John Hussman: Questions Congress Must Ask on the Fed's BSC Deal

Excerpt from the Hussman Funds' Weekly Market Comment (3/31/08) regarding the House and Senate's inquiries into the Fed's involvement on JPMorgan's (JPM) deal to buy out Bear Stearns (BSC):

The deal is being defended on the notion that the global financial system would have "failed" had Bear Stearns not been rescued. But the orderly transfer, netting and settlement of financial derivatives and other "qualified financial contracts" [QFCs] is precisely what Title IX of the Bankruptcy Act of 2005 was written to facilitate. In effect, the Federal Reserve and the Treasury decided to ignore existing law and provide a bailout to the benefit of Bear Stearns' bondholders at public expense...

The financial markets were relieved following the deal, despite a virtually complete loss of the company's stock value (over $20 billion in a matter of months). The risk of financial panic was not about potential losses to Bear Stearns' bondholders either. Instead, the market's relief focused on a single assurance: that J.P. Morgan stood behind the customer and counterparty obligations of Bear Stearns. Even if the Fed provides temporary liquidity, this assurance can still be achieved without a “non-recourse” feature, provided that Bear Stearns' bondholders are not defended against losses...

It appears likely that increased mortgage foreclosures will occur, and that stock prices may decline further, but actions like those of the Fed and Treasury will not avoid these outcomes. Rising foreclosures are the natural downside of a speculative housing boom financed by easy credit and suppressed mortgage rates. Protecting the bondholders of investment banks is not an efficient way to help homeowners. With regard to the equity markets, the rich valuations of recent years were largely based on historically high profit margins (due to a declining share of GDP being paid to workers as wages and salaries). The realignment of these profit margins, and of stock values, is largely inevitable, and is not something that the government should spend public funds to prevent. These uncomfortable realignments will probably continue for a while, but the U.S. economy will recover...

Market Climate

Generally speaking, it is true that the stock market has tended to bottom about 4-5 months before the end of a recession. It is quite dangerous, however, to assume that the current downturn in the market or the economy will be of a specific duration, and to start “looking for a bottom” on that basis. Just as market tops are marked by expectations that economic strength will persist indefinitely, stock markets hit bottom when an economic downturn is taken as full fact, when conditions are widely expected to get substantially worse, and when investors have largely given up on any hope that the economy will improve in the foreseeable future.

My impression is that the early calls for a bottom ignore a realistic sense of history about how market peaks and troughs are formed. Once an ongoing and worsening recession is taken as a matter of common knowledge, it will be reasonable to talk about durable market lows. Until then, investors should recognize that a standard run-of-the-mill bear market averages a loss of about 30%.