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Navigating the Next Recession Part Three

The Grimaldi Forecasts

To build credibility regarding my forecast of the next recession, below I provide excerpts from a number of articles I wrote before and after the Great Recession. As you’ll see, I had begun to see the cracks developing in the U.S. economy as early as January 2008. I hope you’ll read these excerpts because they were written in real-time, without the benefit of hindsight. My commentary below each excerpt will show you that my forecasts about what the so-called Great Recession would look like were pretty accurate. Seeing that, I believe you’ll listen more carefully to my advice on how to best navigate the next recession.

January 2008 Navigator Newsletters

From the Crow’s Nest: “Looking Over the Bow”

“What’s in store for 2008?” I wrote in this newsletter article. “The first half of 2008 will be a continuation of the conditions that dominated the second half of 2007: housing woes, credit crunch, lower interest rates, inflation concerns, and market volatility.”

Navigator outlook #1: Home prices continue to drop. The government bailout plan backfires.  

I wrote, “Credit is going to be hard to get, and this will decrease the number of eligible homebuyers that are in the market. Fewer buyers will mean less demand, which, in turn, will equate to lower purchase offers.”

Looking back, here’s why I was right: Later that year, in a December 1, 2008, press release, Freddie Mac announced, “Conventional Mortgage Home Price Index Purchase-Only Series registered a 7.3 percent annualized decline in U.S. house prices during the third quarter of 2008.” This followed a downward revised 0.9 percent annualized drop in the second quarter. And, the median U.S. home value dropped from $232,400 to $208,600 between January 2008 and January 2009.”

Navigator outlook #2: The Federal Open Market Committee (FOMC) reduces interest rates in the face of growing inflation.

Looking back, the FOMC dropped the discount interest rate a total of 4.0 percent in 2008. A Federal Reserve press release on December 16, 2008, stated, “Since the committee’s last meeting, labor market conditions have deteriorated, and the available data indicated that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.”

Navigator outlook #3: A recession begins in the middle of the year.

I wrote, “If the Fed cuts too much and too soon, it could stimulate an already bubbling inflation pot. This would almost ensure a recession.”

Looking back, a December 23, 2008, press release from The Bureau of Economic Analysis, which stated that real gross domestic product (GDP) “decreased at an annual rate of –0.5 percent in the third quarter of 2008.” We now know a recession started in December of 2007.

Navigator outlook #4: 401(k) contributions will drop.

I wrote, “Even in the wake of the new law requiring all employees of companies with ERISA regulated 401(k) plans to be automatically enrolled into the plan, I foresee cuts in retirement plan contributions. …  The “Smiths” are going to find their budgets even tighter in 2008. Water always finds its own level, and the reservoir will be dangerously low; people will look for ways to cut expenses. 401(k) contributions will be viewed as “overhead,” and the “Smiths” will view 401(k) contributions as non-essential.”

Looking back, this prediction had clearly come true by June 18, 2008, when Christine Dugas wrote in an article in USA Today that Americans who are struggling to stave off eviction or foreclosure were raiding their 401(k) retirement accounts to pay their bills. An estimated 3.1 percent of participants stopped contributing to their employer’s plan in 2008 below the pre-recession level in 2006, when 2.5 percent of participants stopped contributing to their employer’s plan.

Navigator outlook #5: At least one major financial company files for bankruptcy protection, and the CEO is unfairly held responsible.

Looking back, my outlook was proven true when Lehman Brothers—the primary dealer in the U.S. Treasury securities market—filed for bankruptcy protection on September 15, 2008. The filing of Lehman Brothers—which had regional headquarters in London and Tokyo, as well as offices located throughout the world—was the largest bankruptcy in U.S. history.

Navigator outlook #6: Gold continues to soar.

I wrote, “You could see $1,000 per ounce by midyear.”

Looking back, at the end of 2007 gold closed at $833.75 per ounce. The precious metal reached $1,000 per ounce on May 14, 2008. That is in increase of 19.94 percent in less than five months.

Other predictions I made in this newsletter article are as follows:

 “Expect several very good buying days (a drop of 2% or more) during the first quarter of 2008.” There were nine of these days in January.

“Famously, the Fed sat on its hands heading into the 1992 and 2000 elections … which means the Fed needs to act early and often at the beginning of the year.” The Fed’s emergency cut of 75 basis points on January 22, 2008, lowered the federal funds rate to 3.5 percent. Another 50-basis-point cut to 3.0 percent followed on January 30, 2008.

“If we find ourselves in an economy where inflation is over 3.5 percent and the federal funds rate is under 3.5 percent, a recession is almost inevitable.” At the time, annualized core inflation was 4.08 percent, and subsequent data would show we were already in the Great Recession.

