Consumer sentiment improved for the second consecutive month, as lower commodities prices picked the index of consumer confidence up from a 28-year low.

The Reuters/University of Michigan Surveys of Consumers announced its index of consumer confidence inched up a half-point to 61.7 in early August from 61.2 in late July. However, the index fell just shy of economists’ median forecast of 62.0, according to a recent poll conducted by Reuters.

“Consumers still remain pretty pessimistic,” Arun Raha, a senior economist at Swiss Re (OTC ADR: SWCEY) in New York, said in an interview with Bloomberg Television. “This little-higher number is probably the result of lower gas prices. The economy remains pretty weak and consumer sentiment reflects that.”

The index has climbed back from 56.4 in June, its lowest level since May 1980. Any improvement in consumer confidence, however slight, is good news for a U.S. economy that continues to precariously vacillate on the edge of an official recession.

A drop in oil from its July 11 high has led to an 8% decline in prices at the pump, boosting consumer moods and slightly easing overstrained household incomes. [Please click here for a related story on oil prices in today’s issue of Money Morning.]

The decline in oil and other commodities prices also led consumers to lower their inflation expectations to 4.8% over the next year, down from 5.1% in both the June and July surveys.

While consumers are slightly more optimistic, that sentiment is not likely to translate into increased consumer spending, especially as it comes on the heels of a U.S. Labor Department report that indicated the largest-decline in inflation-adjusted wages in 17 years.

“A very weak trend for consumer spending is the most likely scenario,” said Josh Shapiro, an economist for MFR Inc., MarketWatch reported. 

With consumer spending accounting for 70% of U.S. gross domestic product, the outlook for the U.S. economy is far from bright.

“There is little doubt among consumers about the likelihood of a recession,” Richard Curtin, director of the surveys, said in a statement.

News and Related Story Links:

• Bloomberg News:
  U.S. Michigan Consumer Sentiment Index Rose in August

• MarketWatch:
  Consumers still gloomy despite gas-price relief

• Reuters:
  Consumers’ mood improves

• Money Morning:
  Soaring Consumer Prices and Mounting Foreclosures Threaten 2008 Economic Growth

Consumer spending, which accounts for more than 70% of the economy, will be seriously threatened in the months ahead, as prices continue to rise, wages plateau, and government stimulus checks wear thin.

Consumer spending has remained strong in recent months, even jumping 0.8% in the month of May. But that boost was largely inflated by the $50 billion in government rebate checks that were cashed and put to use in the month.

The stimulus will total $107 billion this fiscal year, but that may not be enough, as consumer prices are rising across the board. The consumer price index (CPI) increased 1.1% in June, driving the rate of inflation over the past 12 months to 5%, and it looks as though prices will continue to rise as many businesses grapple with higher raw material costs.

Sara Lee Corp. (SLE), the maker of many American food products, such as Jimmy Dean sausages, said yesterday (Monday) that it would be forced to boost the prices of its meat products by one-fifth this year.

“Price increases vary a lot by type of products but the increases will be as low as zero and some products we will decrease on and other increases [will be] in excess of 20%,” C.J. Fraleigh, Sara Lee’s chief operating officer for North America told the Financial Times.

Kraft Foods Inc. (KFT) said prices for its products will jump by 12%-13% this year, and even as much as 25% in some of its cheese categories. Kellogg Co. (K), ConAgra Foods Inc. (CAG) and Tyson Foods Inc. (TSN) are some of the food companies also planning price increases that will invariably contribute to inflationary pressures in the United States.

Meanwhile, the high price of oil has contributed to a sharp escalation in the price of gasoline and many other consumer products. For instance, global chemical producer Dow Chemical Co. (DOW) recently raised prices on all 3,200 of its products, some by as much as 20%, in the single-biggest price increase in the Michigan-based company’s 111-year history.

The problem is going to get worse in the months ahead, as a survey by the National Association for Business Economics (NABE) has found that almost four times as many businesses plan to charge more for their goods and services next quarter than expect to reduce prices.

