economic woe

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I have recently decided to become an investor! Very exciting stuff.

I have begun to learn the mechanisms of the free market and I have noticed something that is making me nervous (courtesy of Barron's).

It appears that the CPI is increasing at a quick clip due to the increase in the cost of light-sweet crude. Coupled with that the Fed is increasing interest rates.

In effect, everything is going to cost more while everyone will be less able to take out loans.

This sounds like looming economic pain.

Anyone else nervous?

 

We should all be very nervous. And not just about the stuff you've talked about.

The fundamentals of the US economy are all up the tree at the moment. How can the USA continue to pile on foreign debt at record levels without there being consequences? How can the people continue to spend more than they earn without there being consequences? How can house prices continue to rise at such ridiculous rates?

Some economic pain is definitely looming.

 

We have all been through this in various other threads, but lets to it again anyway.

Yes, the CPI is rising rather quickly, and yes when you remove the effects of the price of petrol it does bring the numbers back to a reasonable level. This is not just a factor to damage the US economy, but one that will impact world economies, including Europe and China. As these economies cool, the demand for oil will diminish, and some balance will return to the marketplace. There are other long term factors that have to be addressed, but they are out of the scope of this discussion, so I will only name them; lack of refinery capacity, lack of domestic production of oil, and lack of research into near term viable alternative fuel sources.

As far as interest rates going up, this is primarily necessary to prevent the US economy from overheating and turning inflationary. This really is more of a protection to the international community than it is to the US, though that is not the motivation that drives Greenspan and the politicians in DC. We could allow interest rates to remain low long enough to fire up the inflation rate and use that to devalue our debt, but this is a predatory practice, and would in the short run be detrimental to our citizens.

Finally, there does not have to be a housing bust. Yes, to a certain extent the housing market has climbed too far to fast, but the rising prices of steel, lumber and concrete are partially responsible for this. In fact, cheap labor in the form of illegal foreign workers has been one of the tempering factors in the price of houses. Unless there is a dramatic decrease in the price of these basic resources necessary for building houses, the prices will continue to be supported. I foresee a period of diminished growth in the price of houses to be far more likely than any major market correction for the given market conditions. Now, if something were to happen that radically changed the US economy, then we could see a collapse become more likely, but at this point I would say that over the next 5 years there is a 30% chance we will see housing prices continue to soar, a 60% chance that we see this curve level off, with some minor regional corrections in those areas that have experienced the wildest growth, and a 10% chance of a major nationwide correction.

Doom and gloom always piques people attention, but reality usually falls well short.

 

Come on! The biggest factor sustaining house prices has been the ridiculous credit policies of the last 5 years or so. Greenspan has been creating money hand over fist by keeping interest rates so low and the banks have been lending it to anyone who asks. The levels of household debt are currently at radioactively high levels and everyone is counting on the increase in the 'value' of their houses to keep them afloat. The nation as a whole and all the individuals within it have became borrowers on an unprecented scale. A country has to save and invest in order to grow. You can't have sustainable long term growth by spending other people's money. Anyone who is not concerned by this does not really understand what the whole picture.

Or more likely, I have no idea what I am talking about.

 

No Harbor, you do know somewhat what you are talking about (and a lot more than most on this subject ), but your are also looking at one piece of the whole picture.

You are correct in your belief that easy credit has certainly enabled the housing market to skyrocket to its current levels, but that in and of itself cannot counterbalance the market forces of competition. As long as there are competitive builders and competitive buyers and sellers, it doesn't matter how easy credit is to obtain. The fact of the matter is that it is very expensive to build a house, prime property in cities is a scarce resource, and so the price of houses goes up. If there was no credit available, there probably would be thinner margins on housing, but there would be fewer new homes being built, which would drive the price of new homes up. As you can see, it is a catch-22.

It is a factor of supply and demand, and if the supply doesn't increase, or the demand decrease, the price will not drop, and even if the demand drops, the prices are not likely to fall for some time as people will not be able to afford to sell their home as they would have to pay someone to take it, and many can't afford this. In the 80s there was a major bubble in the town of Incline Village, on the north shore of Lake Tahoe, Nevada. The realty market collapsed, but the price of houses did not drop, the only symptom of the collapse of the bubble was the average time on the market went from 6 months to over 2 years.

I agree with you that the abuse of credit is a major issue in the US, though I do not blame lenders or the government (except for the fact that government schools do little to prepare the youth for the responsibilities of borrowing, but instead lay the blame on the consumer. I will admit that the government, in its desire to encourage home ownership, has added a small amount of fuel to the fire by taxing the earnings on savings, but allowing the interest on mortgages to be written of, hence telling citizens that it is better to borrow to buy a home than to save, but I do not think that you will find many who are willing to trade tax free savings interest for their write-off on their mortgage.

