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| A Tale of Two Economies |
| Monday, 28 April 2008 | ||||||||
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I know you have heard the opening line of Charles Dickens’ classic novel A Tale of Two Cities. It was the best of times, it was the worst of times. This phrase is overused and I hesitated to use it, but it is so fitting for what we are seeing so far this earnings season. We have seen the banks and brokerage houses miss on their earnings estimates and in most cases, their profits are either way down, or they slipped to losses. On the other hand, the non-financial earnings reports have been better than expected for the most part. Most of the companies are showing modest growth in the first quarter. From Google to Apple, Boeing to McDonalds, these companies have exceeded earnings estimates. Some of these companies have charged higher, some have dropped, and some have had little reaction to the earnings reports. As it has been said many times before in IDE, it is all about expectations when it comes to earnings. This may seem all well and good, but I find it concerning. Historically it has been the financials that lead the way out of recessions. The Fed lowers interest rates in order to make credit more readily available and the banks benefit from the increase in loan demand. But I don’t see this happening right now. Just last week, mortgage applications showed a 14 percent decline from the previous week. Both existing home sales and new home sales are at multi-year lows. While the Fed has been dropping rates, the mortgage rates have not been declining. Why is this you ask? From where I sit, it looks like banks are keeping mortgage rates higher than usual. What I mean by this is that they are setting the rates with a higher spread between what they can borrow at and their lending rate. Back when I was the branch manager of a bank in Ohio, the rate on our 30-year mortgage usually ran about 1.5-2 points above the 10-year Treasury note rate. Right now, the yield on the 10-year treasury is at 3.85 percent while the national average for a 30-year mortgage is 7.15 percent. A spread of 3.3 percent.
You can’t really blame the lending institutions, after all, they are trying to recoup some of their losses from the ongoing sub-prime fiasco. The problem is that by keeping the rates inflated, the demand for loans remains low. I have stated on several occasions that I don’t look for the economy to improve until the housing market improves. Given that new home sales in March dropped to the lowest level in almost 17 years and the existing home sales declined after a mild jump in February, I don’t foresee a big improvement in the housing market anytime soon. As I mentioned above, non-financial companies have been reporting better earnings than expected, but the financials have been reporting worse than expected earnings. If this pattern continues past this quarter, the non-financial companies will start to see a decline in earnings as the consumer becomes more and more strapped financially. Food and energy prices continue to skyrocket, eating up more and more of the household income. In the meantime, credit is not as accessible as it has been for the last ten years and we all know that this is not a country of savers. So if food and energy continue to climb, credit remains tight, and the housing market doesn’t improve, the economy is going to get worse before it gets better. The weakness in the earnings of the financials could be leading us deeper into recession rather than leading us out of one this time. Good luck and good trading, Rick P.S. To let me know what you thought of today's article, send an e-mail to: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
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