The poll of the 101 NABE members was taken between June 19 and July 10, and found that a record 75% paid more for materials last quarter and expected to pay more this quarter as well. A net 28% of respondents said they were forced to increase prices from April through June as a result.

Worse, only 20% of the businesses surveyed said salaries increased in that time, the lowest number in four years and an 11% drop from the group’s previous survey in April.  Only 9% of the respondents said they would increase payrolls over the next six months, the fewest in five years.

The information corroborates a separate report from the Department of Labor last week, which said wages, adjusted for inflation, were down 2.4% in the 12 months ended in June.

Employers have cut jobs each month in 2008, with payrolls tumbling for the sixth consecutive month in June. The total number of job losses in the first half of the year was 438,000.

The national unemployment rate has gone up by a full percentage point in the past year, to 5.5%.

News and Related Story Links:

• National Association for Business Economics:
  Continued Caution but Some Signs of Improvement

• Financial Times:
  US food groups plan hefty price rises

• Money Morning:
  Escalating Inflation at Home and Abroad Puts Pressure on Central Bankers

Mirroring the stagflation of the early 1980s, consumer sentiment hit its lowest level since that time period this month as short-term inflation continues to ramp up.

The Reuters/University of Michigan preliminary index of consumer sentiment dropped to 59.5 in May from 62.6 in April. The index is at its lowest level since June 1980. Consumer confidence was at 85.6 as recently as 2007.

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"The consumer is getting extremely grumpy," Brian Bethune, director of financial economics at Global Insight Inc., who had forecast a decline in the confidence index to 59.6, told Bloomberg News. "The economy is flirting with a recession. The only thing keeping it out is this huge amount of pump-priming going on," including aggressive interest-rate reductions by the U.S. Federal Reserve, the government’s stimulus package and deep discounting by retailers.

Lower-income households are feeling the rising prices at the pump and grocery store most acutely, the survey showed, as such households were the main cause for the index’s fourth consecutive monthly decline.

The confidence index was well below economists’ median expectation of a reading of 62.0, according to a Reuters poll, the news service reported.

"Consumer confidence continued to slip in early May due to surging food and fuel prices," the Surveys of Consumers statement said according to Reuters. "Record numbers of consumers viewed the economy in recession and saw little hope of recovery anytime soon."

Consumer spending provides the bulk of U.S. gross domestic product, but a deteriorating housing market coupled with high food and fuel costs are eating away at household discretionary income.

The $117 billion in tax-rebate checks mailed to consumers as part of the Bush administration’s stimulus plan should lead to a rebound in spending in the third quarter, followed by a deceleration by year-end, a Bloomberg poll showed.

News and Related Story Links:

• Bloomberg News:
  U.S. Consumer Sentiment Decreases to 28-Year Low

• Reuters:
  Consumers’ mood grim as early-80s in May

• Money Morning:
  Consumer Sentiment Battered by High Fuel, Housing Slump

High commodity costs, a weakening employment situation and the continued housing slump combined to push consumer sentiment down to its lowest level in a quarter-century.

For the third straight month, the Reuters/University of Michigan sentiment index registered a decline. The index is down to 62.6, from 69.5 the prior month. Economists had expected the index to be a bit higher at 63.0.

"The recent acceleration in the loss in confidence indicates a longer and potentially deeper recession," survey director Richard Curtin said. "All households now anticipate smaller income gains and larger price increases, as just one-in-five now expect their overall finances to improve during the year ahead, the least favorable reading in more than a quarter century."

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The index is at its lowest point since March 1982’s reading of 62.0, when stagflation concerns – high inflation coupled with low growth – were still taking a toll. Due to surging prices on food and fuel and an economy that has already shed 250,000 jobs so far this year, consumer sentiment is taking a beating.

"Consumers are feeling the pinch, not only from the labor market, but also from prices," Aaron Smith, an economist at Moody’s Economy.com in West Chester, Pa., said in a Bloomberg Television interview. "There’s a squeeze on incomes from two sides."

