Systemic Risks to Delaying The Other Subprime Shoe's Drop

by: Larry MacDonald

At least a few practitioners of today’s orthodoxy of passivism, index funds, and investing for the long run were likely rattled by Derek DeCloet’s interview of Fairfax Financial chairman Prem Watsa in the Nov. 24 issue of the Globe and Mail. “Canada’s Warren Buffett,” as he has been called in the past, let it be known that the current credit crisis puts the U.S. stock market on the “cusp” of a prolonged downturn similar to what the Japanese stock market has experienced since the late 1980s.

If Watsa turns out to be right, I would sure hate to be indexing my way through that dismal scenario. Watsa, for his part, has placed most of his insurance firm’s $18-billion portfolio into government bonds, and a chunk of what’s left over into a bet on the price of credit default swaps soaring (as they have).

Could he be right? As mentioned in past blog posts (e.g. Nov. 20), analysts are predicting considerably more write-offs and downgrades in the subprime mess. Forecasters are also calling for further declines in house prices (thanks to historically high inventories of houses for sale) and escalation of foreclosures (thanks in part to billions of adjustable rate mortgages coming due in 2008). It seems things could spiral downward – and maybe even worse than the tech bust if only because the implosion involves the financial sector and its vital role of providing credit to the economy.

Other developments could come out of left field. For example, China’s freeze on bank lending could finally lay low its juggernaut of an economy and, in turn, Chinese demand for global goods and services (and possibly U.S. dollars and government bonds). Also, as recent research study by Khandani and Lo">a recent research study by Khandani and Lo argues, systemic risk in the hedge-fund industry is much higher now.

But a leading independent investment advisory, BCA Research">BCA Research, offers an upbeat outlook. They say the global macroeconomic backdrop remains supportive and market valuations are still modest compared to the levels normally reached in the last stage of bull markets. Plus, with inflation low, central banks are free to lower interest rates and pump up the economy. “Global stock prices will be higher 6-12 months,” concludes the advisory.

BCA Research was a lonely voice predicting the start of the bull market in late 2002, and astutely remained bullish through the dips when many others lost their nerve. If they are right, the passive indexers will win yet another reprieve. But as the final upleg of this protracted bull climbs to elevated valuations, let’s hope the next crisis doesn’t come when the inflationary genie is out of the bottle -- then the Federal Reserve’s rescue might not come soon enough to advert what Watsa expects.`