When Will The U.S. Economy and Stock Market Bottom and Recover? (2008)

With all the bad economic news lately, people have been asking me, "when will the U.S. economy recover?" But the real question should be "when will the housing market recover?" Without the stabilization of the housing market, the probability of a sustained economic recovery within the next 6-12 months is almost zero. Why? First we need to understand how we got to this point in the first place. Then we can examine how the economy can fully recover and what we can do to prepare for this deep consumer-driven recession.

You've heard it all in the media - easy credit, reckless lending, and greed have created the biggest housing bubble ever in the U.S. Basically people have bought homes that they couldn't afford. Certainly there is plenty of blame to go around for this mess - whether it's lender fraud, the greedy buyer, or lack of government oversight, it really doesn't matter at this point because the damage has been done. But one thing is for certain - many ARMs have already reset and millions of people can't afford their bloated mortgages anymore that have led to an unprecedented amount of foreclosures. Because of these foreclosures, banks are stuck with so much bad debt that they are still trying to write it off today. At this juncture, financial institutions are having a difficult time raising sufficient capital to operate their businesses and servicing their debt. Eventually, the banks have no choice but to file for bankruptcy and restructure. This of course leads to huge job losses that could only mean one thing - dramatic decrease of consumer activity. This, in a nutshell, is causing havoc in our fragile economy today.

Because of the massive amount of homes being built all around the country especially in California and Florida, millions of jobs have been created that shouldn't have been created in the first place like mortgage lenders, appraisers, real estate agents, investment bankers, construction workers, home improvement retailers, financial-related jobs, etc. And because home values were doubling within 2-3 years, people were borrowing money against their erroneous home values and bought even more stuff that contributed to our "economic growth." But in reality, a healthy economy cannot grow when people buy goods with mostly debt. So in other words, we have lived in a fake economy for the past 8-10 years and it's going to take many years to unwind.

Sadly, all the jobs that have been created by the housing bubble will be wiped out and then some. There is nowhere to hide as far as job security because almost every industry will be affected. These are unprecedented times and even "safe" government workers at the state and county level are on shaky grounds due to a huge decrease of tax revenue. At the state level, consumers are spending less and may lose their jobs. This translates to less sales and income tax collected by the state. On the county level, property tax revenue will be dramatically lower due to massive amount of foreclosures. Jobs will be scarce at least for 2009.

Without the housing market recovering, financial institutions like consumer banks and investment banks cannot recover. These banks like Wells Fargo, Bank of America, and Morgan Stanley are still writing off huge amount of bad debt and it ain't over yet. Why? Because there are millions of ARMs that are scheduled to reset for the next several years which will trigger the next wave of foreclosures. Yes, it's this bad! Banks cannot survive like this and will fail perhaps in the thousand range when it's all said and done. At the time of this writing, there has been 22 failed banks in 2008, including 3 more banks seized by FDIC just this past weekend. Oh, have I mentioned the $300B Citigroup bailout?? I see bank failures accelerating in the near future.

So what happens now? The way I see it, I think we will see even more job losses in 2009 especially if the automakers and its suppliers fail, which I think is very likely with or without the $25B bailout. Unemployment rate will be close to 10%. We will experience a period of deflation where prices for all goods including gas, food, housing, cars, TVs, and even school tuition come down. Demand simply will not be there. Consumers have no more confidence since they are constantly worrying about their jobs. Easy access to the housing ATM and multiple high-limit credit cards are a thing of the past. And quite frankly, the American people will begin to learn how to save again and be frugal. Of course this can't be good for the economy if consumers are not spending, but this behavioral change will be the first step towards an economic recovery for the long term.

When will the economy recover? Well, as I mentioned, the economy will see bottom when the housing crisis recovers. How? Housing recovers once the median home prices fall to 3-4x median income or pre-2000 levels. Are we there yet? Not quite. Some Bay Area home prices are still at nosebleed levels even with 20-40% drop from the peak. Keep in mind that in a deflationary environment, wages will fall too. That means home prices will need to fall even more to adjust to lower incomes. I don't see home prices bottoming for another year or two.

Once the economy has bottomed, we'll see a L-shape recovery and experience a Japan-like recession that could last up to 10 years. Japan has already experienced a painfully long recession called the "Lost Decade" in the 90's caused by a housing and stock market bust. Sound familiar? Sadly, it's our turn now.

Will the stock market recover in 2009? The stock market typically recovers 6-9 months before the actual economy recovering. The market is always forward-looking. So if you believe that the economy will rebound in the second half of 2009, then buy now. But I think the stock market will fall substantially lower from here (DOW 8,443, S&P 851, Nasdaq 1472) and throughout 2009. With GM and other banks on the brink of collapse, many more non-financial businesses closing, severe housing market correction, frozen credit market, high unemployment rate, I don't see any catalyst for an economic turnaround anytime soon. This means the stock market has nowhere to go but down.

What should we do to prepare for this deep economic downturn? Since the mortgage is the biggest operating expense for most families, revisit your housing situation and decide if it still makes sense for you to own your home especially if you are upside-down. Figure out if you can truly afford your mortgage (33% debt-to-income ratio). If you find that you cannot afford your mortgage and is causing too much stress on the family finances, then consider selling the property (even at a loss) and then rent for a period of time. This is no time to be a hero, as things will get a lot worse before it gets better. House prices will be even lower next year and will continue to go lower until prices are inline with income in your area. Again, this price correction could take a few more years. Just to give you an idea, if home prices fall 50% from the peak, it will take at least 15-25 years to recover those losses (assuming normal 3-5% growth rate).

Other tips to consider during recessionary times: raise cash by saving even more money, buy things you can truly afford, and stay out of the stock market. As I mentioned at the beginning of the year on "How to invest in 2008?": protect your investments and retirement accounts by staying in cash or short-term U.S. Treasuries. There is still absolutely no reason to buy stocks and mutual funds in the U.S. and abroad at least for the next 6-9 months. Yes, things look really bad now, but the economy will turnaround. Just not next year.

What do you think about the economy/stock market and where it's headed? Let me know your thoughts!

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