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And the nationwide decline in home values cannot be ignored. Home prices are down 10% across the country, according to the S&P Case-Shiller home-price index, making consumers less likely to spend as they see their home equity levels dropping.

"Never before in the long history of the surveys have so many consumers reported hearing news of unfavorable economic development as in the April survey," the report read.

Nearly nine in 10 consumers thought the economy was now in recession, Reuters/University of Michigan said, Reuters reported.

News and Related Story Links:

• Bloomberg News:
  U.S. Economy: Sentiment Weakens More Than Anticipated

• MarketWatch:
  Consumer sentiment plunges to 26-year low

• Reuters:
  Consumer sentiment at a 26-year low

Consumer prices rose 0.4% in January, an indication that Federal Reserve policymakers will have to think twice about the risk of inflation before making more interest rate cuts.

Energy prices rose 0.7% last month after gaining 1.7% in December, the Labor Department reported yesterday (Wednesday). Fuel costs were up 4.5%.  Food prices, which account for one-fifth of the consumer price index, jumped 0.7%. The core rate of inflation, which excludes food and energy costs, rose 0.3% after a 0.2% increase in December.

"It’s not a very welcome report from the Fed’s perspective,” Zach Pandl, an economist at Lehman Brothers Holdings Inc. (LEH), told Bloomberg News. "We think the slowing economy will bring down inflation but we are seeing a lot of cost pressures still and that slowdown in inflation looks like it will be gradual.”

Soaring energy and commodity costs, coupled with a weak dollar, are keeping prices high despite the economic downturn we are currently experiencing. Yesterday, the price of light, sweet crude for March delivery settled at a record $100.01 a barrel on the New York Mercantile Exchange, after earlier rising to $100.10, a new trading record.

It was the first time since Jan. 3 that oil had been above $100 a barrel, and yet another sign that energy costs will remain high in coming months. At the same time, the greenback declined to a two-week low against the euro on speculation the Federal Reserve will further cut its benchmark interest rate from 3%.

The Fed has cut rates by a total of 2.25 percentage points since September. The dollar has subsequently dropped about 8% since the beginning of 2007 when compared to a basket of trade-weighted currencies from major U.S. trading partners.

This runs contrary to Fed Chairman Ben S. Bernanke’s Feb. 14 assessment that "inflation expectations appear to have remained reasonably well anchored.”

The next day, the government reported that import prices for January increased 1.7%, more than twice as much as had been expected. The unexpected increase pushed the 12-month price increase to 13.7% from the same period a year prior, the largest increase since 1982.

For the month, the cost of China imports increased 0.8%, and was up 3.3% for the 12-months ended in January. Latin America imports cost 3.6% more, while European Union goods were 1.1% more expensive.

News and Related Story Links:

• Department of Labor:
  Consumer Price Index Summary

• Bloomberg:
  Consumer Prices in U.S. Increase More Than Forecast

• Money Morning:
  Import Prices Rise to 12-Month Record High

Consumer confidence has reached its lowest level since the post-Katrina period, according to the Reuters/University of Michigan preliminary index of consumer sentiment for November.

At 74.5, the index is at its lowest level since October 2005. This is bad news for Wall Street, which hopes that strong consumer spending will keep the economy from slipping into a recession.

“Rising prices for fuel and food had a devastating impact on household budgets, and falling home prices have diminished consumers’ sense of financial security,” said Richard Curtin, the director of the Reuters/University of Michigan Surveys of Consumers. The survey is jointly developed by the university and a unit of Reuters Holdings PLC (RTRSY).

Other measures of consumer confidence reported similar results. The Royal Bank of Canada’s (RY) RBC Cash [Consumer Attitudes and Spending by Household] Index, also released Friday, was 65.9 for the month. This was a slight increase over October’s reading of 64, but not a large enough increase to indicate a substantial upswing in consumer confidence.

