U.S. Stocks To Plunge?

by: Shareholders Unite

Well that's what BlackBay's Schoenberger says. According to him, US stocks are still set to plunge 35%, even if he admitted that:

"So far I'm wrong," Schoenberger acknowledges to Yahoo. However, much of stock market's strength in the first quarter was predicated on expectations that the Federal Reserve would embark on another round of quantitative easing, he says. "Fed Chairman [Ben] Bernanke has clearly put that on the back burner. It's not going to happen anytime soon."[Moneynews]

At least that gives something of a rationale for his '35% plunge' prediction. But we're not convinced, at least not on the logic he is providing. Since it's difficult to argue that stocks are overvalued, some kind of really bad development has to happen before stocks plunge in the order that Shoenberger predicts (35%, or actually more so since they went up significantly after Schoenberger made that call).

What could such a bad development be? Here are some candidates:

Obviously, none of these possible bad events can be excluded, but to actually predict any of them is quite a different matter. In fact, a double dip US recession is most likely to be produced by either an escalation in the euro crisis and/or a hard Chinese landing (we'll leave out the possible disasters in the fourth bullet point).

But if a double dip US recession becomes a reality (or even a real threat), the Fed is much more likely to embark on QE3. Too much bad news could be good news, sort of. The funny thing is, at least part of Schoenberger's rationale for expecting such a steep plunge in stocks is based on his belief that, contrary to the expectations of many, the Fed won't embark on QE3.

Perhaps there is a fourth scenario possible, a return to trend GDP growth (roughly 3%) which could produce rapidly rising interest rates. On present data, with the plunge in labor force participation, damaged household balance sheets as a result of the housing bust, and public spending already a drag on the economy, this isn't very likely but it doesn't have the QE rescue scenario for stocks built in when it happens.

In fact, many would argue the risks are even greater from that scenario, as increased growth could reignite inflation. At present, the banks sit on so many excess reserves because credit demand is still low, but this is picking up a bit already and when it increases further, those excess reserves could actually turn into money in circulation.

If most of the borrowing comes from business to invest in productive capacity, this isn't likely to be much of a problem. Against increased money in circulation stand an increased productive capacity. However, if the borrowing mainly comes from households in order to consume, this might create inflationary pressures insofar the increased consumption doesn't sufficiently induce firms to increase production and productive capacity.

Could the Fed stop inflation in its tracks? Yes. In theory, they could increase the reserve ratio with the stroke of a pen. Unlike the Chinese, who don't use this instrument with any kind of frequency, it could be said that these are exactly the kind of circumstances in which changes in the reserve ratio could be a useful tool.

Otherwise, they'll have to sell back the assets they bought from the banks in order to reduce their excess reserves and/or increase the discount rate. We think this is manageable, but not everybody agrees here.

So we have Schoenberger's prediction of a stock plunge, but too much bad news could be good news (QE to the 'rescue'), but too much good news might in fact create a problem for stocks. But even then, a 35% plunge seems way more likely in a bad news than in a good news scenario to us. If the economy goes back to normal, with some 3% growth, interest rates will rise, but so will earnings.

We feel that something really bad happening to earnings is necessary for the kind of stock crashes that Schoenberger predicts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.