedented negative wealth shock on the personal savings rate is likely to be substantial and expectations that the Fed, Treasury or Congress have some magic wand are wholly unrealistic. At best, all the aggressive policy stimulus will do is cushion the blow.

The reality is that the marginal household is going to expend all of its resources to ensure that monthly housing payments are met, there is enough food on the table for the family, the childrens' education needs are looked after and the depleted retirement nest-egg is replenished.

Economics is a behavioral science. It is surprising to me that so many economists lock themselves into a black box and cant see that there is a generational change going on in terms of how households, at the margin, are allocating their budgets toward discretionary spending and how they are approaching the concept of credit. Attitudes toward non-essential spending and debt have changed. This is not just a cyclical development, but a secular shift.

The 2001-07 experience of no-doc loans, 0% financing, option ARMs and subprime credit has proven to be a nightmare for many households. There is more than enough survey evidence from the Fed to show that it is not just the supply of credit that has tightened dramatically. Household demand for personal loans and residential mortgages has scarcely been as weak as they are today, despite the plunge in interest rates and all the Feds efforts to boost liquidity.

The problem is that after seven years of reckless lending and borrowing behavior, households are spending a near-record 14% of their after-tax income on interest and principal to cover the mountain of debt that has been taken on. It has reached a point where the household sector is spending more on interest than it is on food. I'm not sure that is sustainable. While some households are walking away from their debt (i.e., jingle mail) or are becoming delinquent, the majority are doing their best to stay current because missing credit payments with regularity can reduce ones FICO score by between 70 and 130 points.

Fully 35% of a persons FICO score boils down to ones history of making payments on time. The average FICO score today now is down to 690 after the borrowing spree of the past seven years. Yet to obtain a plain-vanilla 30-year fixed rate mortgage, the minimum score is 760. For a 15-year HELOC, it is 740. And, for a three-year auto loan, the minimum FICO is 720. This is a primary reason why the credit cycle is not about to be revived. It is not that standards are too tough as much as the unprecedented borrowing binge over the past seven years has left the household sector, at the margin, with a credit profile that is too risky for the banking community to justify to their shareholders.

Meanwhile, the government thinks that we have a supply problem when it comes to credit. The government is doing everything in its power to re-start the credit cycle, but here's the problem: we have so much debt outstanding that were all choking on it. The aggregate level of private sector debt relative to GDP is still near a historic peak of 172%, and it only began to correct in the first quarter of 2008. Even with all the modifications and write-downs, the household and business debt-to-income ratio is still 50 percentage points above the long-run pre-bubble norm. So, it is difficult to believe that we can actually embark on a new credit cycle when the level of outstanding private sector debt remains $6 trillion beyond the bounds of what the economy has traditionally been capable of handling. As evidenced in the past year, the process of unwinding this excess credit is enormously deflationary. The Fed, Treasury, Congress and the incoming Obama administration have the daunting task of ensuring that this transition phase toward debt elimination is as orderly as possible, basically to promote social stability.

In the meantime, its doubtful that anything is going to bottom in advance of the housing sector, which led the contraction in credit, the bear market in equities and the recession. Since housing led us in, I think its going to have to be the area of the economy and the markets that leads us out, and Im talking specifically about home prices, which peaked in the summer of 2006. I remain convinced that there is at least another 15% downside to nationwide home prices as the problems on the coasts migrate to the financial centers in the Northeast.

Despite the fact that the builders have taken starts down to all-time lows, the problem is that completions of single-family homes of 760,000 units at an annual rate in November were running nearly 90% above the level of new home sales, which have plunged to 407,000. Thats a gap we havent seen in 14 years, which is why it is laughable to suggest that the builders have made great inroads in redressing their inventory overhang. We think nothing could be further from the truth.

Now, when I say another 15% downside to home prices, it is strictly about looking at the supply and demand curves. The reality is that when you have 10.6 months supply of unsold single-family homes in the resale market, an unbelievable 16.7 months supply of unsold condos and on top of that, an 11.5 months supply of new unsold housing inventory, the data are telling you that there are still more sellers than there are buyers, even at the latest depressed price point. It's not that people don't want a house at all; they just don't want the debt obligation that goes along with it. That is what the Fed surveys show unequivocally - household demand for mortgages and consumer credit has never been as low as it is today. This is a major theme for 2009, and a deeply deflationary theme at that.

As a sign of how weak the demand for housing remains, more than three years after he peak was turned in, existing home sales plunged 8.6% in November to 4.49 million units (annual rate) and the level of single-family sales is now down to 11-year lows. That is flattering because 45% of Novembers sales had to do with distressed foreclosure activity. The problem is that while re-sales are down more than 10% in the past year, there has been no decline in the number of homes and condos that are listed for sale. At 4.2 million units, this inventory is the same today as it was a year ago, not to mention double what it was during the boom years.


