On April 30th in The Coming Crash: Four Reasons Pro and Con, we examined the array of bullish and bearish forces, and argued that the bearish case was overwhelmingly strong. As the below monthly chart shows (click to enlarge), it was a timely exercise. Because we need to do this for our own background research, we present this for our readers to consider.
S&P500 Monthly Chart Courtesy AVAFX 20JUN25
Here’s our latest summary. In order to save both of us time, I’ve kept this short with links to the sources for those seeking more detail.
The best case I’ve seen was from: 6 Reasons Markets Won’t Crash, Derek Hoffman’s case for markets avoiding any major dip and recovering within the coming year. Here are excerpts from his rationale:
1. The Threat Of A BP Collapse Does Not Fundamentally Threaten Global Markets: At least not like “the Credit Crisis Collective of AIG (AIG), Ambak, Bear Stearns, Citigroup (C), Fannie Mae (FNM) Freddie Mac (FRE), Lehman Brothers (OTC:LEHMQ), MBIA Inc (MBIA), Merrill Lynch (BAC), Wachovia (WFC), WaMu (JPM). These financial cancers caused well over $1 trillion in market cap losses. In the case of BP, there are Dow components and blue-chip companies like Chevron (CVX), Exxon Mobil (XOM), Shell (RDS.A), Proctor & Gamble (PG) and Marathon (MRO) gaining market share as beneficiaries of the BP Bust.”
2. Global Liquidity: The $1 trillion EU Stimulus Package Should Boost Markets Like The $787 US Stimulus Package Of February 2009
3. Upcoming Congressional Elections in November Should Mean Another Extension Of The First-Time Home Buyer Tax Credit: Thus providing at least some near term support for real estate prices, and by extension, the financial sector’s massive loan portfolios.
4. The Job Market Will Improve : This week, the Business Roundtable — a group of CEOs from large US companies — shared their survey showing that 39% of CEOs expect to hire new employees in the second half of 2010. In conjunction with positive double digit sales growth from a high number of companies so far this year, private employment numbers could see a significant and surprising rise.
5. Technological Innovation Will Provide At Least A Partial Fix: Current and coming consumer electronics hits, along with Google advertising innovations will spur both spending and small business growth.
6. Consumer Spending Is Not Dead
Our Take On The Bullish Argument
The key underlying assumptions here are:
- Any potential BP collapse can be contained and would not threaten systemic risk. My concern is that the world is carrying a lot more debt since late 2008-early 2009, and thus more sensitive to another major corporate collapse. Liability is very hard to quantify here, and thus it’s a case where the uncertainty alone becomes fatal.
- The US will be able to continue to extend the homebuyer tax credit under election year political pressure. As John Mauldin notes below, this past week Congress couldn’t pass extended unemployment benefits, so it’s unlikely more stimulus will get through at this time. Of course, as elections get close, that may change.
- The EU will ultimately enact its stimulus program despite the wave of austerity and will avoid any market shaking blowups
- CEO hiring sentiment surveys and improving sales will translate into an improvement in the US jobs market
- Consumer spending is not a lost cause
While I have my doubts about every one of these, what is compelling here is that the author need only be partially right about these to be right for at least the coming year. From more of an international perspective, it seems that much of the above depends on whether:
- The EU can avoid a major market-shaking crisis
- Global credit markets and governments will be able to continue issuing and absorbing the levels of government debt contemplated. I’m dead serious when I warn that we should not underestimate government ability to creatively manipulate markets. Too much capital flowing to gold or shorting sovereign debt? Shut the markets down. German efforts to do so have failed mostly because the rest of the world isn’t on board yet. That could change when things get desperate.
From Top Ten Reasons to Be Bearish by Abigail Doolittle: Nothing really original but an exceptional summary and a must read too:
10. Poor Outlook for Small Businesses – Small businesses make up more than 50% of non-farm GDP, employ about half of the nation’s private sector workforce…many are putting growth plans “on hold”. If 50% of GDP and employment remains “on hold”, it points to the strong possibility of a double dip recession and, in turn, another decline in the S&P 500.
