1. Economic Review and Outlook October 2009 Muwabi

2. Table of Contents Introduction Demographics Markets Real Estate Employment GDP Credit/Deflation Government Response Leading Indicators Conclusion

3. I. Introduction Muwabi

4. Introduction Thanks for taking the time to read this presentation. As many economists predict an end to the recession and contemplate recovery, it is important to step back and examine every area of the economy to assess these claims. In the worst recession since the Great Depression, a fundamental understanding of the economy and how to thrive under any market condition is essential for households, businesses, government, and investors. I believe there are many errors being circulated in diagnosing the causes of this economic environment, implementing solutions, and forecasting future economic results. We’ve experienced the hazards of blindly delegating to the wisdom of economists, government, and financial institutions without giving second thought to alternative possibilities. This economic review and outlook attempts to provide a consolidated view of every aspect needed to make intelligent financial decisions at the present time. While there are certainly more factors worth exploring, I found these to be the best representation of explaining this country’s current economic condition. All data in this presentation is available from public sources. Forecasts, extrapolations, interpretations, and commentary are provided with each data set and represent the conclusions of the author and Muwabi Forum. As data and indicators change, the author reserves the right to update or change conclusions and insights. Please lend your support to Muwabi’s mission of increasing public awareness and providing for the common economic good. My intention is to invoke thought and discussion, while developing an ongoing relationship with the Muwabi community in these matters. I look forward to any comments and feedback! Dan Perry

5. II. Demographics Muwabi

6. Demographics It is no coincidence that demographics reached a favorable point as history’s greatest bull market began. Population statistics were dense in middle ages, with the greatest concentration in the middle 30s age group. Households in this age group typically have rising incomes, with increased spending on their families. Home and car upgrades are consistent with trends in this age group.

7. Demographics Demographics played a major role in the credit and housing expansion during the 2000s. There was heavy concentration in the 40-55 age group, which is typically consistent with peak income and spending. Households are also on their second or third home upgrade by this time. Japan experienced a similar boom in the 1980s when their age demographics exhibited similar patterns.

8. Demographics Baby Boomers reach retirement age in mass quantities during the 2010 decade. During these ages, spending typically decreases and housing activity moves toward the downsizing phase. Productivity will be lost in the labor markets, as more workers will be required to support retirees. Government will find it difficult to cover Social Security and Medicare expenses with such a substantial elderly population.

10. Exasperating this trend are the low savings of many facing retirement during the next few years. With retirement accounts below expectations and housing prices on the decline, many Boomers will be entering retirement in dire financial situations. It is unreasonable to expect their consumption habits to continue.

12. Markets: Equity Without looking at this graph through the lens of time, we see the S&P 500 historically moved in similar directions to the dollar’s value. The orange line indicates a divergence from this pattern, where stock movements almost perfectly correlate to the inverse of the dollar’s value. With money supply expanding so rapidly, the dollar has lost significant stability and has now become the main indicator of asset prices. Observe days when the dollar strengthens relative to other currency and stocks almost always decline. In the March-present rally the dollar has been rapidly sinking, sending asset to an even more rapid appreciation.

13. Markets: Equity S&P 500 in $ S&P 500 in € Another view of the dollar’s impact on stocks compares the S&P 500 growth to its growth in Euros. The big boom in stocks from 2003-2007 is marginalized in real terms. While the decline over the last two years was still substantial, it was much less dramatic when viewed in Euros. The current 50% appreciation in stock prices are almost completely explained by a declining dollar. Currency fluctuation and instability has become the most important determinant of asset performance.

14. Markets: Equity Sector Stocks vs Employment Employment news has been disastrous across almost all sectors during this recession, although show signs of improvement since March. On the contrary, stocks have exploded since bottoming this March. When comparing stock gains to the industry’s overall health, it makes them appear grossly overvalued. Many of these industries are still deteriorating but have managed stock gains in excess of 50%.

