Money Monday

Halloween is around the corner...and Business Week's current issue reminds us of five little gremlins that could spook the stock market around then:

* softening in the housing sector

* the threat of recession

* continued inflation fears

* declining earnings

* geopolitical 'hobgoblins'

Readers will notice that these are not the three fundamental problems of the economy...but smaller ones....more immediate ones....the little spooks, not the big monsters.

Take the first. From San Diego comes shocking news: while almost everyone now expects a 'soft landing' for housing, many marginal homeowners are hitting the tarmac without landing gear.

Foreclosures are running ten times - that's 1,000% - ahead of a year ago.

Default notices are being sent out at three times the rate of last year. Trust deed sales are almost 500% greater than 2005. And the number of defaults that lead to foreclosures, at 35%, is seven times higher than it was 12 months ago.

What's going on? Here's our simple guess. During the last five years, people on the margins - those without any cushion of savings to fall back on in emergencies - have only been rescued from default, foreclosure and bankruptcy by a bubbling housing market and a devious credit industry.

"Need money?" said the lenders. "No problem...how much do you want?"

Now, with property prices flat or falling, the lenders are not so free and easy with their money - and are beginning to wonder how they'll get repaid. And, the marginal, stretched debtor has nowhere to go...but into foreclosure. A lot of houses end up in the hands of the banks, as a result. REO (real estate owned by banks) in the San Diego area has risen six times from a year ago.

Corporate earnings, meanwhile, are also near record levels. But the earnings didn't come out of nowhere. Often overlooked in the workings of a housing bubble is the effect on corporate earnings, which are what is left after a business has paid its expenses. Chief among these expenses is labor. So, if a business can sell more product without increasing labor costs, it can add to its earnings. Typically, wages rise with output. A business needs more inputs of labor in order to increase its outputs of product. It also needs laborers with more money in their pockets in order to buy the products. But a few facts conspired to change the usual formula. Asian labor began doing much of the work - at substantially reduced rates. And instead of relying upon additional wages to increase spending, Americans simply borrowed more. What's more, an increasingly large percentage of U.S. total earnings came from sources that had little extra wage-costs behind them: financing and natural resource production.

Wages remained stable; earnings rose.

But now, if the consumer is no longer able to borrow against his house, he will have no choice but to cut back spending. Then, corporate earnings should fall on two accounts: one, because of reduced consumer spending, and two, because of reduced consumer financing.

Corporate CEOs have already begun to worry about it...a recent survey shows confidence among these executives has fallen to a five-year low.

In such circumstances, of course, recession would not be far away.

As for inflation...what do you expect, when you goose up the money supply year after year?

And to geopolitics...well, who knows what lies ahead?