Because consumer spending accounts for as much as 70% of all economic activity in the $13 trillion U.S. economy, consumer confidence is a closely watched indicator. High consumer confidence is considered a harbinger of future growth, while declining confidence is viewed as a warning that economic activity is destined to slow. Although the indicator’s current level isn’t low enough to suggest that a recession is imminent, the Reuters/University of Michigan index has dropped steadily over the past several months. 

“This month’s decline reflects the fallout from the ongoing housing-market correction, the turmoil in the subprime market, the volatility in the stock market and rising gasoline prices,” Steven Wood, president of Insight Economics LLC in Danville, Calif., told Bloomberg News.

The continued tightening of lending standards has reduced the availability of credit, making it tougher for some consumers to finance bigger-ticket purchases. In addition, consumers are trying to pay down debt and build up emergency cash reserves in the event economic conditions only continue to get worse.

“Consumers have become more prudent and more interested in rebuilding their reserve funds as a precaution against any future adverse economic developments,” added Curtin, the Reuters survey director.

Several retailers are expected to miss fourth-quarter sales predictions. While Wal-Mart Stores Inc. (WMT) and some other discount firms have lured shoppers with heavy price reductions, such other chains as J.C. Penney Co. Inc. (JCP) and Target Corp. (TGT) posted disappointing November results, Bloomberg reported.

News and Related Story Links:

• RBC:
  The RBC CASH Index November News Release.

• Bloomberg:
  U.S. Michigan Consumer Sentiment Index Falls to 74.5.

• Associated Press:
  Consumer Confidence Near Two-Year Low.

• Wikipedia:
  Hurricane Katrina.

Consumer confidence dipped in November, providing the latest bit of conflicting data about the prospects for this year’s holiday shopping season.

Spiraling fuel costs and dwindling home prices – which have persisted since summer and which aren’t expected to improve for the foreseeable future – were blamed for the disappointing consumer confidence report. Both U.S. Federal Reserve policymakers and private-sector economists have reacted by slashing growth forecasts for this year and next, and the central bank has twice cut short-term interest rates in an effort to reverse the U.S. economy’s flagging fortunes.

The Conference Board’s confidence index decreased to 87.3 for November, its lowest level in two years. October’s confidence reading was revised down to 95.2 from a previously reported 95.6. This comes as no surprise, considering home values dropped 4.5% in the third quarter from a year earlier while oil continues to flirt with the psychologically important $100 a barrel mark. 

"This is a strong indication that consumers are going to pull back sharply and growth is going to be very weak," Nigel Gault, an economist at Global Insight Inc., told Bloomberg News. "The message to the Fed should be that they need to keep cutting rates."

U.S. Federal Reserve Chairman Ben S. Bernanke and central bank policymakers reduced the key Federal Funds Rate by half a percentage point in September and a quarter point in October. The rate now stands at 4.5%. The policymaking Federal Open Market Committee (FOMC) has scheduled its last meeting of the year for Dec. 11.

As far as the shopping season is concerned, the picture has gotten bleaker. Retailers got off to a good start last week. Shoppers spent $10.3 billion on holiday purchases on "Black Friday," the nickname for the day of shopping insanity that follows Thanksgiving Thursday – called that because at one time it was considered the day retailers turned profitable for the year. That outlay was actually 8.3% more than a year earlier, reported ShopperTrak RCT Corp., a Chicago-based research firm.

Those statistics were both ahead of forecasts.

But the subprime mortgage mess and related market conditions were bound to finally influence consumer confidence at some point. Yesterday’s consumer confidence report seems to indicate that’ finally happened.

"The financial markets are a mess, the housing market is burning down, and gasoline prices are at record highs and you think that consumer confidence could hold up?" asked Joel Naroff, president and chief economist for the Holland, Pa.-based Naroff Economic Advisors. "Not a chance."

But there is still a silver lining to be found. The current indications are that the job market is still reasonably strong. Most consumer confidence gauges reflected concern about the more-distant future, and not necessarily the immediate future.

Will the drop in consumer confidence mean the holiday shopping season will be a disaster?

