Jim Welsh on Stocks, Gold, Dollar, Bonds, ETFs

Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, “The Financial Commentator”, since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.

In his March 2007 letter, he warned that a tightening of lending standards by banks represented a sea change that would lead to a slowdown in the economy before the end of 2007, and more credit losses for banks. In October, he noted that technical weakness in the U.S stock market, combined with an economic slowdown would be bearish for stocks. In December 2007, he warned, “Most investors really don’t understand the credit creation process, and as a result, don’t comprehend the scope of this crisis, or the Fed’s limited ability to deal with it. It really is different this time.” In his March 2008 letter, he forecast a rally in the S&P to 1420-1440, before the bear market in stocks would resume. His analysis provides a unique blend of fundamental and technical analysis

This is his October 21, 2008 writing:


In the July letter I wrote, “Bank balance sheets are not only burdened by loans they are unable to
securitize, since global securitization is down 84%, but their capital base is being squeezed
unmercifully, as they write off bad loans and increase loan loss reserves. Unfortunately, large banks,
regional banks, and community banks will be forced to recognize more losses as home prices fall
further, and default rates climb on home equity and auto loans, credit cards and corporate debt, due
to weak economic growth. Oh, and commercial real estate prices have just started falling. It’s bad,
and it’s going to get worse.” Six months ago, the International Monetary Fund estimated global
losses would total $950 billion. Two weeks ago the IMF increased their estimate to $1.4 trillion. I
had noted in the July letter that Bridgewater Associates, a respected research firm, had estimated that
losses from the credit crisis could total $1.6 trillion. As estimates converge, confidence builds that
these estimates are at least in the ballpark. It is noteworthy that only $600 billion in losses have so far
been recognized. Despite all the turmoil and almost frantic efforts by global central banks and the
U.S. Treasury to address the credit crisis, the reality may be that we aren’t even half way through this

This perspective certainly is contrary to what one hears on CNBC, Bloomberg, and read in the
financial press. Within days of the stock markets reversal on October 10, a consensus has developed
that by mid 2009, the economy will have weathered the worst and begun to improve. And since the
market is a discounting mechanism, it will bottom soon (if it hasn’t already), and begin to advance in
anticipation of the better times ahead. If this story line sounds familiar, it should. After the market
reversed higher in mid-March, a cavalcade of analysts forecast a second half rebound in 2008, based
on Fed rate cuts and a $160 billion stimulus plan. In my February letter I offered this assessment of
their forecast. “I think the experts on Wall Street are asking the wrong question. The question is not
whether the economy will get a lift from the rate cuts and fiscal stimulus. It will. The more important
question is whether the boost will be enough to ignite a self sustaining economic expansion. This is
going to be made more difficult in coming quarters, since the availability of credit from banks and
the corporate credit market will not be supportive of consumer spending and corporate investment. If
the one-time lift from fiscal stimulus fails to launch a self sustaining economic expansion, the
economy will sink again, after the temporary effects of the tax rebate have been spent. Will the $160
billion in stimulus be enough to ignite a self sustaining economic recovery in the face of significant
headwinds? I don’t think so, which will give Wall Street experts forecasting a snappy recovery later
this year another unpleasant surprise.”

In coming weeks, Congress will debate the merits and composition of a second stimulus package,
that will likely total between $200-$300 billion. Hopefully, it will be better crafted than the first stimulus program. It is estimated that consumers spent less than 20% of the $100 billion they
received in rebate checks. In other words, Congress spent $5 for each $1 added to the economy. As I
recall, the 2001 tax rebate had a similar economic impact. However, the 2003 tax cut gave the
economy the charge it needed to launch a self sustaining economic recovery. For the record, in 2003,
I supported the tax cut, but thought it was weighted too much toward the top tax brackets. Even if
one doesn’t like the idea of tax cuts, a quick perusal of how the economy responded in 2003 might
counter the ideological objections. Job growth, state tax collections, and GDP all improved smartly,
starting in the spring of 2003. Interestingly, the National Association of Business Economics said the
recession that started in March 2001, ended in November 2001. (The NABE is the official recession
arbiter.) But job growth, state tax collections, and GDP all remained weak, until after the 2003 tax
cut went into effect. Coincidence? I don’t think so.
A one-time tax rebate can only give the economy a short-term lift. Whereas a tax cut continues to
provide the economy an ongoing lift, which over time generates more tax revenue. In other words,
the tax rebate cost taxpayers $100 billion and only goosed the economy by $20 billion. A $100
billion tax cut would, over time, give the economy more than a $20 billion lift, and generate future
taxes to offset the cost of the tax cut. But let’s be realistic. Given the deficits Congress will be
creating in the next two years, the tax cuts 95% of taxpayers will supposedly get, will be either short-
lived, or an illusion. In 2017, Medicare will be in trouble, and Congress will be forced to find new
sources of revenue, and the middle class is the biggest potential source.