15. Markets: Equity The thesis of the current market upturn being a bear market rally is supported by historical examples. During the two biggest deflationary episodes in recent history, there were several major stock market rallies despite general weakness across the larger span of these recessions. Considering the strong parallels in causes and symptoms between the current recession and these events, it’s likely we’ll see major market fluctuations and a W shaped stock market for many years.

16. Markets: Bonds Despite a record setting stock rally, investors are still displaying an increasing appetite for risk. The spread between 10 Year Treasuries and Baa corporate bonds peaked around March’s stock market bottom, indicating a low tolerance for risky assets at the time. Slowly this spread has decreased but currently stands far away from 2007’s levels when the S&P 500 hit record prices. This indicates a possible continuance of stock appreciation until the spread begins increasing again.

17. Markets: Commodities Gold has historically been viewed as a hedge against economic uncertainty and has thus been inversely correlated to stock performance. In an unstable dollar environment, gold and equities have had identical price movements.

18. Market: Commodities Historically, oil price appreciation has been a strong indicator of economic weakness. It would be irrational for oil prices to rise at the same time as companies with high transportation and fuel costs. Like gold, however, oil and equity have moved higher during times of dollar weakness. The dollar has been driving asset prices of all types and defying normal market behavior. Forecasting any future investment direction starts with the movement of the dollar.

20. There is still a noticeably high risk tolerance among investors. Bear market rallies have lasted longer than the current seven month version and will probably continue slightly higher. Once government actions begin slowing down and corporate debt defaults cause rate appreciation, the absence of positive economic data will most likely force asset prices down and send investors fleeing back to the dollar’s safety. The timetable is difficult to predict but will most likely occur if economic weakness persists.

22. Real Estate Throughout American history, homeowners have relied on ownership more than mortgages. With diminished lending standards and the recent popularity of HELOCs, home equity has shrunk to its current rate of 44%. Meanwhile, total real estate has grown at incredible rates, representing an unsustainable pattern requiring a lengthy correction process.

23. Real Estate Homeownership rate has always been around 63-65%. During the housing bubble, lax lending standards allowed many people to own homes that ordinarily wouldn’t qualify for mortgages. While this rate has decreased after the bubble’s collapse, we still remain at levels far above average.

24. Real Estate The West experienced the biggest housing boom and is now being hardest hit by the market downturn. Florida was significantly impacted by the real estate crash but the rest of the Southern region escaped a major impact. These regions are struggling with high unemployment, as almost all states are above 10%. These states may hit bottom sooner after experiencing such a sharp downturn. Recovery is a distant thought, however, with such substantial inventory outstanding.

25. Real Estate Both the Midwest and Northeast experienced the highs and lows of the housing bubble, but less severely than the most troubled areas of other regions. High unemployment persists in many of these states, with Michigan and Ohio in outright depression. Inventory is historically high in the Midwest, insuring a long road to recovery. Inventory is much more manageable in the Northeast, indicating price stabilization much sooner than other regions.

26. Real Estate Commercial real estate is the Fed’s biggest worry and rightfully so. The expansion in office buildings, strip malls, retail outlets, hotels, condo buildings, and almost every other form of development reached its maximum. The current high levels of vacancy are not a byproduct of decreasing demand but overexpansion and overcapacity. CRE is just now becoming a major economic problem and should persist as leases continue coming up for renewal (where tenants will almost certainly demand lower rent) or tenants default. Either way, most developers will lose significant money on already over-leveraged projects. This cannot bode well for regional banks with heavy commercial loan exposure.

