The Recession We Just Dodged (Hopefully)

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
August 30, 2005

** Our hearts and prayers go out to the victims of Hurricane Katrina. The damage and devastation in Louisiana, Mississippi and northward are shocking, even though the storm was not as powerful as expected. Please consider donating to the American Red Cross and the Salvation Army. **

IN THIS ISSUE:

1. Why My Long-term Perspective Is Changing

2. What The Media Didn’t Tell You About The Hurricane

3. Stratfor.com: The Geopolitics Of Hurricane Katrina

4. Hurricane Damage Still Not Known

5. Where Oil Prices Are Headed

6. What To Do Now In Your Portfolio

Introduction

News coverage of Hurricane Katrina has been wall-to-wall, 24/7, for the last several days as the devastating storm swept through Louisiana, Mississippi and elsewhere. As of this writing, deaths are thought to be in the hundreds, and damage is estimated at a minimum of $25 billion. I predict it will be twice that!

Actually, the death and destruction from Hurricane Katrina could have been much worse. At the last minute, Katrina weakened from a Category 5 hurricane to Category 4, and the storm turned slightly eastward. New Orleans avoided a direct hit which could have inundated the below sea level city with 10-15 feet of water or more.

Had Katrina remained a Cat 5 hurricane, and had it made a direct hit on New Orleans, deaths would have been in the many thousands. Yet nowhere in the mainstream media did we hear that Katrina had the potential to devastate the Mississippi River, change its path and make it un-navigable for months or even longer.

Had this happened, the US economy could have been thrown into a severe recession – or worse. There would have been chronic shortages of many goods and materials that flow up and down the Mississippi River on a daily basis. Oil prices would have surely soared above $100 per barrel. Our world would have changed literally in the course of a day.

In this week’s E-Letter, I will discuss this issue since the mainstream media didn’t touch it. I do so because I think it is critically important for all of us to understand how vulnerable the US is to a recession, and how the next recession – whenever it comes – could be extremely serious and long-lasting.

As I am about to hit the “send” button, we have learned that the situation in New Orleans is deteriorating rapidly. Water is rising from underground. Some of the events alluded to below are now actually happening in New Orleans.

Why My Long-term Perspective Is Changing

Since I began writing this weekly E-Letter in 2002, I have steadfastly been an optimist. In my monthly newsletter, I have been an optimist for the last 20+ years. Since 2002, specifically, I have continually predicted that the US economy would surprise on the upside, and it has. I have continually predicted that consumers would continue to increase spending, and they have, despite all the gloom-and-doom predictions that consumer spending was about to fall off a cliff due to record debt levels.

Since just before the war in Iraq began in 2003, I have continually predicted that stock prices would trend higher, and they have. [FYI, if you took my advice in February 2003 and moved to a fully invested position in equities, you would be a happy camper today. Let’s say you bought the S&P 500 Index in late February of 2003 at 850 or below. Today, the S&P 500 is well above 1200. That is a gain of over 40%.]

While I have been optimistic about the long-term outlook for the US economy and the stock markets in general, my perspective is changing. Unless something surprising happens, I expect to become increasingly bearish and negative over the next year or so.

The reasons for this evolving change in my long-term outlook are too numerous to explain in one – or even several – weekly E-Letters. I will be discussing them in bits and pieces in future E-Letters. For now, suffice it to say that I believe some of the negatives the gloom-and-doom crowd has warned about for the last 20-30 years are finally going to come home to roost over the next 5-10 years.

Do not get me wrong – I am not bearish or negative today. Today, it still looks like the economy will remain strong for at least another six months or a year, maybe even longer. There is no recession in sight today, although that could change if oil soars to above $100 per barrel, or if some other major negative surprise occurs. So, for now, I am still a bull on the economy. But I am growing weary.

The Hurricane Recession We Just Dodged (Maybe)

As noted above, no one (that I heard or read) in the mainstream media covered the very real possibility that Hurricane Katrina could have virtually wiped out New Orleans AND devastated the Mississippi River to the point that it was un-navigable for months or even longer. Had the latter occurred, the US could have been almost instantly thrust into a serious recession and very possibly a national crisis.

The only research outfit (that I read) that considered this very real possibility was our good friends at Stratfor.com. Rather than summarize their concerns, here is the warning they issued last Sunday, August 28 as Katrina bore down on the Gulf Coast:

QUOTE:
The Geopolitics of Katrina

A Category 5 hurricane, the most severe type measured, Katrina has been reported heading directly toward the city of New Orleans. This would be a human catastrophe, since New Orleans sits in a bowl below sea level. However, Katrina is not only moving on New Orleans. It also is moving on the Port of Southern Louisiana. Were it to strike directly and furiously, Katrina would not only take a massive human toll, but also an enormous geopolitical one.

The Port of Southern Louisiana is the fifth-largest port in the world in terms of tonnage, and the largest port in the United States… It is bigger than Houston, Chiba and Nagoya, Antwerp and New York/New Jersey. It is a key link in U.S. imports and exports and critical to the global economy.