"Probably not," Naroff said. "People still have their jobs and incomes are rising, so they will spend.  But the concerns about future job prospects could lead to somewhat muted holiday shopping …With the next FOMC meeting just two weeks away, it would be nice if some signals were being sent. I would like to see another rate cut, but the odds are still against it.  It just means the Fed will have some catching up to do early next year."

News and Related Story Links:

• Money Morning Economic Analysis:
  Black Friday Has Retailers Dreaming of a Green Christmas.

• Money Morning Economic Analysis:
  Born to Shop: Holiday Retail Season Could Be Better Than Experts Think.

• Money Morning:
  Retail Sales Inch Ahead, Hinting at a Less-Than-Happy Holiday Shopping Season.

• Money Morning:
  Federal Reserve to Increase Disclosure, Will Now Publish Economic Forecasts Quarterly.

• Money Morning:
  The Week That Was: Team Bernanke and Interest Rates Have U.S. Economy Headed in the Wrong Direction.

• Money Morning:
  An Optimist Jobs Report Grants the Fed Some Breathing Room.

• Bloomberg:
  U.S. Economy: Confidence Drops More Than Predicted

PepsiCo Inc. (PEP) ended its third quarter with big numbers – a 17% gain in net income, a 19% increase in earnings per share, and an 11% gain in revenue – largely because of its continually growing international presence.

The global beverage-and-food company has been ramping up operations in China, where Pepsi’s risky color change is gaining ground in its Olympic-sized cola war with Coca-Cola (KO).

Pepsi’s four main divisions all posted net revenue growth: Frito-Lay North America was up 6%, PepsiCo Beverages North America up 3%, Quaker Foods North America up 2%, and PepsiCo International up 22%, an impressive increase fueled by double-digit growth in China, Russia, Pakistan and the Middle East.

Overall, Pepsi reported net income for the quarter ended Sept. 8 of $1.74 billion, or $1.06 cents a share. That compares with net income of $1.49 billion, or 89 cents a share, for the comparable quarter a year ago.

And all this was accomplished even though the price of corn – a major ingredient of its soda and snacks – soared 21% this year on the Chicago Board of Exchange.

"Our third quarter performance was very strong, with double-digit revenue and operating profit growth," PepsiCo Chairman and CEO Indra Nooyi told the Wall Street Journal. "All of the company’s operating divisions successfully navigated through an environment of higher input costs in order to deliver balanced top- and bottom-line performance."

The Upside of the Falling Dollar

But underneath the numbers, the currency shift and diminishing value of the dollar has given Pepsi – and many other globally focused U.S. companies – a strong and steady tailwind. The dollar’s fall against currencies around the world is driving down the overseas prices of U.S. exports, and driving up export sales. That’s helped stabilize the U.S. manufacturing job base.

For Pepsi, "favorable foreign currency upsides allowed us to reinvest in several international markets in the quarter," Nooyi said in a company statement.

And the falling dollar opens many other doors for U.S. investors to profit. Not just riding the coattails of internationally moving American companies like Pepsi, Yum! Brands Inc. (YUM) and Exxon Mobil Corp. (XOM), but by investing in exchange traded funds (ETFs) and in foreign currencies gaining on the dollar.

News and Related Story Links:

• Money Morning Investment Analysis:
  Pepsi ‘Goes Red’ in China.

• Wall Street Journal:
  PepsiCo’s Net Climbs 16%.

• Money Morning Investment Analysis:
  Eleven Ways to Profit from the Falling U.S. Dollar.

Invest in the homebuilding sector at your own risk.

U.S. homebuilders such as D.R. Horton Inc. (DRI), KB Homes (KB) and Pulte Homes Inc. (PHM) capped the sector’s biggest two-day advance since August yesterday (Tuesday), thanks to a growing investor belief that the worst of the subprime-mortgage crisis has passed. On Monday – a day in which banking giants Citigroup Inc. (C) and UBS AG (UBS) released horrid third-quarter results – the Dow Jones Industrial Average surged to an all-time record above the 14,000 mark, ostensibly because investors believed the subprime mess and the accompanying global credit crisis was at least now largely defined.