27. Real Estate Additional signs of trouble are all over the place, guaranteeing the bottom in foreclosures and prices are probably still years away… “Option Mortages To Explode, Officials Warn” Reuters by Lisa Lambert Thu Sept 17, 2009 The federal government and states are girding themselves for the next foreclosure crisis in the country's housing downturn: payment option adjustable rate mortgages that are beginning to reset. "Payment option ARMs are about to explode," Iowa Attorney General Tom Miller said after a Thursday meeting with members of President Barack Obama's administration to discuss ways to combat mortgage scams. "That's the next round of potential foreclosures in our country," he said… Because the new monthly payments can be five or 10 times what borrowers are accustomed to paying, they "threaten a much greater hit to the consumer than the subprimes," Goddard said, referring to the mortgages often extended to less credit-worthy U.S. Foreclosure Filings Jump 23% to Record in Third Quarter Bloomberg by Dan Levy Oct 15, 2009 A total of 937,840 homes received a default or auction notice or were repossessed by banks, a 23 percent increase from a year earlier, the Irvine, California-based seller of default data said today in a report. One out of every 136 U.S. households received a filing, the highest quarterly rate in records dating to January 2005. “The problem is prime loans going into foreclosure and people being underwater and losing their jobs,” Richard Green, director of the Lusk Center for Real Estate at the University of Southern California in Los Angeles, said in an interview. “It’s a really bad number.” Mounting foreclosures mean U.S. home prices probably will resume falling, analysts from Amherst Securities Group LP in New York said Sept. 23. A “shadow inventory” of 7 million properties are in the foreclosure process or likely to be seized, up from 1.27 million in 2005, they said. “Underwater’ Mortgages to Hit 48%, Deutsche Bank Says” Bloomberg by Jody Shenn Aug 5, 2009 Almost half of U.S. homeowners with a mortgage are likely to owe more than their properties are worth before the housing recession ends, Deutsche Bank AG said. The percentage of “underwater” loans may rise to 48 percent, or 25 million homes, as prices drop through the first quarter of 2011, Karen Weaver and Ying Shen, analysts in New York at Deutsche Bank, wrote in a report today. As of March 31, the share of homes mortgaged for more than their value was 26 percent, or about 14 million properties, according to Deutsche Bank. Further deterioration will depress consumer spending and boost defaults by borrowers who face unemployment, divorce, disability or other financial challenges, the securitization analysts said. “Borrowers may also ‘ruthlessly’ or strategically default even without such life events,” they wrote. Housing Crash to Resume on 7 Million Foreclosures, Amherst Says Bloomberg by Jody Shenn Sept 23, 2009 The “huge shadow inventory,” reflecting mortgages already being foreclosed upon or now delinquent and likely to be, compares with 1.27 million in 2005, the analysts led by Laurie Goodman wrote today in a report. Assuming no other homes are on the market, it would take 1.35 years to sell the properties based on the current pace of existing-home sales, they said. Helping to stoke speculation the housing slump has ended, an S&P/Case-Shiller index for 20 U.S. metropolitan areas showed the first month-over-month increases in values since 2006 in May and June, reducing the drop from the peak to 31 percent. Echoing other mortgage-bond analysts including those at Barclays Capital Inc., Amherst cautioned that a change in the mix of foreclosure and traditional sales over different parts of the year lifted prices in the period, as the distressed share shrank. “The favorable seasonals will disappear over the coming months, and the reality of a 7 million-unit housing overhang is likely to set in,” they said.

29. Real estate was a major cause of this crisis and will ultimately lead the economy to recovery. Despite Fed efforts, the majority of current activity is from first time buyers exercising federal tax credits, investors, and low-end downsizing.

31. Unemployment U6 unemployment is shown here and represents a better indicator of economic health than typical unemployment. U6 measures the rate of people fully unemployed, underemployed, or having given up looking for a job. This rate is currently at 17% and climbing, representing depression level statistics.

34. GDP The following chart breaks down the various components of GDP. Consumption has not decreased as much as most people assume but will probably be trending downward for a significant period of time. Investment has been hit hardest as businesses have focused on cost cutting rather than making significant capital purchases or maintaining inventories. The complete inactivity of this sector guarantees short term growth in the near future. Both imports and exports have recently decreased although both should recover as the global economy emerges from stagnation. Federal government spending increases have been offset by cuts in state and local budgets. This trend will likely continue for several years.

35. GDP Although consumption will almost certainly decrease in the coming quarters, it doesn’t guarantee further recession despite comprising 70% of U.S. GDP. Over the last few quarters, consumption has only been a minor factor in GDP declines. Businesses will need to restock depleted inventories at some stage, while the dollar’s decline should boost exports. The government has displayed a willingness to increase spending despite record deficits. These events should keep GDP positive for several quarters but expectations are for a double or triple dip recession. The absence of consumption growth is simply too much to overcome in the intermediate term.