The Port of Southern Louisiana stretches up and down the Mississippi River for about 50 miles, running north and south of New Orleans from St. James to St. Charles Parish. It is the key port for the export of grains to the rest of the world -- corn, soybeans, wheat and animal feed. Midwestern farmers and global consumers depend on those exports. The United States imports crude oil, petrochemicals, steel, fertilizers and ores through the port. Fifteen percent of all U.S. exports by value go through the port. Nearly half of the exports go to Europe.

The Port of Southern Louisiana is a river port. It depends on the navigability of the Mississippi River. The Mississippi is notorious for changing its course, and in southern Louisiana -- indeed along much of its length -- levees both protect the land from its water and maintain its course and navigability. Dredging and other maintenance are constant and necessary to maintain its navigability. It is fragile.

If New Orleans is hit, the Port of Southern Louisiana, by definition, also will be hit. No one can predict the precise course of the storm or its consequences. However, if we speculate on worse-case scenarios the following consequences jump out:

• The port might become in whole or part unusable if levees burst. If the damage to the river and port facilities could not be repaired within 30 days when the U.S. harvests are at their peak, the effect on global agricultural prices could be substantial.

• There is a large refinery at Belle Chasse. It is the only refinery that is seriously threatened by the storm, but if it were to be inundated, 250,000 barrels per day would go off line. Moreover, the threat of environmental danger would be substantial.

• About 2 percent of world crude production and roughly 25 percent of U.S.-produced crude comes from the Gulf of Mexico and already is affected by Katrina. Platforms in the path of Katrina have been evacuated but others continue pumping. If this follows normal patterns, most production will be back on line within hours or days. However, if a Category 5 hurricane (of which there have only been three others in history) has a different effect, the damage could be longer lasting. Depending on the effect on the Port of Southern Louisiana, the ability to ship could be affected.

• A narrow, two-lane highway that handles approximately 10,000 vehicles a day, is used for transport of cargo and petroleum products and provides port access for thousands of employees is threatened with closure. A closure of as long as two weeks could rapidly push gasoline prices higher.

At a time when oil prices are in the mid-60-dollar range and starting to hurt, the hurricane has an obvious effect. However, it must be borne in mind that the Mississippi remains a key American shipping route, particularly for the export and import of a variety of primary commodities from grain to oil, as well as steel and rubber. Andrew Jackson fought hard to keep the British from taking New Orleans because he knew it was the main artery for U.S. trade with the world. He was right and its role has not changed since then…

… The breaching of levees along the Mississippi would constitute a massive disaster for the U.S. and global economies. With the levees in place, the Mississippi is forced to follow an unnatural course. Should they break, the river will follow its own course, making itself unnavigable in the process.

A tremendous amount of economic activity is centered on the Mississippi River. In fact, the amount of commerce flowing up and down the river dwarfs all that of all other transportation systems in the United States -- including freight shipped by rail and highway. If the river cannot be used, dire consequences will hit the U.S. economy…

This is not a prediction. We do not know the path of the storm and we cannot predict its effects. It is a warning that if a Category 5 hurricane hits the Port of Southern Louisiana and causes the damage that is merely at the outer reach of the probable, the effect on the global system will be substantial. END QUOTE

It is not entirely clear yet that the Mississippi River is out of danger of levees breaching or changing course. As discussed below, water is continuing to pour into the city of New Orleans.

Hurricane Damages Still Not Known

As this is written on Tuesday, the damages from Hurricane Katrina are still not fully known. Rescue teams are fighting their way into New Orleans, Biloxi, Gulf Port and other towns and cities in the storm ravaged areas.

Much more troubling, water is pouring into New Orleans. Officials now believe that the water is coming from underground, and there is no way to stop it. Over 80% of New Orleans is under water, and the water continues to rise. The situation is becoming desperate.

Col. Rich Wagenaar of the Army Corps of Engineers said a levee breach in the eastern part of the city was causing flooding and “significant evacuations” in Orleans and St. Bernard parishes. He did not know how many people were affected by the flooding. Authorities also were gathering information on a levee breach in the western part of New Orleans. Jason Binet of the Army Corps of Engineers said that the breach began Monday afternoon and may have grown overnight.

We still do not have accurate assessments of the damage to the Port of Southern Louisiana. Nor do we have accurate damage reports on the many offshore drilling rigs in the Gulf. The media suggests that daily oil production will be reduced by apprx. 1 million barrels per day; however, it could be much higher. It remains to be seen how long it will take to get oil production back to normal levels.

It is also not known how long it will be before the Mississippi River will reopen to commercial traffic. In fact, it is not altogether certain that none of the levees along the river have been breached. Almost certainly, parts of the river will have to be dredged, which could take days or weeks depending on the amount of silting. And we also don’t know the extent of damage to oil tankers and related vessels from the hurricane.

FOX News reports this morning that as many as 90 oil drilling rigs are either adrift or badly damaged in the Gulf of Mexico. I do not know if this estimate is correct, but it certainly doesn’t sound good.