The good news is the composition of the second stimulus package will not be the make or break
factor in whether a self sustaining economic expansion will be lifting off by mid 2009. The more
important factors are the functionality of the credit creation process, and the degree of economic
weakness caused by the credit crisis.

Since January 2007, banks have progressively increased their lending standards. They are now at
their highest level ever, for most type of consumer loans, and large and small business borrowers. As
I have noted on numerous occasions since March 2007, the availability of credit is far more
important than the price. Although the Federal Reserve has lowered short term rates from 5.25% to
1.5%, many consumers and companies have not only seen their cost of credit not go down, they have
seen their access to credit reduced or denied. The Federal Reserve can push money into the banking
system, and the Treasury can force feed $250 billion into banks, but they can’t make banks lend into
a weak economy. In the current environment, the only borrowers banks are interested in lending to
are those who don’t need the money. Lending to those who really need money is just a prescription
for more loan losses. The stark reality is that the capital base of banks in the G7 nations is too small
to support the current level of lending. In the short run, the capital base of international banks is
going to shrink further, as banks absorb the next $600 to $800 billion in losses from all forms of
credit. The U.S. and other governments can inject capital to bolster banks’ capital base, but that’s not
going to stem the tide of coming losses. Until real estate values, both residential and commercial,
find a floor, no one knows with any certainty how big the total losses will be. All we know right now
is that real estate prices are falling, and are expected to fall further in 2009.

In recent years, international banks leveraged their capital base, using ratios of 30 to 40 to 1. As they
lower their leverage to 15 to 20 to 1 over the next year, banks are being forced to sell assets at a time
when there aren’t many buyers. And those buyers who are interested are having a difficult time
borrowing money to finance the transaction. After international banks lower their leverage ratios, it is
important to remember they will not be increasing their leverage for a long time, as governments are
likely to pass legislation that limits bank leverage in the future. The combination of a smaller
capital base and less leverage will mean less credit creation in coming years. As I have noted many
times over the last year, between 1975 and 2000 credit grew 2.4% faster than GDP growth in the
U.S., and 3.7% faster from 2000 to 2007. Less credit growth in coming years means less economic
growth. With interest rates already at generational lows, and consumer debt as a percent of GDP up
from 44% in 1982 to 100% of GDP now, consumers will have to rely on income growth, rather than
borrowing to fund their spending. As discussed later, the outlook for income growth during a
recession is not good. After seeing their home values decline and their 401K become a 2.5K,
consumers who can, will choose to increase their savings. In other words, consumer spending is
likely to suppress growth in coming years, rather than riding to its rescue.

Few financial analysts have realized how weaker credit growth and consumer spending will translate
into an extended period of sub-par economic growth. It would appear that many analysts are equating
a narrowing of credit spreads, as a sign an economic recovery will automatically follow in about six
to nine months. A narrowing of credit spreads is a sign that the most intense phase of the credit
crisis is passing, but tells us nothing about how soon credit creation will revive sufficiently to
support a lasting recovery. The valley between the end of the crisis phase and actual recovery is
likely to take longer than those who have misread this entire crisis expect. This will likely lead to at
least one false start. As I wrote in the April letter, “I believe the dramatic slowdown in credit creation
we’ve just experienced will have a lasting effect on the availability and cost of credit and on
economic growth. Since consumers represent 70% of GDP, just a 1% increase in savings will shave
.7% off of annual GDP growth. A tidal wave of baby boomers will begin retiring in coming years,
and many will need to sell their home and stocks to fund their retirement. Are these the agents of a
secular change that we will look back on in a few years, and, with the benefit of hindsight, recognize
just how important they were?”

In September, 168,000 jobs were lost, even though the Unemployment Rate held steady at 6.1%.
Since January, 900,000 jobs have been eliminated. Total aggregate hours worked declined at a 2.0%
annualized rate in the third quarter, which is equivalent to a monthly decline of 300,000-400,000
jobs. As the labor market weakens further in coming months, the Unemployment Rate will climb to
at least 7.0% in 2009.

The increase in the Unemployment Rate, however, will not tell the whole story. In the fall of 2007, I
noted that employers had been reducing temporary workers and the hours worked by regular workers
for months. I thought these steps were a precursor to actual job losses, if the economy weakened as I
expected. When the December employment figures were announced on January 3, most analysts
were surprised by the job losses, and the stock market swooned. In recessions, the squeeze on 4
worker’s income intensifies, as businesses cut back on hours, skip paying bonuses, and provide raises
that don’t keep pace with inflation.