But don’t you believe it.

Peter Bookvar, equity strategist at Miller Tabak, is thinking along similar lines.

"You don’t have a multi-year credit bubble that is over in a couple of months," Bookvar told MarketWatch.com yesterday. "Why the market thinks that is beyond me."

Market trading in the housing-and-finance-related sectors will prove us correct in the days and weeks to come.

The Fed-Fueled Crisis

This whole subprime mortgage crisis – as well as the global credit crunch that grew out of it – is part of a financial bubble or speculative mania, not unlike the "dot-bomb" crisis that derailed high-tech stocks back in 2000. Both of these bubbles grew out of the overly open monetary policies of the U.S. Federal Reserve, the same Fed that just cut interest rates by a greater-than-expected half a percentage point back on Sept. 18.

Right up to the eve of that policymaking Federal Open Market Committee (FOMC) meeting last month, Contrarian investors such as Jim Rogers were arguing that the central bank shouldn’t be cutting interest rates, but should actually be raising the benchmark Federal Funds Rate. I wasn’t quite so contrary: However, I did argue that the Fed should hold the line on interest rates, and that it shouldn’t be looking to bail out the hedge-fund and investment-bank speculators who knew what the risks were. Nor should it be helping to bail out mid-level European lenders who had absolutely no business speculating in subprime mortgages. I mean, why a German or French bank would want to invest in the debt that consumers with lousy credit were using to buy homes in marginally justifiable transactions – and in the United States, no less – is beyond me. They deserve what they got, and don’t rate a bailout.

But they got one, and that’s only going to prolong the pain U.S. investors are going to experience.

If you don’t believe me, just look at some past bubbles.

Bubbles, Bubbles, Toil and Troubles

During the big Internet frenzy, telecom companies (as well as many wannabes from other sectors) searched for ways to capitalize on this new medium for the masses. Scores of companies built high-speed communications networks, burying fiber-optic cable faster than Johnny Appleseed planted Golden Delicious apple trees. But the analogy is perhaps fitting, since most of those greed-fueled companies ended up eating their fiber-optic networks. Indeed, when the dot-com bubble burst and the end came, Merrill Lynch estimated that of the millions of miles of fiber-optic networks that had been built, 97.5% was "dark," or superfluous.

Thankfully, in the seven years since, such innovations as video-on-demand, streaming media, Internet Telephony, videoconferencing, and countless other inventions have helped the new landlords of those networks recoup their "pennies-on-the-dollar" purchase prices.

But tech-stock investors – especially those who were late to the party in the latter half of 1999 and the first few months of 2000 – haven’t been so fortunate.

The bellwether index of that period was the Nasdaq Composite Index, which peaked in March 2000 at 5,048.62. It’s not been back since, and won’t reach that peak far above us for years – and maybe not for decades.

[At yesterday's close of 2,747.11, the Nasdaq is down about 2,300 points - or 46% - from its all-time high. For comparison, consider the Great Crash of 1929, and the Great Depression that followed. In researching our book, Contrarian Investing, my co-author and I found that the Dow fell from a high of 381 on Sept. 3, 1929 to a July 1932 trough of 41 - a sickening decline of 89%. The Dow didn't eclipse its 1929 high again for good until November 1954 - nearly a full 25 years later. The situation here isn't nearly so dire. But this example demonstrates just how deeply a financial crisis can wound an economy.]

I’ve done a lot of research on speculative bubbles and financial manias, and I’ve found one thing to be true time and again through history. Whenever there is a speculative mania, it’s never confined to one asset class. A bubble owes its very life to the fact that it’s being fueled by cheap money or easy credit. And, as the bubble inflates, it creates more of the same. Soon there’s all this easy money sloshing about in the economy. Basic physics holds that water will find the easiest route to travel, and as the level of easy money rises, it overflows the confining banks of the conventional economy, and starts fueling bubbles in other areas – just as the tech-stock bubble of 1999-2000 helped fire off the housing bubble we’re suffering through today.

