3 Reasons the Economy Is Headed South

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Last Tuesday, as I perused the financial news, the "up" market set against a flurry of negative economic releases brought home Alice's disorientation as she traipsed through Wonderland. The fact is, the day's news provided a host of reasons for skepticism that the economy -- and hence the market -- can recover without a lengthy and Herculean effort.

At one point during the day, against the backdrop of a Dow that was up strongly, if not spectacularly, the handful of news events featured on Yahoo! Finance indicated that crude oil prices had moved above $113 a barrel. They've since pushed higher in their breakneck run to who knows where, as home foreclosures had catapulted by 57% in March and the same month's wholesale prices had risen by nearly triple the anticipated amount.

Since I don't see any of this trio of negative trends abating anytime soon, I wonder precisely what it is that will buoy consumer confidence, boost the economy, and wring the nearly unprecedented daily loop-de-loops out of the equities markets. Given this admitted dose of pessimism, perhaps we'd do well to examine each of these three current economic problems in slightly more detail.

Crude prices
Crude prices have increased by about two-thirds in just the past year, after essentially doubling during the prior few years. I'd love to provide you with a simple reason or two for these jumps, but the fact is they relate to everything from a U.S. dollar that's become anemic beyond belief, to steadily increasing global demand (especially in the big developing duo, China and India), on to concerns about output declining in a variety of producing venues across the world.

As all Fools know, escalating crude prices eventually lead to both higher gasoline charges and increased levies for a range of products manufactured from hydrocarbons and for the transportation that inevitably links producers to consumer for all products and many services. And when we substitute synthetic fuel made from corn for a portion of our oil-based gasoline, the food chain similarly receives an inflationary jolt.

Higher oil prices benefit the likes of ExxonMobil (NYSE: XOM), BP (NYSE: BP), Halliburton (NYSE: HAL), and Transocean (NYSE: RIG). But if there's any truth to predictions by some knowledgeable observers that we'll be paying $200 a barrel by 2010, our economy and the markets collectively could be in for a peck of prolonged trouble. But perhaps the most amazing element of this set of circumstances is that they're occurring against the nearly complete absence of any meaningful U.S. national energy policy.

Housing
As it burst, the bubble in housing spread to credit markets across the U.S. and beyond. And as Tuesday's reports indicated, the resetting of adjustable rate mortgages that can trigger foreclosures has yet to reach its zenith. With as many as a million bank-owned houses likely to hit the market this year, the bloated inventory of new and pre-owned homes for sale might not begin to shrink anytime soon.

While such big builders as Pulte (NYSE: PHM), Ryland (NYSE: RYL), and Lennar (NYSE: LEN) are obviously working their way off their cyclical lows, I continue to advise my Foolish friends to exercise appropriate caution in building positions in the group. Indeed, you can predict as well as I what effect a continued hike in crude prices could have on consumer confidence and, hence, on a housing recovery going forward.

General inflation
I've already discussed the inflationary trends precipitated by increasing fuel and food costs. And while the Labor Department's Producer Price Index increased by 1.1% for March alone (a truly surprising one-month jump), what economists call the "core index," which eliminates the effects of fuel and food, was up a more measured 0.2% for the month.

I have a couple of reactions to the latter number: First, if the Feds were to eliminate all categories from the index, inflation would be at zero. But that wouldn't offer a very realistic reflection of the world, would it? And second, I wonder just how long it'll be before recent or expected run-ups in a number of non-oil commodities, from coking coal to copper come flapping home to roost.

Conclusion
For now, the markets are optimistically riding a wave of positive earnings reports and (perhaps to their credit) disregarding my Chicken Little concerns. That's good, and I hope it lasts. Beyond that, I only ask that my Foolish friends remain aware that an awfully big bump could lie unseen ahead.

For related Foolishness:

• Big Oil, Big Profits
• Big Oil Goes Small
• Don't Let Inflation Burn You