This is an extremely complex issue, and there are literally university classes that solely study these market forces, so I don't think that anyone is going to be able to give an explanation that will completely explain the model on a forum page. We can certainly discuss the major forces and the effects of them, and you have definitely touched on one if them that I chose not to address in my previous post, but please understand that I was not attempting to cover something up, or to create a false impression, I was simply addressing the predominant forces that are driving the price of housing up. In fact from another perspective you have touched on an issue that could be a lead weight around the necks of American homeowners for decades should the availability to easy borrowing dissipate. If this were to happen, a larger scale event such as happened in Incline (and I am sure has happened in greater and lesser or degrees in many places) could sweep the entire country, in which case I still do not see the prices of houses rapidly dwindling, but rather the difficulty of finding a qualified buyer greatly extending the time homes are on the market.

However there are those who would totally disagree with me, and would fully place the blame on the loose credit market, I just believe that it is a little naïve to blame the price of anything on one factor.

 

OK, house prices aside,what is going to happen to all of this debt? How is it ever going to be repaid?

 

Painfully. But I am not sure if you are speaking of personal debt, corporate debt, or government debt.

In all three of these I must be honest and state that I cannot foresee the future in this regard. I am hopeful that the FairTax act will pass, as I see it as a first step in the elimination of many of the ecomoronic (yeah I made that one up) situation we are currently in. This tax plan would definitely go a long way to encouraging people to save, and would discourage borrowing.

As far as corporate debt goes, I believe that we have seen the peak of corporate greed (which I reality is investor greed), and that investors have begun to learn the lessons offered by the WorldCom's of the world, and will be more adverse to investing in companies employing such leverage, refusing to place bets on such heavily encumbered companies.
For government debt, I hope for the demise of one of the major parties (or at least its banishment to obscurity) and for the rise of a party of responsibility, but individual, corporate, and governmental. I do believe that it is possible that the US government is going to be forced to curtail spending, or spike the economy to create large inflation to alleviate the debt. I believe however that while some spending restraint must be shown, as has been demonstrated by the increases in tax revenues under the President's tax plan, the best way to relieve the debt is though a strong economy, and through meaningful tax policy overhauls (again, read FairTax), the flow of jobs and dollars out of the US can be reversed, leading to economic windfalls that will be able to retire the US debt over the next 2 or 3 decades, though it will not be easy as people will want to divert any surpluses to pork (con) or social (lib) spending.

I know I haven't truly answered your question, but have instead provided ways in which this debt can be paid. If these things do not happen (or something else as monumental happen) and you want a worst-case scenario, I think that America could head into another depression, and that it will take the world along for the ride. This would be a painful period for all of us, and there could be horrifying consequences in many parts of the world as a result (famine, plague, war, and the rest of the 78 horsemen). I believe that the gold standard, as well as the biggest gun standard (whoever has the most strength gets what they demand) could be seen again, and that we could see conflicts that make WWII look like a mild disagreement.

The people of the US created this monster, and I only hope that we are responsible enough to slay it before it is unleashed on the world.

 

Would that be the fraction which voted the current administration into power ? Because I think that the Bush administration bears great responsability for the current situaton, and the faster this is realized, the faster one can go back to some sane policies.

I would be plenty nervous if I'd actually had stuff to lose (like investments in the stock market, or some such) So far, I don't, so I am not But I think there are some rough times ahead. And I cannot claim knowledge of intricate economic details/theories, but it just seems to me that such huge imbalances as have been created in the US economy cannot simply go away. Just consider how much the top earners make compared with the average worker (and I think is something ridiculous, like 400 times, or so) and how much this ratio has increased in the past 5-10 years...

 

Well summarised, Darkwolf. You've managed to cover the range of possible outcomes, given the amazing uncertainty that surround economic events like this. It is hard to where things will go from here but it does look like things will have to get a bit tougher before we can see any real improvements.

You definitely need to find a way to reverse the flow of jobs to Asia but the only sustainable way to do that is to find a way to export more than you import. All the while you continue to purchase manufactured trinkets from Asia and sell them very little in return, nothing will change.

 

Is Beijing increasing interest rates? Does the market in China even operate in that fashion?

I have one point to nitpick with your supply-side argument regarding the increasing value of homes. The value of homes previously built has increased as well! Clearly this implies demand is driving the increase, rather than just inflationary commodities. Perhaps there is a bit of a perfect storm occurring with both forces driving prices higher.

I also have another question if you have the time DW. Given that interest rates are going to keep increasing for the foreseeable future, would it be wise for a small time (exceptionally small time) investor to perhaps think about value stocks rather than growth stocks? I just can't imagine these companies being able to grow significantly given a slowdown in their ability to gain growth-fueling loans (other than through diluting their stock), coupled with a slowdown in their customers ability to take out loans.

