The Important Differences Between The 2008 And 2012 Markets

Includes: JNJ, MSFT, T, WMT, XOM
by: Philip Mause

Will 2012 markets be a repeat of 2008? That's a scary thought. In 2008, we started the year with some misgivings, but economic indicators looked reasonably sound. The housing/mortgage disaster swallowed up the stock market and the economy and pitched us into the deepest recession since the 1930's. It was caused by unmanageable debt: By the basic mortgages, which soon were driven underwater by declining home prices. And also by the mortgage-backed securities which collapsed in value and tanked several major financial institutions, froze the interbank lending market, and destroyed the bond market.

Once again, we are faced with "unmanageable" debt - this time the sovereign debt of the eurozone countries. Once again, large and interdependent financial institutions hold massive amounts of questionable paper and the phrase, "bank run," is getting more popular. Are we about to repeat the disaster we lived through four years ago?

There are important differences between the two situations and the evaluation of these differences is crucial to determining the danger of a repeat of the Panic of 2008. First of all, the underlying debt is quite different. When a low income person buys a house worth $600,000 and finances the purchase with a $700,000 mortgage because of an inflated appraisal and rolled in fees, there is really no way the principal will be repaid in a declining house price market. Somebody, somewhere is going to take a big hit.

On the other hand, sovereign debt can be extended and ultimately paid a number of ways. Most of the European countries own a wider range of assets than the United States government (shares of electric or telephone utilities, parts of businesses, etc.) and can sell those assets. Taxes can be increased. Charges for the use of spectrum can be increased. In the short term, the bond market can be stabilized by permitting those who owe money to the government (taxpayers and buyers of government assets) to settle their accounts by delivering government bonds rather than cash (the Italian government is apparently doing this already). None of these measures are available to the hapless homeowner whose house is now worth only $300,000 but who owes $700,000.

There is another very important difference. Central Banks generally either buy sovereign debt instruments or accept them as collateral. The ECB has already bought significant amounts of sovereign debt. On the other hand, in the United States, the Federal Reserve was not in the practice of buying mortgages, houses or non-agency mortgage-backed securities. It was, therefore, more complicated for the Federal Reserve to come to the rescue. It is true that there has been considerable controversy about the role of the ECB. Nevertheless, the ECB definitely has the way, if not always to will, to stabilize a sovereign debt instrument market by intervening and buying up sovereign bonds.

In one very important respect, the eurozone debt crisis may be more dangerous than the Panic of 2008. When the bank run started in the United States, a very important element of the solution was the introduction of enhanced deposit insurance. The United States government, through the FDIC, insured larger deposits than it had in the past and also insured interbank loans and some bonds. Most people quickly determined that these guarantees were solid because the United States government could always raise money by issuing bonds and, if absolutely necessary, having the Federal Reserve print money to buy the bonds. In essence, depositors were protected by an assurance that, if all else failed, money would be printed to pay them off. In Europe, if the crisis develops due to a sovereign's bankruptcy, enhanced deposit insurance backed by a guarantee issued by that very sovereign would not be very reassuring and would not likely prevent the development of a bank run.

I think we will see a year and, unfortunately, several years of brinkmanship on the part of the Europeans as the Germans hold other countries' feet to the fire. And then at the last moment, the situation will be rescued by ECB sovereign debt purchases. This scenario will likely be played out a number of times. It will produce years of sluggish economic activity in Europe as austerity chokes off economic growth. But a cataclysm will probably be avoided. Of course, by August 1914, Europe had been on the brink of war several times and each time the situation had been resolved. So, it is not impossible that the canoe will drift over the waterfall. But so many people, businesses, and countries have so much to lose that Europe is most likely to print its way out of its problems the same way the United States and Japan have done.

We are likely to see a persistent decline in the euro, slow economic growth in the eurozone, some pressure on the dollar-denominated earnings of U.S. companies dependent on European sales, and a continued nervousness on the part of investors. Financial institutions have become so interconnected that the stocks of large U.S. banks will be subject to periodic squalls, sending share prices down quickly. The Fed will probably be more accommodating than economic conditions in the United States would warrant because of concerns over a eurozone blow up.

The low interest rate driven stock market - in which reliable dividend payers become more and more attractive to investors - will continue. In the long run, investors will do much, much better with a group of reliable dividend stocks with strong balance sheets like Exxon (NYSE:XOM), Johnson & Johnson (NYSE:JNJ), Microsoft (NASDAQ:MSFT), Wal-Mart (NYSE:WMT), and AT&T (NYSE:T) than with Treasuries, but a strong stomach will be required for the rollercoaster ride.

Disclosure: I am long WMT, XOM, JNJ, T, MSFT.