The excess supply is acting as a dead weight drag on prices. Basically, at just over $180,000 the median value of an existing home is back to where it was when we published our inaugural bubble report back in 2004. To actually go back to the home price levels that prevailed when real estate was in the mania stage in 2001 would mean a retreat toward $150,000 or another 15-20% downside from here. The move all the way down to $180,000 today from the bubble peak of over $230,000 in the summer of 2006 sounds big at -22% and it is for anyone who was buying at that time but keep in mind that median prices are still 40% higher now than they were a decade ago. In other words, there's still plenty of helium to take out of this balloon.

This huge inventory for existing homes is competing head-on with the market for new homes, where sales are now at their lowest level since January 1991. But back then, there were 315,000 new homes for sale that had yet to sell, compared with 374,000 currently. It is 100% true that the level of unsold new inventories is coming down, but not as fast as sales are. The builders have worked down their unsold inventory by 25% in the past year, but the problem is that sales are down 35%. The net result is that the unsold inventory remains intractable at 11.5 months supply. It has been north of 11 months supply for four months in a row,which is unprecedented in the 50-year history of the series. We have a very limited sample size of other periods when the unsold inventory proved to be so intractable; only three other occasions in the past four decades. We found that it took a year to get the inventory ratio below 8 months on a consistent basis, and not until that happens can we expect to see a decisive floor established under
residential real estate prices.

As a sign of how difficult it remains for builders to find buyers, the median length of time it took to sell a completed new home was a record 9.3 months in November. That compares to six months a year ago and four months two years ago. In a sign that the decline in demand for housing may be more of a secular story, we also have to consider that in December, following the plunge in mortgage rates to 30-year lows of just over 5%, the customer traffic component of the NAHB index fell to a record low of 7. We also saw the U of M homebuying conditions index fall to 65 from 72 in November.

What has caught my eye is that a huge chunk of demand has been lost because housing is no longer viewed as an appropriate asset class. The U of M survey for December showed that a record-low 3% of the public see residential real estate as either a good investment or an asset with price appreciation prospects. At the peak of the housing boom three years ago, almost 25% of the homes being sold were being sold for investment purposes.

Its worth mentioning that housing demand has continued to collapse even though homeowner affordability ratios are at their best levels in four decades. So it seems to me that we are not going to be able to grow our way out of the inventory mess. Instead, the builders are going to have to become even more aggressive in cutting production. Until we get to some equilibrium between supply and demand,house prices will continue to deflate, and the ability on the part of private lenders to extend credit will remain impaired as more losses become exposed and writedowns taken, and few households are going to be willing to borrow in order to finance an asset that is in a secular deflation. Based on our macro forecast, total credit losses will come to $2 trillion this cycle. As a result, we believe it is tough to make the assertion that we are even past the half-way mark on the write-down phase.

While the Fed will continue to boost the supply of money, we're not convinced that velocity or turnover will reaccelerate in time to generate a return to inflation in 2009 or 2010. All the Fed is doing is ensuring that the burgeoning demand for cash is being met because if the central bank did not move to ensure the liquidity needs were met, the asset liquidation would be far more acute.

Deflation will be a more enduring theme than most realize. It is perfectly understandable, but still dangerous, to be clueless about the mechanism that determines whether we experience inflation or deflation. Even with the upcoming stimulus, this economy, which has been growing below potential since June 2006, will very likely continue to do so this year and into next year as well. This means a sustained widening in the output gap; in other words, growth in aggregate demand exceeding available supply, higher unemployment rates and lower capacity utilization rates will be a reality as far as the eye can see.
The deflation story is going to prove to be a much more enduring theme than many realize, in our view, and investors will want to ensure the portfolio is positioned for it, which comes down to five characteristics:

A focus on safe yield, wherever you can get it: long-term non-callable government bonds, closed-end muni funds and high-quality corporates.

Screen for dividend yield and consistent dividend growth in the equity market.

Whether it be credit or equities, a focus on companies with low debt/equity ratios and high liquid asset ratios; balance sheet quality is even more important than usual. Avoid highly leveraged companies at all costs. The same methodology should be applied to municipal bonds, and differentiate between those with and without high cash reserves and high debt rollover calendars.

Ultra-selectivity regarding financials since the real cost of debt and debt service rise in a deflationary period, as do default, delinquency and charge-off rates. The same can be said for retailing, where margins become crimped. Screening for inventory turns is very important because cost containment is imperative as top lines are suppressed by declining final sales prices.

Focus attention on sectors or companies with these micro characteristics:
low fixed costs, high variable cost, no unionization, high barriers to entry/some sort of oligopolistic features and a relatively high level of demand inelasticity (utilities, staples, health care). Also focus on companies with high inventory turnover ratios in a deflationary backdrop.

