The Capital Commerce Debate: Round 1


Will the housing slowdown tank the rest of the economy, or will job and income growth continue to support and eventually strengthen the current expansion? These are just two of the critical questions that will be vigorously analyzed and argued this week in the inaugural Capital Commerce debate.

On one side, we have the bullish Donald Luskin, chief investment officer at Trend Macrolytics, an economics and investment consulting firm. He also writes the popular blog The Conspiracy to Keep You Poor and Stupid.

On the other side, we have the bearish Barry Ritholtz, proprietor of Ritholtz Research & Analytics. He writes an equally popular blog, The Big Picture. Today, each gentleman presents his overall view of the economy.

Donald Luskin: The Bullish View

Forecasting the economy right now is even more of a challenge than usual. That's because we really have two economies operating at the same time—the housing sector and everything else. Happily, when this kind of conceptual challenge exists, it means there's an opportunity to make some money in the market. That's because a lot of players will get confused and analyze the economy incorrectly, and securities will be mispriced as a result.

The housing sector has been very weak. It's been in decline for the last five quarters. In the most recently reported quarter, the fourth quarter of 2006, the decline reached its worst level so far—a decline of 19.8 percent on a quarter-over-quarter basis, annualized.

Overall in that same quarter, real gross domestic product grew at a ho-hum 2.5 percent rate. But if it hadn't been for the big drop in housing, real gross domestic product would have been up a whopping 3.7 percent.

The same pattern happened in every quarter of 2006. Every single time, housing dragged overall growth down—while the rest of the economy turned in spectacular results.

So, has the economy been weakening? Depends what you mean by "the economy." If you mean the whole thing, including housing, then it's been weakening. At the same time, it's striking that the deep weakness in housing hasn't harmed the rest of the economy at all.

Without housing, on a trailing four-quarter basis, every quarter in 2006 was better than any quarter in 2005. The worse the housing problem has gotten, the more growth in the rest of the economy has accelerated. It's almost as though the rest of the economy were saying, "Thank God, we got that stupid housing boom out of the way."

For several years, the bears had predicted a housing crash. They claimed that the economy was being propped up by artificial growth in housing, stimulated by low interest rates. Without the prop of housing, the economy would collapse. Surprise! Housing has collapsed, and the rest of the economy just got stronger.

So as far as I'm concerned, the burden of proof is on the bears here, and the stock market would seem to agree with me. Within easy reach of new highs, stocks aren't acting like housing is going to drag the whole economy down.

Starting in February, the crisis in subprime lending gave the bears more ammunition and gave stocks a reason to pause in what had been an uninterrupted ascent since last June. But for most of the bears, subprime has been an argument of convenience. They were bearish before they ever heard the term—now they're seizing on it to justify something they believed all along.

I think stocks will be at new highs within the next few weeks, and the bears are just going to have to find themselves another story. For now, the bears are playing the role of useful bricks in a very profitable wall of worry.

Barry Ritholtz: The Bearish View

It is always a challenge to summarize nuanced complexities into something short and sweet, but here is the 7-Minute Sopranos version of my macroeconomic and market views.

Let's start with the Nasdaq crash of 2000—the defining market event of the past decade. The peak-to-trough losses were 78 percent, and historically, that has taken many, many years to recover from. I guesstimate we are halfway through that process.

The crash was followed by a recession in 2000-01. Businesses slashed headcount and reduced capital expenditures, while the American consumer barely slowed—the reason the recession was so mild. Only the terrorist attacks of Sept. 11, 2001, managed to slow shoppers, however briefly.

In response to these economic concerns, the Fed slashed rates to levels not seen in 46 years (other banks cut rates also). Massive economic stimulus included not one but two major tax cuts (2001 and 2003), huge deficit spending, funding of two wars, and mass printing of dollars.

This broad economic largess did not go unnoticed by the markets. After making a double bottom (October 2002 and March 2003), stocks exploded in 2003. Indeed, much of the market gains over the past five years came in the nine months following the March 2003 start of the Iraq war.

With the cost of money slashed to multigenerational lows, dollar-denominated assets also took off: oil, gold, industrial metals, real estate, etc., made runs to multiyear highs.

This cycle has been backwards—ultralow rates started a huge round of home price appreciation, which led to a mortgage-fueled spending spree. In most recoveries, job creation and wage gains lead to spending and housing growth; this cycle was turned upside down: As consumers extracted huge amounts of equity out of their homes, they added to an already red-hot expansion in Asia—in particular, China. (And I am not in the housing bubble crowd)

But there is no free lunch, and this global economic re-inflation eventually led to inflation. Energy, food, medical care, housing, educational expenses, transportation—all cost appreciably more than they used to. In response, central banks began a series of tightenings; the Fed raised rates from 1 percent to 5.25 percent, inverting the yield curve and cooling the red-hot housing market.

At the same time, the purchasing power of the dollar slid. If you haven't traveled abroad recently, prepare yourself for some sticker shock: Your dollar is worth much less than it used to be.

Where does this lead us? I call this the "slow-motion slow-down." With housing fading, nothing else has arisen to take its place. Business capital expenditure is softening; corporate profits are decelerating—despite being at record highs when measured as a percentage of GDP.