38. Credit/Deflation CPI went negative year over year for the first time since the 1950s. After an explosion in prices and basic living expenses, prices appear destined to decrease toward more sustainable levels. In the absence of peak credit conditions, household demand has diminished and forced both asset value declines and a more favorable consumer price environment. In the absence of 2006 level consumption, expectations are for CPI levels to remain depressed for several years.

39. Credit/Deflation CPI would have been significantly higher over the past 20 years if the Case Shiller housing index were substituted for Owner’s Equivalent Rent (which comprises about 25% of CPI). Likewise, CPI would be significantly lower after the housing bubble collapsed. This graph illustrates how OER has not considered the dramatic rise and fall of actual home prices. Considering housing is a household’s largest expenditure, CPI has been understated until 2007 and is now being overstated relative to economic realities.

40. Credit/Deflation The savings rate dipped to zero at the height of the bubble, reflecting an overleveraged society in an environment of unsustainable living expenses. While savings rate has increased, it still hasn’t passed the modern era’s average of 7%. Expectations are for the savings rate to settle at an above average rate as consumers pay down debt, catch up on underfunded retirement accounts, and embrace frugality trends. A higher savings rate ensures the last decade was a period of peak consumption and thus peak earnings for many businesses.

41. Credit/ Deflation Household net worth began growing at unprecedented rates in the 1980s and exploded from 2003-2007. During both of the last asset bubbles, net worth grew 20% faster than disposable income as evidenced by the spikes in this chart’s line. This ratio has fallen back to historical norms, indicating the economy has reached a more sustainable equilibrium. Any recovery would require income to accompany the growth in asset prices (stocks).

42. Credit/Deflation Difficulties in subprime lending were enough to cause a near systemic collapse. Since then, delinquency and defaults have been skyrocketing in virtually every loan type. Credit cards, prime mortgages, and commercial real estate have been the latest troubled loan types and show no sign of slowing down. We’ve already seen almost 100 bank failures in 2009 and an astounding number on the FDIC’s troubled list. These types of losses are bound to indefinitely plague the banks with most adverse exposure including Wells Fargo, Bank of America, and Citigroup. Without favorable accounting rules and windfall investment profits, it’d be difficult to prove the solvency of these institutions.

43. Credit/ Deflation Since 1992, we’ve seen an explosion in consumer credit outstanding. It’s unreasonable to think income came close to keeping pace with the 7.5% annual credit expansion. The trend line represents substantial growth but at a reasonable rate consistent with income growth. At the current run rate of 4.5% annual credit contraction, it will take almost a full decade to reach the sustainable trend line. With credit contracting at this rate, a credit based economy has little chance of a V shaped recovery anytime soon.

44. Credit/Deflation Securitized loans represented a large portion of this credit growth and gave banks incentive to supply loans even when risk may have dictated otherwise. Despite significant Fed intervention, the securitization market remains depressed. With banks dealing with troubled balance sheets of their own, credit cannot grow until this market unfreezes. With a moral hazard in underwriting standards, untrustworthy credit ratings, and a troubled environment, this will probably lag any economic progress elsewhere.

45. Credit/Deflation While the mainstream has been frequently warning of inflation, the Treasury market is indicating expectations of deflation. Treasury rates are already historically low but still appear on a downward trajectory. Even long term Treasuries are not skyrocketing despite quantitative easing and record deficits.

46. Credit/Deflation Cash For Clunkers was widely reported as a success, but really only moved demand forward. A month later, almost every brand is far below results from last year (22.7% total). Weakness is likely to continue, as most people intending to purchase a car would have done so during this period of free government incentives. Similar government programs like the first-time homebuyer credit are destined for the same type of results.

48. In a credit driven economy, a V shaped recovery is highly unlikely until lending approaches normal activity. Banks are unlikely to supply new loans due to high unemployment and troubles with their own balance sheet. Consumers already have debt trouble and are no longer the credit seeking force they once were. Without credit, regular consumption and asset purchase decline will lead to lower prices across the board.