February 2008 Navigator Newsletters
From the Crow’s Nest: “Warning Shots”

In this article, I wrote that “I believe the worst is yet to come,” and explained that it is “because unlike many other corrections (1987, 1997, 1998, 2001, and 2002), this time all American homeowners have their biggest assets on the table, their houses.”

“Many Americans,” I wrote, “are still suffering from ‘not here-itis.’ I talk to subscribers all over the country, and almost every one says the same thing when it comes to real estate: ‘The market is bad, but not here.’”

“Let me tell you something: Other than some remote areas of the country, everyone has been hit hard. If you have not been hit, then you probably did not participate in the boom in the first place. Over the last 10 years, billions of dollars of home equity loans were taken on houses. Every time you pull money out of your house, you just repurchased it for a higher price. Now, the prices are dropping and teaser rates are resettling. To editorialize, the government plan is a drop in the bucket to fix the problem because it will help some people keep their homes, but it will not create new buyers.”

Today, more than five years later, the housing market has still not recovered.

March 2008 Navigator Newsletters
From the Crow’s Nest: “No H.E.L.P. on the Horizon”

“I think a topic yet to see the media spotlight is Home Equity Loan Period (HELP),” I wrote in this article. “This is a stipulation in most of the $9.7 trillion worth of home-equity loans that were outstanding in this country at the end of 2006.”

“What is a ‘loan period?’ As stated by the U.S. Federal Reserve Board (Fed), many home-equity plans set a fixed period during which you can borrow/draw money, such as 10 years. At the end of this draw period, you may be allowed to renew the credit line. If your plan does not allow renewals, you will not be able to borrow additional money once the period has ended. Some plans may call for payment in full of any outstanding balance at the end of the period. Others may allow repayment over a fixed period (the repayment period)—for example 10 years.”

“Let’s dissect this. HELP is the length of time that a home-equity loan or line of credit will allow withdrawals. After the draw period is over, the line of credit is withdrawn. The Fed is correct in stating that a new line of credit can be established. However, remember that in order to do that, there must be at least 20 percent equity in your home (equity being the difference between the current value of your home and the current debt you owe on it). If an individual wants to re-establish a line of credit, there is a high likelihood that the equity was maxed out on the prior line of credit. My guess is there will not be enough equity in the home to qualify for another line of credit. In other words, no HELP is on the way. Equity is created in two ways: either by reducing the principal debt of the property or by the property increasing in value. Conversely, equity can be reduced in two ways: either by increasing the amount of debt on the property (tapping into the line of credit) or by the value of the home decreasing. Nationally, home prices are suffering the biggest decline on record.”

“When the end of the draw period is reached, one of two things will happen. Either a one-time balloon payment will be required or the bank will amortize the loan for a period of 10 to 15 years. Either way, the house ATM is closed and now it is time to repay all that equity and interest. Some people will be able to make the payments, some will not. Some will lose their homes, some will not. Some will try to refinance again, some will apply for a reverse mortgage.  Many will stay afloat, some will not. For most of the United States, HELP is not on the way.”

Looking back, we all know what happened. Low interest rates—designed to spur economists and market growth after the dot-com bust—sent Americans on a shopping spree. Everyone was a real-estate investor, and everyone could afford it, thanks to the new mortgage products offered by banks who were willing to overlook the ordinary due diligence measures. But it was unsustainable. National home sales and prices both fell dramatically in March of 2007. Home sales were down 13 percent to 482,000 from the peak of 554,000 in March 2006. The national median home price was down  nearly 6 percent to $217,000 from the peak of $230,200 in July 2006. The plunge was the steepest since 1989. Economist Nouriel Roubini warned that the housing sector was in “free fall” and would derail the rest of the economy, causing a recession in 2007. He was a couple years too early, but he was right.

June 2008 Navigator Newsletters
From the Crow’s Nest: “Navigating without a Compass”

In this article, I offered “a couple of thoughts about the ‘recession’ we may be in or are about to enter.”

“I called for a 70 percent chance of a recession to start in the middle of 2008. I have not changed my forecast. In fact, using ‘government math,’ we are already in a recession,” I wrote.

I expanded as follows: “On May 15, 2008, the government reported that the Consumer Price Index (CPI) increase was only 0.2 percent in April and a moderate 3.9 percent for the year. Core CPI (which excludes food and energy) rose only 2.3 percent. As part of the reading, the government reported that gasoline prices dropped by 2.0 percent in April 2008. Yes, dropped by 2.0 percent!”