9. Cash Outflows Are Trending Poorly –Should this trend [of mutual fund outflows] continue, it will put managers in an awkward position of having to sell “winners” to meet redemptions due to the low levels of cash on hand. If both of these trends continue, one would have to believe it will have a negative impact on the S&P 500.
8. Tax Cut Expirations – Are causing income and production figures to be front loaded into 2010 at the expense of a harder dip for these in 2011.
7. Deflation –…until the asset class at the eye of the financial storm – residential housing – heals via stabilized pricing, we are living in a world of deflation. This is reinforced by record low mortgage rates. In more micro-terms, over the last 12 months, the core rate of inflation has risen only 0.9% or well below the 2.0% average annual increase over the past 10 years. In addition, returning to small business owners, 28% reported making price reductions in May, an increase over April, while this price cutting contributed to a high percentage of such owners reporting declining sales. Lastly, the Fed’s extraordinary liquidity efforts of the last two years have led to stagnant money rather than monetary expansion…
6. High Unemployment – 15 million Americans are out of work…Private sector hiring appears to be at a standstill with only 41,000 new jobs created in May. 46% of the unemployed have been out of work for more than 6 months or the highest percentage since this record has been kept back in 1946. The real unemployment rate, counting those who have simply stopped looking for a job, is nearly 17%… a rather bleak picture on the employment situation here in the U.S. and one that will lead consumers to remain on the spending sidelines and especially for houses.
5. Commercial Real Estate “Crash” – Various sources estimate that between $1.3 and $3.5 trillion in commercial loans is (sic) coming due in the next 5 years with more of it weighted toward 2012. This could be an ugly event. ..if banks are unwilling or unable to offer new financing …real estate owners will then be put in the awkward position of having to pay for multi-million dollar commercial real estate holdings in cash.. [many won’t be able to do so, and] this will force mainly small and mid-sized banks, and insurance companies, to write down bad loans and determine what to do with portfolios of commercial real estate in a depressed market…and create “a downward spiral of economic contraction.”
4. Housing Double Dip –it is the combination of the S&P/Case-Shiller Index and annual housing starts that demonstrate that the housing market’s direction is down….It is difficult to see how the gravity of either chart can be warded off in the next 5 to 10 years, and thus to understand how the housing market can move in any direction other than down.
3. Financial Institutions Are Tied to the Housing Market –…if the decline in housing is accompanied by a worsening unemployment picture “it will really flow through” to U.S. banks and insurance companies. This “flow through” will show up in two places: (1) security portfolios, and, (2) loan portfolios. Remember the “toxic assets” of 2008? They still exist to the degree that they were not sold off or written down. If the upcoming decline in housing is aggravated by unemployment, it is likely to spur another wave of delinquencies and foreclosures. This will hit the value of the security portfolios because much of the paper will become “toxic” again due to the non-performing loans layered in the various, and sometimes repackaged, tranches of debt. However, it will also hit the loan portfolios of banks, and this analyst thought this was the real danger, because banks will have to write off a new wave of bad loans and figure out to unload houses in a truly distressed housing market. All of this is why I continue to believe that until the asset class at the eye of the financial crisis heals – housing – we can be assured that the crisis itself is not over.
2. The World’s Unsustainable Borrowing Binge of the Last 30 Years – “Unsustainable” because active borrowing as measured by the Federal Reserve collapsed in 2009 to -$611 billion from its annual peak of $4.6 trillion in 2007. That is a huge, almost incomprehensible decline in borrowing to have occurred in two years. The U.S. government has attempted to shoulder some of that load by borrowing about $2.9 trillion in the last two years, but it is a nearly impossible task. Should it prove to be more than the U.S.’s balance sheet can handle, it will result in foreign creditors demanding a higher rate of return on Treasurys [sic]as is happening in Greece today. This will devastate banks because their fixed-rate assets will be underwater, but more frighteningly, the U.S. dollar will become severely devalued if not collapsed.
