Just three weeks ago, right here in Money and Markets, I warned of “Four Hidden Surprises†– a housing market collapse, an inflation spike, a tighter Fed, and possibly, another financial shock like the collapse of Long-Term Capital Management.
My recommendations then (and now):
1. Keep lots of money in cash.
2. Dump long-term bonds.
3. Avoid stocks with exposure to housing, construction, and risky lending.
I wish I had been wrong. I don’t like bad surprises any more than you do. But, unfortunately, if anything, my fears are being realized even faster than I expected.
Let’s examine them one at a time …
Looming Surprise #1
A Housing Market Collapse
Three weeks ago, I wrote:
“I see a serious meltdown brewing in the housing and construction sectors. And I see a Fed that’s caught between a rock and a hard place. It may want to stop raising rates … or even ease them … to spare homeowners a lot of pain. But it can’t with global inflation pressures building. …
“Forget that ‘soft landing’ crap that the real estate industry is feeding you. By virtually every possible measure, the U.S. housing market is caving in.â€
Now, here’s what’s happened:
The Philadelphia Housing Index, made up of 20 stocks related to the housing market, plunged 28 points, or about 12%.
Reason: One builder after another has come out with reports of plunging sales. And one region after another is reporting major, double-digit sales declines.
Inventories of unsold homes have soared.
Looming Surprise #2
An Inflation Spike
Three weeks ago, I wrote:
“The big surprise ahead: The CPI numbers, especially the ‘core’ ones, could just keep getting worse.â€
The actual event:
The latest CPI numbers just came out this week. Here’s the scoop:
- Overall CPI jumped 0.4% in May after rising 0.6% in April.
- Prices surged at an annualized rate of 5.2% in the first five months of 2006. That’s much worse than the CPI’s 3.4% increase in 2005 and almost double the 2.7% inflation rate in 2004.
- Plus, so-called “core†inflation climbed 0.3% for the third month in a row. This measure excludes food and energy, and it’s closely watched by both the Fed and the markets. Prices rose for a broad range of goods and services – housing, medical care, airfares, recreation, you name it.
Other numbers have been equally bad. Import prices climbed 1.6% in May, twice as much as Wall Street’s forecast.
The news was even worse for “non-fuel†import prices, a core inflation measure that the market follows closely. These prices surged 0.7% – the most in any month since 2002 (when the government started tracking the category).
And the Producer Price Index jumped 4.3% year over year in May, the biggest rise since January.
Make no mistake: Inflation is all around us. It’s spreading. It’s accelerating. It’s emerging as the number one factor driving the fate of your investments.
Looming Surprise #3
A Tighter Fed
In “Four Hidden Surprises,†I said:
“Could the Fed have more in store than a ‘one and done’ rate hike in June? Absolutely!â€
Not long after, “Gentle Ben†Bernanke went on a rampage! Earlier this month, the Fed Chairman warned that the recent rise in prices was “unwelcome.†The market was shocked.
On June 7, Atlanta Fed President Jack Guynn said “headline measures of inflation … have been bothersome … [Core inflation] has moved into the upper end of – or beyond – the range I consider acceptable …†The market reeled again.
Governor Donald Kohn talked about raising “a warning flag,†and again investors were taken aback.
So far it’s just talk. But the evidence is certainly mounting that the Fed is not going to STOP raising rates. Not now. Maybe not later either.
One other note: It’s not just the Fed. Every central banker from South Korea to South Africa is hiking rates right now.
Looming Surprise #4
Another Blow-Up Like
Long-Term Capital
Management?
Three weeks ago, I asked:
“Could there be another major hedge fund that’s about to blow up?
“Could we get a bout of panic selling and more ‘flight to quality’?â€
I didn’t know what was going to happen. I thought maybe we could see something similar to the blow-up of Long-Term Capital Management (LTCM), a big hedge fund whose failure shook the world in 1998.
Now, we don’t have a LTCM. But we do have some similar trends forming:
- Some emerging markets are getting hit hard. Back in 1998, it was Russia. Now it’s Saudi Arabia, Iceland, and Colombia. Most people are ignoring them. But I’m not. I’m watching them carefully to see if the flight from risk – and to quality – of the past few weeks is going to continue.
Another indicator I’m watching is the Chicago Board Options Exchange Volatility Index (VIX). When it’s low, it means markets are quiet and stable. When it’s rising, it means things are beginning to heat up – usually in the wrong direction.
- Last, I watch junk bonds. If their yields are rising faster than the yields on Treasuries, it tells me investors are demanding more return to cover the risk. In other words: They’re getting scared.
Right now, all three of these indicators – emerging markets, the VIX and the junk bonds – are telling me that some major hedge funds or institutions are getting annihilated. We don’t know who yet. But we soon will.
And in the meantime …
Don’t Take Any Chances …
Stay safe! How many Wall Street pundits have paraded in front of the cameras on CNBC and called the bust in the worst stock market dogs – housing stocks, U.S. tech stocks, and others – a “bargain hunters’ paradise� I’ve lost count!
We’ve had a relief rally over the past couple of days. Use it as your selling opportunity – to get out of what my colleague Tony Sagami calls the “flea-bitten dogs.†These include:
- Stocks vulnerable to rising interest rates – construction companies, banks, mortgage lenders, and others.
- Stocks vulnerable to rising energy costs – airlines, transportation companies, etc.
- Stocks vulnerable to intense foreign competition – chip makers, personal computers and a whole list of stocks that Tony has warned you away from.
Watch bonds and the dollar closely! I’ve been bearish on bonds and the U.S. dollar for a long time. And clearly, the inflation data and price justify that stance.
This week, bonds showed some hesitation to sell off on the “bad†inflation news. They even inched up in price at first, causing rates to slip a bit. The dollar benefited from some buying.
My take: That was almost entirely “safe haven†buying. Investors were parking cash in the dollar and dollar-denominated bonds to wait out the stock market sell-off.
But it didn’t change the long-term picture one bit. And lo and behold, now bonds, notes, and short-term instruments like eurodollars are falling in price again – as interest rates resume their upward march.
What’s going to happen if the housing carnage spreads throughout the economy? Too soon to say. Right now it’s almost certain the Fed will hike short-term rates at the end of this month. And traders are starting to wonder whether even more hikes will follow after that.
Above all else, stay flexible. More surprises are coming.
Until next time,
Mike
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About MONEY AND MARKETS
MONEY AND MARKETS (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, and Tony Sagami. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM. Nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical inasmuch as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Colleen Collins, Amber Dakar, Ekaterina Evseeva, Monica Lewman-Garcia, Wendy Montes de Oca, Jennifer Moran, Red Morgan, and Julie Trudeau.
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