John Mauldin Economic Musings

Frightening excerpts from John Mauldin's newsletter:

Earnings Estimates
Earnings may drop 31% in the second quarter and 18% in the next before gaining 74 % in the last three months of the year, analysts predict. Banks are projected to account for all of the rebound in the final quarter. Without financial companies, the gain turns into a 5% decline, the data show.
The above estimates are based on operating earnings, not as reported earnings. Long time readers know that operating earnings are actually earnings before interest and Bad Stuff. As reported earnings are what companies actually report on their tax reports, as a gauge of profitability they are much more reliable. Before the mid-90s the difference between operating and as reported earnings was typically quite small. Then companies found that they could play the market if they played games with their operating earnings.
Operating earnings are earnings which typically do not take into account one time, non-recurring events. The number of items which get classified as “non-recurring” has mushroomed to the point where projected operating earnings for 2009 are more than double the estimates of as reported earnings. Operating earnings for 2008 was almost three times actual or as reported earnings.

Housing Mess -- Will Deepen in 2010-2011
They contend that much of the bad news in the subprime and housing market has been written off. And one would have to admit that a lot has been, and with the relaxation of mark-to-market, there may indeed be some truth to that suggestion. But there are still some issues that remain in the future for housing problems. Take a look at the graph below. (Not sure where it is from as it was sent to me, but I have seen the same data elsewhere.) Notice that monthly mortgage rate resets declined markedly in 2009 from 2008, only to rise once again in 2010 and 2011.

Shadow Inventory of Foreclosed Homes
We are seeing what some call a “shadow inventory” of foreclosed homes. “We believe there are in the neighborhood of 600,000 properties nationwide that banks have repossessed but not put on the market,” said Rick Sharga, vice president of RealtyTrac, which compiles nationwide statistics on foreclosures.
Realty Trac in a survey found that only 30% of foreclosures were listed for sale... Add in homes that people would like to sell but simply can’t find buyers and must either hold or rent, and the unsold inventory numbers that are public are likely far below actual available homes.
Might some homes in foreclosure be held off the market as banks eventually want to negotiate with the homeowner? Possibly, but other surveys show that anywhere from 30-40% of homes in the foreclosure process in many areas are actually already vacant. There is no one with whom to negotiate.
Typically a foreclosed home sells within a few weeks as banks take the first “reasonable” offer. Again, it normally takes about three months from foreclosure to where the home is sold. It takes a few months to get a home ready. But surveys show it is taking a lot longer, and many homes have not made it onto the market, even as more homes are being foreclosed each month. There are just so many homes it is hard to get them onto the market and sold. Normally there are about 160,000 homes are year in foreclosures sales. We are now seeing 80,000 a month, or six times normal levels and rising.
Second, lenders could be deferring sales to put off having to acknowledge the actual extent of their loss. "With banks in the stress they're in, I don't think they're anxious to show losses in assets on their balance sheets," one observer said.
Finally, banks may not want to flood the market with foreclosures, driving prices down even more. They are simply managing their assets so as to recover the most capital they can.
Given that the graph above says that there will be more mortgage misery as so many mortgages reset in the next two years, and given the unknowable nature of the losses, it is somewhat optimistic to think financial profits will rise by 74% in the fourth quarter. But it gets worse.

Commercial Real Estate
We are now starting to see some real deterioration in traditional bank lending. Delinquencies on home equity loans are rising rapidly. The American Banking Association released a composite index of eight different types of consumer loans and the delinquency rate on this 35 year old composite jumped to a record high of 3.22%.
The above data reflects 4th quarter data. As unemployment is up 2% since then and is rising, it is more than reasonable to assume that we will see another record rise in delinquencies this quarter. With unemployment headed to over 10% and maybe 11% from today’s 8.5%, delinquencies are likely to continue to rise for the entire year.
Commercial mortgages are in trouble. S&P has warned they may cut ratings on $97 billion in commercial mortgage asset backed debt. The country’s 10 biggest banks have $327.6 billion in commercial mortgages, according to regulatory filings. A projected tripling in the default rate would result in losses of about 7% of total unpaid balances,according to estimates from analysts at research firm Reis Inc. (Bloomberg)

P/E Ratios Go Negative
The P/E ratio for the end of the second quarter is 1944 (not a typo). The losses of the 4th quarter almost wipe out all earnings for the 12 months ending June 30. But by the end of the 3rd quarter, the P/E ratio has dropped to a negative -467.That has never happened. We have never seen negative earnings over a 12 month period since WW2. (I don’t have data for the Depression era.)

“…Much of the excitement in the stock market – at least that is related to the current performance of the economy - seems to be centered on an economy that is performing less badly than expected. The risks here seem to be that if the trends in data surprises change, so could investor's attitudes toward stocks that are currently overbought on a number of measures.
“…If the high correlation between stock prices and data surprises holds, the recent rally in stocks might be tested. Even if the economy has bottomed, it's very likely that the eventual recovery will prove to be uneven, causing the flow of positive surprises to be uneven. During these periods, the risks to stocks will be greatest when the market is overbought and investors have priced in high expectations of positive data surprises continuing.”
The projections of many market analysts assume that we will have something that will look like a normal recovery. I have objected that that could be a very bad assumption, as we are not having a normal recession. This is already a very lengthy recession, and is just going to get longer. As I will note below, there are reasons to think we could see a mild recovery late this year only to dip back into recession next year.
Even ignoring the disastrous 4th quarter of 2008, what if earnings drop by 80% or more, which is quite possible? That means they have to rise by 400% to get back to new highs. That could take some time. Even if they could rise at an unlikely 24% a year, it would take six years to see new highs. Look at what a mountain corporate earnings must climb.
Further, the Democratic Congress and the Obama administration are going to enact the largest tax increase in history in 2010, just as the economy is barely recovering, as the Bush tax cuts go away because the Republicans could not make them permanent when they had the chance. We are going to pay for that with a likely dip back into a recession in 2010, or at the very least a prolonged weak economy.

Social Security -- About to Implode
And then there is the last piece of data I want to bring to your attention, which is the most troubling of all. Everyone knows that the government spends the Social Security surpluses on current spending, “borrowing” the money and putting it into a “Social Security Trust Fund” which is basically just US debt we owe to the trust fund. In other words, there is no trust fund with anything other than paper debt. It is accounting legerdemain.
Everyone assumed that the real problem was some time later next decade when there would no longer be surpluses. In 2008, the Congressional Budget Office (CBO) projected that there would be $703 billion in surpluses from 2009-18. Recently, the CBO has revised those estimates downward. It now projects surpluses to be on $83 billion.

Trillion Dollar Deficits
But there is a limit to continued $2 trillion deficits without an appreciable rise in interest rates that will be needed to attract buyers of treasury bonds, which of course increases interest rate payments on the national debt, while also crowding out corporate and personal borrowing. This is not going to end well, and the end game is getting a lot closer.
All in all, the next few years are going to be a very difficult environment for corporate earnings. To think we are headed back to the halcyon years of 2004-06 is not very realistic. And if you expect a major bull market to develop in this climate, you are not paying attention.
The original question was “Is that recovery we see?” I think the answer is no.