“Here’s government math in action. The average U.S. price for a gallon of regular gasoline was $3.28 on March 31, 2008. The same gallon would cost you $3.60 on April 30. That’s an increase of 9.75 percent. However, the government forecast was for gasoline to increase by more than that so according to the government, gasoline prices actually declined. You cannot make this stuff up.”

“So, using government math, we are already in a recession. Why? Gross domestic product (GDP) grew by 4.0 percent in the third quarter of 2007, then it dropped to a growth rate of only 0.6 percent in both the fourth quarter of 2007 and the first quarter of 2008. If the government were consistent with its math, we would be in a recession already.”   

“Why does the government want to keep CPI numbers in line? More than one third of the federal government’s budget consists of entitlements, the costs of which are adjusted based on a change in the CPI. Many readers will know these as Cost of Living Adjustments (COLA).”

In this article, I also explained what I called “government math in the private sector,” writing, “If, at this year’s holiday party, I announce that everybody is getting a 10 percent raise in 2014, that would make the Navigator team very happy. However, when they get their first checks in 2014, they see a raise of only 2.0 percent. On the pay stub is a disclaimer that says the 10 percent raise is on any day worked except Tuesday, Wednesday, Thursday, and Friday. So the 10 percent raise is in reality only 2.0 percent. “

Looking back, we were already in a recession. And, there was no COLA on Social Security benefits in 2010 and 2011—interesting.

November 2008 Navigator Newsletters
From the Crow’s Nest: “A Recession Starts Mid Year: The Credit Markets Could Freeze Up”

At this point, many Americans—though perhaps not all—knew we were in a financial crisis. Bear Stearns and Lehman Brothers had folded, and the credit crunch had begun. So I speculated how we got there, nothing that “there are five parties that caused this financial crisis.”

“Alan Greenspan,” I wrote, noting that “in an October 3, 2007, episode of 60 Minutes interview about the housing crisis, Leslie Stahl asked, ‘If you knew these practices were going on, or even maybe just suspected something illegal or shady, why didn’t you speak out? I mean you had a huge megaphone, people really listened to Alan Greenspan.’ Greenspan responded, ‘I was aware a lot of these practices were going on, but I had no notion of how significant they had become until very late. I didn’t really get it until very late in 2005 or 2006.”

“The Republicans,” I wrote, noting that “the Republican controlled federal-government-spent money like they were printing it themselves, which they were. They mishandled the war in Iraq, making a two-year conflict last six-plus years. At the height of our economic expansion in 2006, they did nothing in preparation for the impending slowdown. They pushed as many people as possible into houses that they could not afford.”

“The Democrats,” I wrote, noting that “since taking control of Congress in January 2007, the Democrats could not detect a “category-five” financial crisis. This past July, Representative Barney Frank said that Fannie Mae and Freddie Mac “looked very good going forward.” Less than 75 days later, they collapsed. Senator Chris Dodd got a sweetheart mortgage from Countrywide.  It was the Clinton administration that pressed Fannie Mae and Freddie Mac to ease underwriting requirements in the first place.”

“Wall Street,” I wrote, noting that Lehman Brothers was massively over leveraged (30 to 1), and the same is true of Bear Sterns. Their CEOs were either incompetent or neglectful, and either is bad—not to mention the problems at Merrill Lynch, Washington Mutual, Wachovia and AIG.

“The public,” I wrote, noting that We got drunk on home-equity loans. We got greedy and lazy, and abandoned all of our financial common sense.  We lived in a dream world of credit, and now the alarm clock has rung.”

As it turned out, we were all to blame Conservatives tend to blame Greenspan for keeping interest rates too low as the real-estate bubble inflated, spurring a frenzy of irresponsible borrowing. Liberals are more likely to focus on Greenspan’s aversion to regulation, which led to the emergence of an unsupervised market for exotic derivatives such as credit default swaps and collateralized debt obligations. In an earlier chapter, I talked about the role the election played in Greenspan’s choices. But Wall Street and the public have also been widely held responsible for the Great Recession as well.

I also wrote that “2009 will be an unprecedented year. More banks will fail in 2009 than in 2008.” As it turns out, 140 banks fell in 2009 vs. 30 in 2008.

I added that “home prices will continue to decline.” On December 30, 2008, the S&P/Case-Shiller U.S. Home Price Index recorded its largest year-over-year drop. Since that point, the housing market has not fully recovered.

 “Will the recession end or extend into a depression?” I asked in 2008. “Right now, I feel all signs point to lower equity markets, lower commodity prices and lower interest rates. Consumer activity makes up two thirds of the economy, and the consumer will continue to struggle. Unemployment will reach 10 percent, and household income will decline. In 2002 (the year after our last recession), the S&P 500 Index lost 22 percent.”

