Why I'm So Bearish

I think the recession will last longer than the consensus. After it ends, I see a prolonged period of sluggish economic growth.

I lived and worked in Tokyo in the roaring '80s. By the end of the decade, Japanese property prices had climbed to preposterous levels. Whenever I expressed skepticism about local real estate prices to the Japanese, I received this kind of response: "You foreigners don't understand. Japan is a small island nation with no natural resources. Property prices only go up."

In 1990, the bubble burst. The value of Japanese real estate, as well as the value of Japanese stock values, ultimately fell 70% to 80%. They have never really recovered.

In 1993, I relocated to Hong Kong. China was booming and Hong Kong property prices were headed into the stratosphere. When I questioned how this was sustainable, I repeatedly heard this response from locals: "Hong Kong is a small island with no natural resources. Property prices only go up."

In 1997, the Asian economic crisis erupted and China regained sovereignty over Hong Kong from Britain. The Hong Kong real estate market collapsed and eventually declined 50%.


In February 2006, I repatriated to the U.S. Interested in buying a house, I did some research on the residential market. My vocabulary wasn't large enough then to comprehend terms such as collateralized mortgage obligation and credit-default swap, but what I saw looked and smelled familiar: a bubble.

The rationale from Americans was a bit different from what I heard in Asia. It went like this:: In the U.S., waves of young immigrants feed demand for housing, which never falls in price (at least not nationwide), etc., etc. Apparently, Americans are as capable of getting drunk on their own bubbly as the Japanese and Chinese.

Now, residential prices in the U.S. have retreated 25% from their peak in mid 2006 and are still falling fast. Less than a year ago, UBS's forecast of systemic credit losses totaling $600 billion sounded outlandish. Now, Goldman Sachs's $1.8-trillion projection, which is equivalent to more than the entire equity capital of the U.S. banking system, sounds reasonable. The vastly overleveraged financial system has imploded like a busted pyramid scheme.

Still wondering why I'm so bearish? Just as in Asia, we had a spectacular (and sad) misallocation of capital due to unsound lending and borrowing practices and risk assessment. The wealth destruction is similarly colossal.

The Japanese make wonderful cars, cameras and cartoons, but they've basically lost two decades of economic growth now. I'm not expecting the same scenario in the U.S., but I do anticipate much worse economic and stock-market performance than the consensus, including the outlooks of Kiplinger's Personal Finance and the Kiplinger Letter. That consensus sees the economy reaching a bottom by midyear and starting to improve.

I'm not counting on economic expansion in the back half of the year, and when the economy starts to mend, my fear is we will be in for a prolonged period of anemic growth. I've seen this before.

What will change my outlook? It will be hard. One of the main reasons for my pessimism is the staggering national and, especially, consumer debt. The economic growth and rising profit margins of the past decade were largely fueled by an enormous run-up in debt. To put it to numbers, the ratio of debt to gross domestic product surged over the past decade from 250% to a scary 350%. The indebtedness must and will decline. But the last time this ratio fell dramatically coincided with the Great Depression.

Household savings rates in the U.S. have collapsed from a historical range of 8% to 10% to virtually zero. Consumers evidently thought rising home equity (not to mention stock portfolios) was like a piggy bank, so they borrowed furiously and extracted trillions of dollars from their homes at the top of the residential market. This Ponzi scheme has now collapsed.

The truth is that American consumers have spent a few trillion dollars more than they could afford over the past decade. They are now cutting consumption dramatically and boosting savings at a fairly rapid clip. Milton Ezrati, an economist at Lord Abbett, thinks it could take at least five more years for U.S. households to restore their balance sheets to equilibrium. As a result, I'd estimate that the share of GDP represented by consumer spending will tumble from 72% to 65% over the next few years. That is the equivalent of subtracting $1 trillion of demand per year.

Collapses of heavily leveraged asset bubbles are never pretty. When you add the effect of years of excess consumption, undersaving and illusory economic expansion, you have a pretty toxic brew. We didn't get here overnight, and we won't emerge overnight. I see a prolonged period of subdued economic activity in which 2% growth, one-third less than in recent decades, is the norm.

Growth of this sort generates pretty mediocre earnings growth and sluggish employment expansion. Wall Street's earnings estimates for this year are still wildly optimistic. If Goldman Sachs's top-down estimate of $53 per share for earnings of Standard & Poor's 500-stock index is accurate, then the market, at 16 times that figure (based on the S&P's January 16 close), doesn't seem terribly cheap. Remember, an unsustainable credit bubble pumped up earnings and profit margins in recent years.

My bearishness extends over the next few years. Long-term, I see reason for some optimism. I think stocks can reward investors with a respectable return over the next seven to ten years. They are likely to perform better than they did over the past ten years, when stocks returned a negative 1.8% annualized, the worst period since the Depression of the 1930s.

Although I'm more pessimistic about the stock market and general economic issues than my colleagues at Kiplinger, there's one thing we all agree on: If you have cash you may need in the next few years, I would stay away from stocks altogether. In an economy with prospects as bleak as this one, you need to play a strong game of defense.

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