1. The Ugliest Chart of All Time –the S&P 500’s severe double top with a technical target that is far, far below where the index is today.
For more on the bear case, see: Here Comes The Recession by John Mauldin.
He adds to the above points:
A large coming tax increase in 2011 will likely push the US back into recession: If you cut taxes by 1% of GDP then you get as much as a 3% boost in the economy. The reverse is true for tax increases. Christina Romer, Obama’s head of the Council of Economic Advisors, did the research along with her husband, so this is not a Republican conclusion…If the economy is growing at less than 2% by the end of the year, then a tax increase of more than 1% of GDP could and probably would be the tipping point. Add in an almost equal amount of state and local tax increases (and spending cuts) and you have the recipe for a full-blown recession
Mauldin acknowledges that tax cuts or more stimulus could reverse this process, but notes that If Congress cannot extend unemployment benefits, as happened this past week, then other stimulus is unlikely.
Lack Of An Inverted Yield Curve To Predict Recession Doesn’t Apply In A Zero Interest Rate Environment
ECRI Leading Indicators Are Falling At Speeds Suggesting A Coming Recession (even though double-dips are rare-so are the circumstances of extreme excessive debt on public and private levels)
The Threatened US Real Estate Collapse Part II- The American PIIGS
We add this section to the evidence cited above on the bearish side.
As the risk of the PIIGS nations’ sovereign debt default threatens the EU’s banking system and economy, so does America’s bad real estate debt threaten the US financial sector and economy. The risk of a wave of mortgage defaults crashing US banks is truly ‘the American PIIGS.’
As you may recall, the US subprime real-estate lending crisis undermined confidence in the US financial sector, which caused the current global downturn, and introduced so many to the meaning of systemic risk. America bought time to heal itself via:
- The biggest bailout program in its history: That’s well known
- A temporary lull in mortgage refinancing: Less known but also important. Here’s the chart I’ve presented often before, click to enlarge, (hat tip to Graham Summers who presented it here), that illustrates how a lull in US mortgage rate resets is ending, and a new wave of similar size to that which sparked the original (aka subprime) crisis is upon us. This threatens a new wave of defaults that will once again undermine the US financial sector.
Here Comes Another Wave of Mortgage Rate Resets As Large As The Subprime Crisis Wave 14jun27
Obviously, much depends on at what rate these loans reset. The current risk aversion has helped keep benchmark 10 year T-bill rates low. However we don’t know how long that will continue with the US selling an average of $50 bln in debt per week. Last week’s 5 year bond auction’s bid to cover ratio was 2.58, very poor for this relatively short duration and even worse considering that the current downtrend in stocks, which should support demand for supposedly ultimate safe-haven US debt.
As one who spends a lot of time watching and pondering forex markets, I’ve been asking myself what it would take to turn around the dominant forex trend, the downtrend in the EURUSD pair. This single pair alone accounts for about a third of all forex trade, and the two currencies thus force each other to move in opposite directions like children on a seesaw. As the top two most widely held currencies, they profoundly influence commodity markets (priced in dollars) and every other asset market I can think of.
If there is anything that could potentially rival the EU sovereign debt crisis for global market impact and reverse the EURUSD trend, it’s the US Real Estate Debt Crisis, the one that set off the current Great Recession.
If we get Part II, then unless the EU pulls off a minor miracle, a double dip recession will be a best case scenario, and a Great Depression becomes a distinct possibility (likelihood?) as the two prime economic blocks, the EU and US, pull each other down in the mother of all systemic collapses
The big themes here:
- If we get some more tax cuts or stimulus, markets may hang on. If not, then double dip is ahead.
- The biggest unknown not mentioned by those cited above is the wildcard factor presented by the very real possibility of more trouble from the EU or a serious slowdown in China. The global economy is still a weak patient that is attempting to come off of stimulus life support. It is vulnerable to being overwhelmed by an otherwise minor event.
In sum, the balance of evidence suggests that we see a test to around March 2009 levels on sheer uncertainty.
Disclosure: No Positions