To get the inflation that many are worried about, the policy stimulus is going to have to go beyond just plugging holes in a leaky boat to reviving growth in domestic demand to a rate that exceeds the growth rate of aggregate supply(labor force + productivity growth). The problem is not one of supply, it is about insufficient demand. And that is why it is far too early to be talking about the next inflation cycle. The consumer represents 70% of that demand, and were learning a lot about the consumer with each and every passing data point; to say that frugality has replaced frivolity has become an understatement.

For the here and now, the triple combination of declining employment, eroding wages and the conscious effort to raise the savings rate is triggering a near collapse in consumer spending, which peaked in nominal terms in June, has declined every month since and is down at a 5.2% annual rate. This goes down as the sharpest retrenchment in consumption on record. During that time, discretionary spending has collapsed at nearly a 15% average annual rate: motor vehicles (-38.7%), movies (-36.6%), air travel (-32.7%),sporting goods (-12.7%), hotels (-12.5%), casinos (-11.7%), jewelry (-10.3%),furniture (-9.8%), home improvement (-8.2%), appliances (-7.3%), clothing (-6.6%), computers (-6.5%), electronics (-6.5%), toys (-3.3%) and books (-2.3%).

Even so-called recession-proof items like food (-3.6% SAAR) are being cut back on as households shift from veal marsala to pot roast, and from brand name to private label (in real or unit terms, food consumption has declined for six months in a row, so this is not just about lower prices, but also about shifting spending patterns even when it comes to grocery shopping). Utilities have also declined at a 4.9% annual rate, though some of this is clearly price related. There are also widespread anecdotal reports of households falling behind on the monthly gas and electricity bills.

The only areas where consumers have allocated more of their budget toward since the spending peak in June are sundries/drugs (+6.3% SAAR), medical services (+4.4%), telecom services (+4.8%; the cell phone, we are finding out, is a staple in this cycle), cable (+7.3%; clearly a substitute for movies, as movie attendance during the holiday season was off 5% YoY) and education services (+4.7%).

The American consumer isn't just 70% of US GDP, but also close to 20% of global GDP. Its still the largest entity in the world, and were starting to see vivid signs that the spillover on global trade flows has triggered one of the worst global recessions in the past century. What really caught my eye last week in the ISM index was the export component,which sagged to an all-time low of 35.5 in December from 41.0 in each of the past two months. This is critical because whatever anemic growth in GDP we saw last year, it was all accounted for by rising export volumes. That story is over, but there's even more to it than what it means for large-cap industrials. Korean exports are down 17% year on year. Taiwan exports are down 38%. Japan just posted its first back-to-back trade deficits in 28 years. Hong Kong exports are down 5%. China's manufacturing sector has been in a recession for five straight months and we have reason to believe that real GDP growth there went negative sequentially in the fourth quarter. India just posted its first decline in industrial production in 14 years and Russi's economy is deep in recession right now.

History teaches us that global downturns often lead to global conflicts and beggar thy neighbor economic policies, including currency devaluations, debt defaults,trade barriers, government procurement policies and heightened geopolitical tensions. We are already seeing very early examples of this. Ecuador just defaulted on its foreign debt. Venezuela is considering currency devaluation and Russia has already embarked on this course, as did Vietnam. The UK has allowed Sterling to drop to parity against the euro for the first time. There is also some talk that Japan may intervene in the FX market to prevent the yen from firming any more than it already has. Brazil's trade surplus narrowed to a six-year low of $24.7 billion in 2008, almost half of the $40 billion surplus posted in 2007 when the BRICs were the darlings of the world's investor class. The response? Sanction a 23% depreciation of your currency. If you read the papers over the holiday period, rampant fiscal stimulus, auto bailouts and other rescue packages are occurring all over the world. There is a growing risk of protectionism, which has a historical pattern of following periods of deep global recessions (i.e., this is all about self-preservation). For example, since that ballyhooed G-20 meeting in Washington in November, five of those countries Russia, India, Indonesia, Brazil and Argentina have announced their intentions to raise import tariffs or otherwise restrict trade. Russia has announced plans to raise tariffs on autos. India has already lifted duties on iron, steel and soy. Brazil and Argentina are putting together a case within Mercosur for boosting external tariffs.

The risks of growing protectionism are also rising substantially. The failure of Doha round of trade talks alone could shrink global trade volumes by between $728 billion and $1.7 trillion. Gold is going to be an important hedge. Security of supply and government procurement policies may also end up putting a floor under the beleaguered commodity complex earlier than a lot of people think. When we see rival banks calling for $30/barrel oil at a time when Market Vane sentiment on crude and base metals is at just 20% bullish, it sure would look to us as if the sector is washed out following a record 60% peak-to-trough slide. Our contrarian instincts are piqued. And, global defense stocks in 2009 should be a solid investment, in our opinion.