50. Government Response It’s no secret that banks have increased loss reserves and significantly reduced lending activity. Despite the numerous Fed liquidity programs, banks have been reluctant to move this money into the open market. This chart shows just how excessive this reserve growth has become. This is a good indicator into bank’s expectations of future losses and making the conscious decision to protect their balance sheets.

51. Government Response National debt has reached levels appropriate for concern. All the current deficit spending represents future tax liabilities and lost economic productivity. As debt eclipses GDP and beyond, capacity to handle this debt will decrease. Recent projections have national debt reaching $25 trillion by 2020. This does not include obligations to Social Security, Medicare, and government pensions. The government’s capacity to support the economy will diminish at some point.

54. Leading Indicators M2 (liquid money supply) has grown at a more reasonable rate than most aspects of the economy over the last 20 years. M2 can be considered a major leading indicator because it represents cash available for consumption and investment. Magnifying the most recent time period, we see M2 has flattened over the last year compared to previous times. Considering how much money is being printed by the Federal Reserve, it demonstrates how it has yet to reach the market for possible consumption.

55. Leading Indicators Consumer sentiment has been weak throughout this long recession but has improved lately. The current level is now consistent with the average sentiment less than 3 months before past recessions have ended. While consensus is for GDP to grow before year’s end, consumer sentiment has no correlation with asset prices, employment, or credit conditions.

56. Leading Indicators Industrial capacity utilization has historically been the best indicator of entering and exiting recessions. The orange trend line represents the beginning of past recessions and the green line represents the recession’s end. The recession end has almost always coincided with the bottom of capacity utilization for that cycle. With current utilization now increasing several months in a row, the data is indicating an end to the recession in 3Q 2009.

57. Leading Indicators Construction activity remains at some of history’s lowest levels. The sparse activity taking place in the construction industry has been largely due to government incentives and spending. Considering the overcapacity and excess inventory in today’s market, these numbers will probably remain depressed for a long time.

58. Leading Indicators Initial Unemployment claims appear to be on a decreasing trend but are still at incredibly high levels and guaranteed to contribute to even higher unemployment rates. The current recession has far eclipsed the average claims of past recessions and is nowhere close to non-recession averages.

59. Leading Indicators Manufacturing was never an economic strong point even during the peaks of the past decade. Nonetheless, this recession still managed to be particularly brutal to this sector of the economy. Recent months show positive trends in new orders, however, at this rate it will take several years to regain a healthy position consistent with the trend line.

61. Stock prices have been publicized as a prominent leading indicator but their use in today’s situation is less applicable than past recessions. Stock growth has outpaced PE ratios, revenue growth, and executive’s own forecasts on the state of their own company. Considering the dollar has been the primary driver of stock prices, their forecasting potential is limited.

63. Conclusion While my economic outlook is generally negative, there have been various signs of economic life and possible optimism. Unfortunately this may be short lived, as any recovery will result in interest rate hikes and potential tax increases. The reality is the global economy still has significant unwinding of its excesses before recovery is on the horizon. Regardless of this analysis, there is a wide variety of economic opinions and all deserve proper consideration. While the views expressed here are mine, there are plenty of other great ideas worthy of discussion. The conclusion I hope all readers can appreciate is to continue questioning common assumptions. Individuals will always do best to consider various options but ultimately trust their own instincts. Muwabi will continue refreshing this economic outlook and providing additional resources on a daily basis. Thanks for visiting and please come back again.

64. About Muwabi Muwabi was created in May 2008 as a forum for economic and political discussion. Its creator and administrator, Dan Perry, is a member of the financial services community with an interest in promoting greater economic literacy and providing the public with a service for better economic decision making. While the site is only in its infant stages, there are additional plans to improve content, design, and services offered. A news database, expert commentary, research services, economic consulting, and asset management tools are some of the ideas for further development. If you are interested in contributing, providing feedback, or partnering with this effort, please contact me at any time. Thanks! Dan Perry danperry@muwabi.com (708) 257-3128