The S&P 500 Index lost 26 percent of its value in 2009, and commodities showed similar losses. The federal funds rate—which couldn’t go any lower—remained steady.  Unemployment was 9.3 percent. So I was pretty close.

May 2009 Navigator Newsletters
From the Crow’s Nest: “This is Not Your 2006 Economy”

In my all-time favorite article in the Navigator newsletters, I explained why the interest-rate cuts leading up to the Great Recession were like adding high-performance equipment to the engine of your sports-utility vehicle (SUV).

 “Look at it like this. In 2000, our economy was humming along, then the technology bubble burst and trillions of dollars of capital evaporated, sending the economy into the recession of 2001. Then U.S. Federal Reserve Board (Fed) Chairman Allan Greenspan cut the federal funds rates from January 2, 2001, through June 25, 2003, to only 1 percent.”

“The Greenspan rate cuts were like adding high-performance equipment to the engine of your sports-utility vehicle (SUV). The first series of rate cuts in early 2001 were the equivalent of adding fuel injection, which increased the horsepower from 200 to 325. Additional rate cuts increased the airflow by adding a high volume exhaust system and filters, increasing the horsepower to 400. By 2002 the engine was humming along like a 465 horsepower Z/28 Camaro with a four speed manual transmission. The final rate cut in 2003 pushed the engine to over 600 horsepower! Government deregulation of Fannie Mae and Freddie Mac was the high-octane jet fuel and nitrous oxide that rocketed the engine to over 800 horsepower! Now you have a racecar that could give NASCAR’s superstar Jimmy Johnson a run for his money, and the economy/markets soared. The Dow Jones hit 14,000 and GDP mushroomed to $14.2 trillion annually. But as we now know, the economy could not sustain that performance for very long. With all that stress and all those moving parts causing heat and friction, something had to give. Some parts had to start to wear out, and that is exactly what happened.”

“The first sign of trouble was on August 17, 2007; the engine sprang an oil leak, causing a slight loss in horsepower. The Fed (pit crew) fixed it by dropping the discount rate half a percentage point. Jimmy Johnson (consumers) felt the problem was fixed, but the pit crew knew the fix was only temporary and hoped the car would reach the finish line (the presidential election).”

“The next problem was a loss of compression in cylinder one. This was caused by the Bear Stearns collapse in March 2008. Before the pit crew could fix the problem, cylinder two gave out when Bank of America saved Merrill Lynch from bankruptcy. Citigroup and AIG seized up, and Washington Mutual was gone. By then, pit crew chief Henry Paulson knew he had real trouble on his hands. The engine was losing oil and started to overheat. He called for an emergency pit stop (September 2008) and said the engine would seize up immediately without a $700 billion rebuild to protect the damaged cylinders. The driver was not convinced the car would finish the race, so he persuaded the car owner (tax payers) to rebuild the troubled cylinders. Only a few laps after the rebuild, four cylinders were blown and the car lost the third and fourth gears (October 2008).”

“The car was able to finish the race, but crossed the finish line (the inauguration of President Barak Obama) with massive engine damage and only first and second gears.”

“After the race season ended, the team owner voted in a new pit crew and crew chief. The new team started with the same eight-cylinder 200 horsepower engine. But instead of adding performance enhancers, the Government is installing performance governors, or restrictors, in the name of taxes, social programs and national debt. President Obama signaled this during his April 16, 2009 appearance at Georgetown University where he said, ‘Even as we clean up balance sheets and get credit flowing again, even as people start spending and businesses start hiring—all that’s going to happen—we have to realize that we cannot go back to the bubble-and-bust economy that led us to this point.’” 

“I am not passing judgment on the president’s policies; I am just reporting as an economist what I believe will be the macroeconomic effects of said polices. I am forecasting that the rebuilt engine of the future will be a clean burning, low compression, aggressively filtered, gas sipping, electronic hybrid PCV (politically correct vehicle) with only 125 horsepower.  I envision a cross between a Toyota Prius and a Moped. I am okay with all of this. But this PCV will not have the power of a NASCAR or even a Honda Accord; so do not expect the economic pull of one.”

Looking back, I couldn’t have been more correct. Since I wrote this column, the economy has plodded along, but hasn’t completed recovered from the Great Recession. Sure, the markets are back, for the most part, but look at the economy. Unemployment is still at an astounding 7.6 percent, and the situation is getting worse, because the payroll tax hikes that kicked in at the beginning of 2013 and Obamacare are weighing on employers and consumers alike. And, the fed has created a new problem when, in an attempt to get the economy back on track, it has significantly increased the U.S. money supply. Sound familiar? Boom, bust, boom, bust. Unfortunately, I think we’re in for another bust.