And the fallout from that bubble won’t just go away because the Fed cut interest rates once, or even twice, or because the chief executive officer of Citigroup says the banks disappointing third quarter has allowed the company to better visualize the better days to come. Here’s why.

Citigroup and the Two Views of ‘Normal.’

This is actually a two-part problem, right now: The housing market is in deep trouble – still – and the financial markets still haven’t fully factored in the problems that are still to come.

The reason investors sent homebuilding stocks on their two-day jaunt was – at least initially – fueled by a ratings upgrade by an analyst at (of all places) Citigroup, the banking heavyweight that on Monday announced that big writedowns would cause the third-quarter profits at the No. 1 U.S. bank to plunge by 60%.

The banking giant attributed the $1.4 billion pretax writeoff to lousy mortgage investments, deteriorations in the consumer-credit markets, and debt it got stuck with because of some corporate buyout deals that went bad.

Some Wall Streeters were calling for the head of Citigroup Chairman and CEO
Charles Prince. But yesterday, Citi’s "other" prince – Saudi Prince Alwaleed bin Talal Alsaud, the bank’s single-biggest investor – said he was backing the current management team, even with the third-quarter "hiccup."

Even so, top Wall Street banking analyst Richard X. Bove said investors misunderstood what the Citigroup CEO meant with his reference to a "return to a normal earnings environment this quarter." If Bove is correct, the outlook is much more dour than investors currently believe.

Investors thought Prince meant that Citi would return to the level of profitability they were anticipating before the subprime mortgage problem surfaced, Punk Zeigel’s Bove wrote in a note to clients. But what Prince really meant was that Citigroup and its peers are merely on a track to normal profitability, Bove wrote.

Bove took the unusual step of cutting his rating on Citigroup to "Sell" from "Market Perform," and lowered his price target to $43 from the prior target of $53, The Associated Press reported.

Then there’s the housing market…

Housing Bubble is Double Trouble

When I heard that homebuilder stocks were rallying, I first thought back to the fiber-optic debacle of 1999-2000. This isn’t exactly the same situation, since it’s not so much an overbuilding boom that we’re looking at here. But it is an "over-selling" boom. Overly low interest rates created overly accessible credit.

With interest rates at abnormally low levels thanks to the rate-cutting campaign former Fed Chairman Alan Greenspan engineered to short-circuit the Asian contagion and the implosion of the Long-Term Capital Management hedge fund (see all the trouble those hedge-fund bailouts can cause?), consumers with solid credit were able to qualify for and then buy a much-larger and much-more-expensive house than they could have afforded during more normalized periods.

Then there were the consumers with poor, or undocumented, credit ratings, which fueled the subprime-mortgage market.

In short, while we didn’t build too many houses during this bubble, we probably sold too many. Many deals just shouldn’t have been made.

And while experts claim they suddenly have a handle on how much subprime debt is out in the market – a contention I have a tough time believing – that’s far from being the only problem. Consumers who "stretched" a bit to buy a house on credit, or to buy a bigger house than they could afford, often resorted to "adjustable-rate mortgages, or ARMs. But these ARMs have an added, troublesome feature, a trigger known as "resets." The premise of a reset is simple: As interest rates rise, high-credit-risk borrowers with adjustable-rate mortgages are going to get clobbered.

Over the next few months, more than 2 million homeowners with subprime ARMs are looking at resets – and at much-higher interest rates – a reality that’s likely to deepen and lengthen an already-dismal housing downturn.

More than $50 billion in ARM loans will reset this month alone, a record for a single month, says Economy.com, an econometric firm based in West Chester, Penna.

Even the near-term numbers don’t look that good: Just yesterday (Tuesday), the National Association of Realtors reported that that the pending home sales index fell 6.5% in August after dropping a revised 10.7% in July. The index – a forward-looking gauge of home sales – is at its lowest point since it was created in 2001.
[For our full report on this story, please click here].