According to the media, 10 oil refineries were closed prior to the hurricane. It is still uncertain whether those facilities were damaged significantly or when they will reopen. Needless to say, all of this is bullish news for the oil and gasoline markets.

Where Oil Prices Are Headed

By Sunday evening, I expected that crude oil and gasoline futures would be locked “limit up” on Monday. When we awoke yesterday morning (Monday), we learned that crude oil prices in the Far East had spiked to $70.80 per barrel. As the day wore on and the hurricane moved northward, oil prices drifted lower to close just above $67 per barrel, a much more benign response than I expected.

This morning (Tuesday) oil prices are surging again; crude hit a new record high of $70.85 per barrel earlier today. One thing I can tell you for sure is, no one knows where oil prices are going from here. Depending on the damage to the Port of Southern Louisiana, Port Fourchon and others, to the Mississippi River, to the refineries, to the rigs in the Gulf and to the oil tankers and related vessels, oil prices could surge much higher.

Should oil prices continue to surge, this is certainly not good news for the stock markets. Stocks closed mildly higher Monday, with the Dow up almost 66 points on the day, mainly due to reports that the hurricane damage was not as bad as earlier feared. Today, however, stocks are sharply lower and falling as this is written. The Dow was down 100 points earlier this morning.

As I wrote last week, most economists have been raising their estimates for US economic growth in the last half of this year and the first half of next year. Most economists have come to agree that the US economy will not be significantly hurt by oil prices in the $50 per barrel range. However, with prices now well above $50, there will be further problems for the economy.

While there is no exact science to it, many economists agree that GDP will be cut with oil prices at current levels. The number that is floating around is that for each $10 crude oil rises above $50, it will result in roughly a 0.5% cut in GDP. So at $70 per barrel, GDP would be reduced by roughly 1%, if this analysis is remotely accurate.

As I reported last week, Bloomberg’s latest survey of leading economists indicates an average estimate of 4.1% for 3Q GDP growth, and most expect a 4Q number above 4% also. So even if these numbers are reduced by 1% or so due to soaring oil prices, the economy will still be on solid ground for at least the next six months to a year, again if this analysis is remotely accurate.

It remains to be seen what the latest spike in oil and gasoline prices will do to consumer confidence. Surprisingly, the Conference Board reported this morning that US consumer confidence rose unexpectedly in August , as an improving job market outweighed rising gasoline prices. The Conference Board said its Consumer Confidence Index rose in August to 105.6 from a revised 103.6 in July. Analysts had predicted a decline in August to a reading of 101.5 or so.

This suggests that consumer spending has remained robust this month. Remember, consumer spending makes up almost 70% of GDP. But being realistic, I think we can all see that surging oil prices are taking a toll on many consumers, especially low and middle-income families and those on fixed incomes. These Americans have no choice but to cut back somewhere.

At the end of the day, we simply do not know how high oil and gas prices may go, or how long they may stay at these levels. We do not therefore know how much the economy will be slowed by surging oil and gasoline prices. What we do know is that none of this is good for the equity markets. This is certainly a challenging time for investors!

And there is no doubt that the crisis in New Orleans is worsening. This too may have serious implications for the economy and certainly the markets.

What To Do Now

First off, for you do-it-yourself investors: if you followed my advice in February 2003 (just before the war) to move to a fully-invested position in stocks and/or equity mutual funds, I would now take at least partial profits. You might consider taking all your profits off the table, or at least use a “trailing stop.” If you bought an S&P 500 index fund back in February of 2003, you should be up apprx. 40% (or more) at this point.

For those of you who have money invested with “active” managers who move out of the market (or hedge) from time to time, you don't need to do anything. As usual, you will look to your professional money managers to make those decisions.

For those of you who are more aggressive, and want a way to “short” the market, you may want to take a fresh look at THIRD DAY ADVISORS, LLC. Third Day is one of the newest additions to our stable of recommended equity money managers.

Third Day will actually ‘short’ the stock market from time to time. In fact, Third Day went short at the close of the markets on Monday.

I first recommended Third Day in this E-Letter on January 18. Then on June 7, I also illustrated for you the value of investing in Third Day and Scott Daly’s Asset Enhancement Program, which is much less aggressive. You can click on either of the links above to see the actual performance for Third Day and for Third Day and Scott Daly combined.

Past performance is not necessarily indicative of future results. Third Day is an aggressive program that is not suitable for many investors.

Given the oil wild card, you may want to reconsider investing with Third Day, or a combination of Third Day and Scott Daly, or any of the other professional equity or bond managers we recommend. For more information, you can visit our website or you can call us at 800-348-3601.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Katrina wreaks havoc along Gulf Coast, killing at least 55
http://www.usatoday.com/weather/stormcenter/2005-08-29-katrina_x.htm

FEMA Chief: Katrina was “catastrophic.”
http://www.breitbart.com/news/na/D8CA8E3O0.html

Looting widespread in New Orleans.
http://www.breitbart.com/news/na/D8CA8RA00.html

Eleanor Clift: retract your statements about our military.
http://realclearpolitics.com/Commentary/com-8_30_05_TK.html