In the five recessions since 1969, the median household family experiences a pay cut of 3% to 7%
over a period of three years. Given the contraction in credit creation, high lending standards, declines
in home prices, and 30%+ plunge in the stock market, the current recession will not be mild. This
increases the odds income declines will be closer to 7% than 3% in this recession, and stretch well
into 2010. According to the Census Bureau, median household income was $50,200 in 2007. If
median income falls as it has in the last five recessions, median income will be less than the $50,600
that the equivalent household earned in 2000. This would be significant, since the only time median
income has declined over a 10 year period was in the 1930’s.

The coming squeeze on consumer income in 2009, and probably 2010, will cause consumers to cut
back even more than they already have on spending. Since consumer spending represents 70% of
GDP, any cut back in spending will make the recession deeper and prolonged. When one consumer
decides it is prudent to reduce their spending in a recession, most advisors would laud their decision.
When millions of consumers make the same prudent choice, they collectively make the economic
environment weaker for everyone.

The combination of higher unemployment and falling income is going to cause default rates on every
type of consumer debt to rise. Last week, Bank of America and American Express both reported that
losses on their consumer credit have risen sharply, and these losses were before the credit crisis

As I have noted since early this year, one of the consequences of a consumer led recession is a rise in
retail store closings, which brings the value of commercial real estate down. According to real-estate
research firm Reis, Inc., the vacancy rate at shopping malls in the top 76 U.S. markets rose to 6.6% in
the third quarter, the highest since 2002. For open-air shopping centers, the vacancy rate climbed to
8.4%, the highest since 1994. According to Property and Portfolio Research, developers have built 1
billion square feet of retail space in the 54 largest U.S. markets since 2000, 25% more than they built
in the same period in the 1990’s. In the 54 largest markets, retail space now amounts to 38 square
feet per person, up from 29 square feet in 1983. This suggests that the shakeout in retail commercial
real estate will last a long time.

According to Reis, Inc., the nation’s office vacancy rate jumped .5% to 13.6% in the third quarter,
the biggest increase since just after 9/11. Of the 79 office markets Reis tracks, vacancy rates
increased in 66, while rents were flat or declined in 40 markets. According to Real Capital Analytics,
about 17% of recent office market sales involved sellers in financial distress. According to some
estimates, commercial real estate prices are off 12% from their peak. As I noted in February’s letter,
Goldman Sachs estimated commercial real estate was likely to decline 26% in this cycle. This means
more losses are coming for large banks, community banks, and Wall Street investment banks.

Municipal spending by cities and local governments accounts for 12% of GDP. In the last six years,
states increased their spending an average of 6% per year. This added more than .5% to domestic
GDP each year. According to the Census Bureau, property taxes account for an average of 40% of
general revenue. Forty-five states collect sales taxes, which are the largest tax source or second
largest behind property taxes. Weak retail sales and declining home values are beginning to crimp
state revenues. At the end of the third quarter, 29 states had a combined deficit of $48 billion. Since
states are precluded from running a deficit, they must either raise taxes and fees, or cut back services.
In the next two years, many states will be forced to do both, which will cause a social back lash as
citizens are forced to make do with less government assistance.

Expectations of a mid 2009 economic rebound are likely to mount in coming weeks. Unfortunately,
the stress on the banking system is going to increase in coming months, as banks are forced to write
off more losses. This will lead them to maintain their high lending standards, and restrict the
availability of credit. Higher unemployment and weaker income growth will curb consumer
spending. Less credit and less consumer spending will not be the recipe for a recovery by mid 2009.

Although most analysts believe the stock market always bottoms before the economy recovers,
(since the stock market is a discounting mechanism), that’s not what happened in 2001. The NABE
determined in early 2002, the recession that began in March 2001, ended in November 2001. But the
stock market didn’t bottom until October 2002, and was up less than 3% from that low in March
2003. Does this mean the stock market was discounting the past?

