The U.S. economy has been crippled by the financial crisis. And regardless of what policymakers try to do to spur growth, it will hobble along lamely until two major economic pillars are rectified.
Simply put, there's no chance that stock investors will see a healthy, long-term bull market until credit again begins to flow freely and home prices start rising.
Unfortunately, neither the credit market nor the housing market is yet ready to lead a sustainable economic rebound. But knowing that these are the two legs on which our economy stands, we can effectively gauge their condition, and thus be better able to predict a stock market rally.
Let me explain.
The Credit Crutch
When evaluating the health of the economy, the first place to look is right in the pocket of the American consumer. Consumer spending accounts for between 66%-70% of U.S. gross domestic product (GDP). There simply isn't much hope for the economy if consumers aren't spending. And consumers can't spend freely if they don't have access to credit.
Consumer spending also drives the stock market. At this point, it doesn't matter how productive companies become or how much they cut expenses and overhead; if there's slack demand for their goods and services, they won't meet revenue expectations and stock prices will suffer.
The "Great Recession" has forced many U.S. companies to clean their houses by trimming waste, expenses, and overhead. Also, thanks to low interest rates, businesses can refinance their debts to save on interest expenses. All that is missing is for the demand side of the equation to pick up.
But therein lies the economy's, and by extension, the stock market's problem.
The prospect of a double-dip recession has nothing to do with the health of most of America's companies. What matters is whether or not inexpensive, long-term credit is available to spur demand and consumption.
What's worrisome right now is that big banks aren't anxious to extend credit in the form of direct loans, mortgages, or revolving credit lines. It's a lot safer for them to borrow money from one another and the U.S. Federal Reserve at next to nothing, and then buy risk-free government treasuries and agency paper than it is to extend credit to borrowers in a potentially faltering economy.
The fear that interest rates are close to bottoming out is another impediment to big banks freely extending credit. Because banks borrow on a very short-term basis they have to constantly roll over their short-term borrowings. If short-term rates start rising, banks' funding costs rise, and that erodes margins on the long-term loans they've made. It's even possible for banks to lose money on their loan portfolios if they haven't matched up long loans with short borrowing costs.
While smaller community banks and middle-market regional banks have the same funding issues that big banks have, they don't have the size and clout of the too-big-to-fail banks, so their borrowing costs are actually higher. So is their cost of equity, because investors know they aren't too big to fail. These banks also have smaller commercial loans on their books that they can't offload or refinance as easily as the big banks can. Giant distressed loans are more appealing to institutional and hedge fund investors than the smaller types of loans made more locally by community banks.
Lastly, the Federal Deposit Insurance Corp. (FDIC) and other bank regulators have been playing catch-up in their bank monitoring efforts. Regulators are hitting an increasing number of institutions with enforcement actions, even though it's too little, too late. As regulators look into banks to assess risk management, risk-based capital ratios, credit quality and how losses are accrued, they're finding a lot that they don't like. Enforcement actions are demands to clean up deficiencies, fix accounting issues, shake up management and often require institutions to increase capital.
The net result of these enforcement actions is that management assessment reports create an unwelcome record of problems and deficiencies that scares off equity investors and provides fodder for future lawsuits against bank boards and their officers. In an environment of heightened scrutiny it's unlikely that these banks will be willing to add to their loan books while facing funding, accounting, regulatory and legal headwinds.
Since the extension of credit to consumers by banks is so critical to economic growth, it makes sense for an investor to monitor whether credit to consumers is expanding or contracting,
To follow credit extension trends go to the Federal Reserve's website: www.federalreserve.gov. Click first on the "Economic Research & Data" tab and then the "Data Download Program" link on the left side of the screen. Under the heading "Principal Economic Indicators" click on "Consumer Credit-G.19." From there you can download consumer credit data.
The major leg of the U.S. economy is the residential real estate market.
Simply put, most Americans' largest asset is their home. Homes are a source of pride and stability, and as home prices appreciate, Americans "feel" wealthier and can tap into their home equity when they're in need of a loan.
The National Association of Home Builders estimates that housing contributes between 17%-18% to GDP. It's also a fact that consumer spending related to housing upkeep, appliances, furniture and decoration has a powerful ripple effect throughout the economy.
Putting a floor under sliding housing prices is critical to consumer confidence, consumer health, and the entire economy.
Unfortunately, fixing the residential real estate market may be America's most intractable problem. It's going to require a whole new set of regulatory, lending, and securitization practices.
Smoothing out all of the interconnected pieces of the very complicated residential real estate fabric will be a long, painstaking process. And it's one that investors should carefully monitor. So keep an eye on home price trends and sales numbers.
You can do this by going to www.realtor.org. Click on the "Existing-Home Sales" link under the "Housing Statistics" header. There you'll get the latest housing sales and price data with comparisons to previous months, as well as trend commentary.
Consumer spending and the housing market drive the economy. So knowing if credit extension trends and residential real estate pricing and sales trends are negative or positive will help you navigate the murky depths of this recovery.
More importantly, knowing when those trends have turned positive will give you the strongest signal possible that the direction of the stock market will undoubtedly be up, up and away.
[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.
When that downdraft came, Gilani was ready – and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.
Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.
Take a moment to check out Gilani's capital-wave-investing strategy – and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]
News and Related Story Links:
- Money Morning:
Moribund Housing Market Threatens to Kill Economic Recovery
- Money Morning:
A Helpless Housing Market Keeps Fannie and Freddie in Limbo
- Money Morning:
How to Pick Stocks in the 'New Normal' Economy
- Money Morning:
Flat Consumer Spending and Declining Factory Orders Point to Slower Economic Recovery
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.