Pending home sales are down 21.5% from a year ago and 22% from six months ago, according to MarketWatch.com. Even worse: Economists had been expecting the index to drop only 2.5%.

"This is absolutely awful, confirming that the existing-homes market is now in a freefall,” Ian Shepherdson, chief U.S. economist for High Frequency Economics, wrote in a research report.

Go Global and Profit

If the U.S. housing market is going to continue to erode, so is consumer spending, which accounts for as much as 70% of all U.S. economic activity. Over the past decade, U.S. consumers have repeatedly reduced their savings from their wages until that ratio has actually turned negative. But consumers could spend more than they earned because their savings was being done for them – first by the stock market, and then by the real estate market. Indeed, some economists charge that consumers were using their homes as "virtual ATM machines," extracting cash for cars, vacations, home improvements, and other non-necessities. That’s helped fuel the U.S. economic advance of the past decade or more.

But if housing prices are skidding backward, that’s going to put a crimp in consumer spending. And that’s going to cause new homebuilding – and the overall economy – to slow dramatically for at least the next couple of years.
Some perennially bearish investors are speaking of an even worse scenario. In a recent interview with Bloomberg TV, noted short-seller David W. Tice says that this financial mess could lead to a 40% drop in the value of the Standard & Poor’s 500 Index sometime in the next 12 months. We doubt it will be that bad, but would still preach caution.

One other troublesome point that no one here in the U.S. financial markets seems to be talking about: The real estate market in Great Britain has been white hot, and is eerily reminiscent of the path the U.S. real estate market took right up until the housing market here crashed. Some experts – at least, those overseas – wonder if Great Britain isn’t going to be another United States, perhaps delayed by six months, eight months, or even a year.

It makes me wonder what kind of "subprime surprise" we’ll find was fuel of Great Britain’s housing bubble, and subsequent collapse.

It’s worth watching.

Investors who turn their attentions toward profit opportunities in the right markets overseas, as we have been advocating for some time, won’t see a decline in their investment returns [If you aren't a Money Morning subscriber, please click here to receive our 6,000 word investment report: The Three Best Investments in Asia Today. It's free of charge.]

But those who continue to play "yesterday’s investments" in the U.S. market run the very real risk of being left behind financially.

And none of us wants that to happen.

News and Related Story Links:

• Contrarian Investing, by Anthony M. Gallea and William Patalon III.
• Bloomberg News:
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• Money Morning Investment Analysis:
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• Bloomberg News:
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• Money Morning News:
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• Money Morning Investment Analysis:
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• CNNMoney.com:
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• CNNMoney.com:
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• Money Morning News:
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• CNNMoney.com:
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• Money Morning Investment Analysis:
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• Bloomberg News:
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• MarketWatch.com:
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• MarketWatch.com:
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• The Associated Press:
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• Money Morning Investment Analysis:
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• Money Morning News Analysis:
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• Bloomberg News:
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• Wikipedia:
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• Wikipedia:
  Contrarian Investing.

• Finfacts Ireland: Fifth Anniversary:
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The U.S. Commerce Department reported Friday that consumer spending rose more than forecast in the month of August. The 0.6% increase was the biggest in four months, according to Bloomberg News. It is good news that suggests the U.S. consumer has so far been undeterred by the credit crunch and housing slump.

Adjusted for inflation spending jumped 0.6%, after a 0.3% gain the month before. Inflation-adjusted spending on durable goods such as furniture and automobiles rose 2.8%.

The Federal Reserve’s preferred measure of inflation, which excludes food and energy costs, also showed positive signs in August. It increased 0.1% for the sixth consecutive month. It has rose 1.8% from a year ago, the smallest increase ]since February 2004. The Fed has said it prefers inflation to stay between 1% and 2%.

Also, according to the Commerce Department, construction spending made an unexpected jump, led by factories, hotels, and offices. The National Association of Purchasing Management-Chicago’s index of business activity picked up as well. The index rose to 54.2 in September, beating the 53.8 registered in August.