The U.S. Economy
The stock market has put on a spectacular show in the last few months. On October 23 the Dow Jones Industrial Average crossed 12,100, an all time record, indicating investor optimism resulting from impressive corporate earnings and a steady decline in oil prices in the last several weeks resulting in lower inflation.
It took the Dow nearly six years to recover from the stock market debacle of Spring 2000 triggered by the dot-com bust. Normally it takes a bull market about three years to return to a new high following a major correction.
Another piece of good news was a 0.5% drop in the September consumer price index (CPI), helped by a fall in oil prices. From a high of $78 a barrel in mid-July crude oil prices has fallen to nearly $58 a barrel by mid-October. The fall in the CPI resulted in average worker’s weekly pay increase in of 1% after adjusting for inflation. September was the first month in 2006 when the CPI did not rise.
The core inflation rate, which excludes volatile energy and food prices, rose by a modest 0.2% in September indicating that recent energy price increases have not spread throughout the economy.
But, there is concern about the fact that the core inflation in September ‘06 increased by 2.9% from a year ago. This is a rate higher than what the Fed likes. The Fed’s comfort zone is in the 1%-2% range for the core inflation rate. So the economy is still not out of the woods.
The Fed at its most recent meeting kept the Fed Funds rate unchanged at 5.25% indicating that the economy is performing sufficiently well and the inflation picture at this point does not warrant a rate increase at this time. The door is still left open for an interest rate increase if inflation kicks up again in the fall or the winter.
What could trigger higher inflation in the near term? Higher oil prices because of OPEC cut backs in crude oil production, and worsening of the Middle East situation, and higher labor costs as the economy continues to build up stream.
Housing & Real Estate
According to the U.S. Department of Commerce new home construction in September ’06 was up by 5.9% from August. This comes to an annual rate of 1.77 million new housing units for the year. This is good news for an industry that has been starved for some positive developments. However, housing starts are still 18% below what it was a year ago.
The concern is that permits for new construction (indicator of housing construction in the near future) declined by 6.3% in August. Given that there is a considerable inventory of unsold houses in the market currently homebuilders are likely to cut back on new construction in the months ahead.
– Los Angeles based KB Home recently said that new home orders on the West Coast declined by 58% in the June-August period compared to an year earlier.
– The housing industry that had set records for the sale of new and existing homes for five years (2000-2005) in a row has been steadily losing momentum this year.
– The residential home resale market continues to slow down. Home resales on a monthly basis have been declining steadily each month since March of 2006.Home resale was down in most of the U.S. except for the South, which posted a small gain of nearly 0.4%.
For the first time in ten years median home prices in the U.S. declined. The 2.5% price decline between August 2005 and August 2006 was the biggest drop in forty years. This has raised some concerns about the real estate slump and its impact on the economy.
Even in the San Francisco Bay Area, once considered unsinkable, median home price in the 9 county region declined by 0.8% between September 2005 and September 2006. A large inventory of houses and condominiums has transformed the Bay Area from a sellers’ to a buyers market for the first time in 4.5 years in the aftermath of the Dot-Com Bust.
Southern California home prices increased by 1.9% for the year ending September ’06. This is the smallest gain for the region in ten years.
The bright spot in the real estate sector is the rental market. It is hot. According to RealFacts, a Novato research firm, in mid-October ’06 the average asking rent for a Bay Area apartment was $1,415 compared to $1,378 a year ago and the occupancy rate was 96%. As the expectation of big gains from real estate speculation has vanished more and more people have opted for rentals.
The Stock Market
The recent breaking of the 12,000 mark by the Dow Jones Industrial Average of 30 industrial stocks in recent weeks has been the cause of much celebration among investors. That is understandable. However, from an analytical perspective we need to remember that the Dow is a very limited index. Only 30 stocks represent the U.S. economy with its enormous complexities.
To obtain a more complete understanding of what is really happening in the financial markets we need to take a look at two broader indices—The S&P 500 index of 500 blue-chip stocks and the NASDAQ composite index, which includes 3,000 stocks. The S&P at this point is actually down 13% from its high in March 2002, and the NASDAQ is down 55% from its peak nearly 6 years ago.
The stock market has continued to ignore the impact of the real estate slump on the economy. Many analysts believe that housing slowdown will not be enough to dampen the stock market. Why? The loss of jobs in the homebuilding industry will be offset by growth in non-residential construction (commercial and industrial) construction industry. In addition, we have not witnessed a hit on consumption spending despite fall in home prices in many areas of the country. Equity investors remain focused on earnings and are betting that they will emerge unscathed despite the housing slow down as the Fed engineers a soft landing— modest growth and modest inflation.
The view from the bond market is different. The 10 year Treasury Note yields have declined from 5.25% in June ’06 to 4.56% in the first week of ’06.With the current Fed Funds rate at 5.25% we have a negative yield curve. (Short-term rates are higher than long-term rates). To many analysts that suggests a real slowdown in the economy if not a recession down the road.
My take on the current situation is that the economy is slowing down and the inflation outlook is risky at best. It is unlikely that we will see a Dow 14,000 for quite a while. In the meantime enjoy the ride.
California’s unemployment picture continues to improve. The state unemployment rate in September was 4.8%, slightly down from the 4.9% in August. In September 2005 California unemployment rate was 5.2%. The total number of people unemployed in the state was 858,000. Among the unemployed, 98,4000 left their jobs on their own accord, 260,400 were laid off, and the remaining were temporary jobholders.