To me it seems like time to stick to old faithfuls such as Microsoft and Altria.

Is my logic sound? Should I just keep my money in my checking account before I accidently hurt myself?

The stock market just sounds like so much fun...

 

Well Asia have suffered from years, by western countries exploiting cheap labour, and not caring about harsh working conditions, so Asias (and particularly China) deserve their good fortune.

 

Late Night Thinker - it's always a dodgy business trying to 'time' the stockmarket. Far better to look at the fundamentals of the particular company you want to buy. Unless you would buy the WHOLE company at it's current share price then you shouldn't buy a PART of it at that price either. Many public companies are still shockingly overvalued at the moment that finding a good buy might be tricky.

If you reallly think there are going to be tough times ahead, you might want to consider investing in some gold. That's always a great store of value.

Anyway, your cheque account is a pretty poor place to leave your money. Surely you could get more interest from a savings account?

 

Well...I look at it this way...

I am going to re-use an analogy I used in a PM. I am young and in college; realistically the money I am not willing to invest is instead ingested as beer and pizza. I have very few financial responsibilities. I look at this as my time riding a financial tricycle; while I can skin my knees now with little repercussion, the Winabego with family riding en tow can not be allowed to crash.

So actually I am willing to take some risks.

I am leading toward investing in biotechnology. Not only do I see this sector as my future place of employment, I honestly believe it is going to change the way we live our lives.

So I have been looking around...

I was thinking of investing in a biotech ETF, but they seem to be heavily indexed to a small number of companies: namely Genentech and Amgen.

But according to Jim Cramer of Mad Money fame, it is better to invest in best of breed. So I have to learn how to do research.

I am of the personal opinion that Genentech, while considered best of breed according to the above mentioned Jim Cramer, is highly overvalued with a P/E ratio of 95. 95 is a whoppingly large P/E ratio. I just cannot imagine them being able to deliver earnings enough to support such a high stock price, at least in terms of the timeframe with which I will stay interested.

So I am looking for suggestions on how to do research.

Any other investors frequent this board? How do you conduct your investments? What research resources do you find useful?

 

I would agree with your comments re Genentech. I once met the venture capitalist who provided the initial funding for Genentech when it first started out. He's now worth half a billion dollars. Now HE bought into Genentech at the right time. If you bought it now you'd just be making him richer.

I personally would not invest in biotech because I don't understand it enough and would have no way of analysing a good company from a rubbish one.

When I invest I look at free cash flow first, followed by levels of gearing, followed by growth prospects. Because I can't analyse the free cash flow of a biotech company that may not make any money for 10 years I would find that to be too big a gamble for me, at any age.

 

OK...if you would indulge me HB, could you please expound upon that statement? Gearing? That term is new to me. By free cash flow, do you mean the difference between earnings and then profit after R&D and other activities?

Edit...

OK...i checked out FCF on Investopedia and I think I summarized it correctly. Hey HB, if you have the time, check out www.investopedia.com and let me know if it is as great a resource as I think it is. I am basically an autodidact at heart and sites like that just wet my whistle.

I am going to go check out some SEC filings and see how I can figure out FCF from those statements. I'll let you know if I figure it out. Actually, I'm heading to a friends place for beer and baseball, so this might not happen till tomorrow. Either way...I'll be posting.

[ August 23, 2005, 01:50: Message edited by: Late-Night Thinker ]

 

Free cash flow is the actual cash that a company generates each period. It can be very different to a company's PROFIT which is subject to the often confusing vagaries of accounting regulations. Meanwhile cash is cash. You can see cash flow by looking at a company's statement of cash flows. Some companies are better at making cash than others. For example, a retailer like Wal-Mart receives cash from its customers (and doesn't have to wait a month to get the cash) but it buys its stock on credit (so doesn't pay its suppliers straightaway). Wal-Mart probably has great cash flow. Cash is easy to understand, which is why it is one of the first things I look at.

"Gearing" is another way of saying "leverage". It shows how much a company is propped by debt. Debt can be good, if a company makes more money than it has to pay in interest. But some companies have so much debt that it restricts their growth possibilities. A company with no debt can borrow to invest and grow whereas a highly geared company cannot.

Ultimately, it comes down to really understanding what a company is about. I steer clear of anything I don't understand, hence I have only ever invested seriously into two companies: a fast food and cafe operator and a children's clothing shop. Both of these companies are familiar to me because I spend so much money at them and their operations are fairly straightforward. Every parent I know buys their kids clothes at this shop so I know first hand that its prospects are healthy.

Compare that to anything with the word 'tech' in it, which would be a complete foreign language to me and you'll understand what I'm getting at.