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Mile High Insights

Recession in 2008


First, I would like to clean house and apologize to you. The optimism that I felt and displayed two weeks ago in this space was misplaced. It is now almost certain that the U.S. economy has entered a recession. While I was hopeful to the last moment, the unemployment report of January 4th utterly destroyed my fond expectations for the year. While I doubt that it was some macho optimism � la Larry Kudlow that led me astray, I must admit that I have had always a hard time to join the doom and gloom side of things. Well, this time, I am late but I can not ignore the facts. Just reading today�s headline of economic reports makes me cringe:

Commodities Vulnerable
1/15/2008 3:06 PM EST
By Tony Crescenzi
Shipping rates are plunging and may have an effect on commodities prices.

Inventories a Bright Spot
1/15/2008 1:27 PM EST
By Tony Crescenzi
It seems that businesses have been managing the slowing in demand quite well.

CEO Confidence in Recession Zone
1/15/2008 11:43 AM EST
By Tony Crescenzi
The Conference Board's CEO Confidence Index reached its lowest point in seven years...

Terrible Chain Store Data
1/15/2008 11:08 AM EST
By Tony Crescenzi
This could touch off a vicious cycle of cuts in output, a spike in jobless claims and a big drop in payrolls.

Empire Manufacturing Survey Comes in Weak
1/15/2008 10:02 AM EST
By Tony Crescenzi
The survey's index on general business conditions was at just 9.03, its lowest since...

Retail Sales Boost Odds of a Fed Cut
1/15/2008 9:47 AM EST
By Tony Crescenzi
There's little doubt now that the economy is contracting.

Enough said, the recession is upon us and we need to deal with it. Can�t the Federal Reserve help? Don�t ask. With friends like these, what do we need enemies for? We are on our own and need to get used to the idea. Are there any places to hide? Gold? Emerging Markets? Perhaps in the long run, but in the short run (in the next quarter or two) we will experience the deflationary effects of deleveraging, which will probably hurt emerging markets and precious metals also. In April last year, I had shown you a picture from a McKinsey Study, labeled �Global Flow of Funds�, which clarifies how intertwined all world economies are. A $40 trillion world economy will surely be affected, if the $12 trillion U.S. economy goes into recession. Europe is our biggest trading partner and will be next. Asian economies are dependent on exports to the U.S. and Europe and they will slow down also. Whether they will exerience a recession depends on how successfully the U.S. and Europe can contain their own. I would take a step back for now and liquidate all emerging markets positions. I consider the Baltic Dry Index a leading indicator for the strength of emerging markets and this indicator is flashing red. Take a look.

London's Baltic Dry Index (BDI), which measures freight rates for bulk commodities, mostly iron ore, coal, and grains has fallen by a third from record highs over the last two months. On Friday it suffered the biggest one-day fall since modern data began in 1985. The index is a barometer of the world economy. Markets fear it may be warning that China's voracious demand for commodities is cooling. The CRB-Index is holding its own so far. This Index represents a basket of 17 commodities such as sugar, copper and oil. I consider this more like a coincident indicator for the health of emerging markets. My bet is that this index will soften soon, if not sooner.

Back to my overly optimistic assumptions for the year 2008. First of all, we need to reduce the earnings estimates that I had accepted from Standard and Poors. Their model suggested at the end of December, that the S&P; 500 would earn around $101 in 2008. This clearly seems ambitious now. A dramatically slowing job market, which might already be in a �net reduction mode� will depress consumer confidence and consumer spending. Slowing consumer spending is usually a harbinger for a recession. Recessions mean declining earnings and this in combination with all kinds of asset write-downs will depress our earnings estimate for the S&P; 500 index considerably. I think a haircut down to $85 is necessary. Two weeks ago we also assumed a 10% increase in the S&P; 500 by the end of the year to slightly over 1600. While this also seems optimistic right now, let us just keep that assumption for the time being. The third assumption was that bond yields would hover around 4.5% for the entire year. Under those assumptions, we would have an earnings yield for the index of 5.3% versus a current bond yield of 4.5%. Even under those recessionary conditions, the Fed Model renders stocks undervalued relative to bonds. The big unknown of course is the effect that further asset write-downs will have on the model and on the markets. Bill Gross had introduced the term �shadow banking system�which was built on financial engineering (derivatives) and untouched by regulation. This shadow banking system financed many enterprises in the past, without providing for much reserves or risk analysis. These types of financings, however, will disappear and nobody will take it�s place. I hope that Mr. Bernanke is not going to lose the kingdom for want of a horse.

Hermann Vohs

Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.