Discrepancies like this don’t seem to matter to those who just want to believe the market knows
something about the future. At some point the stock market will bottom, and the economy will begin
to recover. With the benefit of hindsight, (sometime in 2009 or 2010), the believers will point and
say “See the stock market anticipated the recovery!” What they won’t tell you is that a good number
of people thought the market bottomed in August 2007 with the S&P at 1370. Even more were sure
that the failure of Bear Stearns surely marked the bottom in March, when the S&P was 1257. And,
when the S&P held 1200 in mid-July, and the government took over Fannie Mae and Freddie Mac,
the ‘bottom is in’ bandwagon was full. If I told you I was psychic and could guess a number between
1 and 100 randomly chosen, by someone I did not know, and then showed you a tape of someone’s
absolute amazement, when I guessed their number correctly, you might be just a little impressed. Of
course, what I didn’t show you was the tape of the other 34 guesses, with other individuals that were

In late July I was included in an article in the San Diego Union entitled “Five Experts’ Advice for
Tough Times.” I was included in part, I think, because I have shown Dean Calbreath (author of the
article) the tape of my number guessing ability. In that article, I stated we were in a bear market, and
thought the DJIA would decline to 8,000. (The DJIA was 11,500 at the time). On October 10, the

DJIA fell to 7,882. So, has the bottom in the stock market been reached? It’s certainly possible, but there are fundamental and technical reasons why the market will likely go lower. If the economy performs as poorly as I expect, corporate earnings will be crummy for longer than investors expect.

Technically, the market got more oversold in October 2008, than it was in July 2002. The July 2002
low was followed by a slightly lower low in October 2002, and a second retest in March 2003. Since
the October 2008 low was more oversold than the July 2002 low, it seems more likely this low will
be followed by additional selling waves, especially since the economic fundamentals are worse than
in 2002. The low in October 2002 was 7,197 on the DJIA. My guess is that the DJIA will drop below
7,882, but hold above 7,200 in coming weeks. If this develops, a one to three month rally could
follow, as analysts convince themselves that a narrowing in credit spreads and a second bigger
stimulus plan will mean the economy will begin to recover by mid 2009. As more investors embrace
this scenario, selling pressure will dry up, and coupled with a little buying and some short covering,
the market will rally on lighter volume. This is what happened after the March low, and the market
rallied for two months. If this plays out, the DJIA could rise to 9,600-10,200, and the S&P to 1000-
1050. My guess is that after this rally is over, the DJIA will likely drop below 7,200 by next spring.
If the DJIA does drop below 7,882, traders should look for an entry, especially if the DJIA climbs
above 8,200. Use DJIA 7200 as a stop. My managed accounts, for the most part, have been 100%
out of the market since July, in Treasury Bills since mid September, and sleeping at night.

As forecast last fall, the EU, Great Britain, and Japan posted a negative GDP report in the second
quarter, and are weakening. Growth has also slowed in India and China. The global economy is
slowing, and will be far weaker than the ‘decoupling’ crowd expected, just six months ago! This
means the demand for base metals (zinc, lead, copper, and platinum) will be weak. As fears about a
complete credit collapse ease, the fear bid for Gold is going away. I think Gold prices will be pulled
down, as base metal prices decline. Although the extraordinary measures adopted by central banks
may be inflationary in the long run, in the short run they have not yet stopped home and equity prices
from falling, nor prevented a further contraction in credit creation. All signs of deflation. Gold won’t
move up, until after a period of real stability, and we aren’t there yet. This suggests Gold could drop
to $660.

Last month I suggested adding a small position to the Gold stock ETF(GDX) if it dropped below
$35.00. I regret that I forgot to state a stop for this position ($31.60). I apologize for this error.

In the August letter, I recommended shorting the Dollar above 78.00, covering it if it fell to 76.30, or
rose to 78.45. This position was stopped out on September 30 at 78.45. The Dollar has moved above
84.00. The long position in the Euro, recommended in August below 144.75 was stopped at 144.50
on September 29. The Euro is down to 130.00. The Dollar is too overbought to go long, and too
strong to short.

The comments from last month still apply. “If the U.S. experiences a protracted recession, the
global economy will eventually dip into recession. The Chinese trade surplus will shrink, oil
revenues will contract, and global savings will suffer from a weaker economic environment. If the
U.S. budget deficit approaches $800-$1000 billion ($1 trillion) in 2010, a shrinking global savings
pool will translate into less demand. Over time, this would result in higher Treasury yields. I would
not buy Treasury bonds, and believe a good shorting opportunity will develop in coming months.”
A concerted rise in bond yields probably won’t occur until just before the economy bottoms, and
that’s not likely for at least six months.

In the August letter, I recommended a small trading position in the China ETF (FXI) below $38.00, the
Emerging Market ETF (EEM) below $38.00, and the oil stock ETF XLE) below $69.00. Given the market
environment, trading stops should be used. FXI $34.00, EEM $34.45, XLE $65.50. Since these stops were hit, FXI traded down to $24.31, EEM $22.24, and XLE $38.84. That’s why stops are used.

-E. James Welsh

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