Markets Haven't Yet Properly Digested the Bad News

Share prices and corporate fortunes are being riled by the rediscovery of long known and recently denied basic facts. GM (GM) and Ford (F) are overly dependent on SUVs and trucks, shocking! Banks, including investment banks and broker dealers, have many bad securities, leverage issues and further losses? Who would have guessed it? Anyone who has read the news, listened to news radio or contacted any financial press in any way over the last year.

Then again, two and half months ago the Fed solved all the financial economy's problems by making more credit available, against many more classes of collateral for longer time periods. Oh yeah, and if you can get it, credit is cheaper too! What that failed to do new regulations and checks from the Treasury will surely solve. The other shocking revelation about autos, airlines and others requiring cheap fuel is that gas and oil prices have been rising- at least that is the rumor. Wow, shocking new developments abound!

There is a real powerful lesson in this. We have spent two and half months denying the obvious and rallying on spit, dreams and delusions. The credit crisis is still developing. We don't even know the full extent of the initial damage from an ongoing house price deflation, balance sheet carnage and de-leveraging. Total home sales and home prices have more to fall and they have been falling. Like residential construction, these numbers will begin to improve as comparisons get easier from past carnage.

That is nothing to celebrate. Discussing this as strength is somewhere between idiotic and criminal. We face a moving target, economic weakness. Despite 10 weeks of premature victory celebrations the battles are just beginning in earnest. We are about to see what all the housing price slides, construction activity decline, loose credit inflation and balance sheet destruction do to the macro economy. We have not seen the economic weakness yet. Thus, millions are celebrating and waiting for the recovery bounce from a recession we have not had yet, that they claimed would never happen anyway. What would you call this outlook, I call it crazy!

Economics has a well deserved reputation for being wrong. So well it may be again. Here is what basic economics suggests about where we are now.

We are waiting to see how an ongoing credit and housing crisis creates a national economic recession and how this recession reacts back on financial firms and distressed households. You should think in terms of feedback loops. Just like in the bubbly boom, there will be self re-enforcing cycles. The coming set of cycles will be vicious, as opposed to the virtuous cycles of yesteryear.

Where we had imported deflation from globalization, we will have inflation from rising global commodity prices and weak dollars. Where we had limited demands for wage increases and tax receipts the political wind will change and stressed households and governments are likely to want a larger share of the pie. Households spent the last 6 years borrowing - heavily against their rising house prices. This is running in reverse. They will need more money to pay-off past purchases. Some rebalancing will come as default and the rest as wage demands and lower consumption. Where we had asset prices rising much more rapidly than prices in general- inflation- we will have asset price increases lagging inflation. All of this will take place against an uncertain backdrop of stressed financial institutions and households. This will place significant structural pressure on the national economy. This will have local and global effects.

We know this. We also know that the rate cuts and cash injections we have been getting will be fewer, further between and of less potent influence. Rate decisions will be made in an environment defined by rising prices, falling employment, stagnant business investment and recurrent fears of credit and inflation risk.

The Fed and the Treasury bought time. How you spent the time will shape your near term returns. If you took the opportunity to survey the landscape with new eyes and greater skepticism, you will do well. If you drank the kool-aid, decided the worst was over and went back to your old ways, ouch. That is the lesson of this episode and many other attempts to wish away structural economic issues through escalating interventionary policy and group delusion. Beware you did not use the last few months to lose money remaking last year's mistakes.

Disclosure: None

Comments

[ZMaNFaRLee:]

OH no the sky is falling, we are going into another great depression!!! In the long run the United States has always been the money play, ever since it was born. Yes we need time but were not screwed.

2008 Jun 04 08:20 AM

[firefox2:]

Time has been touted as the cure economical ills. We sometimes forget how valuable time is and how it can be wasted by making the wrong decisions. Denial is one of the main culprits. At present, better bird in hand than two in the bush.

2008 Jun 04 08:37 AM

[User 201843:]

Indeed a generation of folks that will ask themselves do I buy or rent? Lots of them will ask themselves can I even live without even "one bird in hand".

2008 Jun 04 08:46 AM

[User 143167:]

The US economy is resilient for sure. but not that resilient to be a good a shape to be a "great value" after only going down 10% in a major credit crisis.

2008 Jun 04 11:03 AM

[G.R.:]

crazy doesnt being to describe whats going on. Criminal describes it better. It doesnt take much skill to RIG the markets higher. After the entire system is set up completely non-transparent and the rules down there are if you cant find buyers for stocks, buy up what is being sold, then raise the price and pray for buyers.

as soon as these markets rise more, the game will be over and you will see the rug pulled in 3-6 months.

2008 Jun 04 01:25 PM

[icandoitdon:]

at this point the fed is a toothless tiger. their only weapon left is preventing bank runs by loaning money to investment firms. that doesn't make the firms any more solvent.

the author has it about right i think...

2008 Jun 05 02:32 AM

[whidbey:]

Moments of happiness followed by hours of despair? You are probably correct; it will take some time,maybe lifetimes, to defeat the delusion we can be solvent and flaunt the need for personal discipline.

I fear the boomers who have less than 70K on average for retirement. I think that is the tipping point for us all. They are the voting block that will control policy the rest of my life.

2008 Jun 05 10:40 AM

[roid:]

Thank you for an insightful article. I am glad to see that at least one other person sees the emperor has no clothes. Meanwhile, the stock market today is acting like happy days are just around the corner. But the economic and financial math says the piper must be paid for the past 7-10 years of housing and credit excesses. House prices will continue to plummet, banks will fail, the economy will tank, unemployment will rise, and the recession will morph quickly into a major depression that make take years to recover from.

2008 Jun 05 04:10 PM

[ed auerbach:]

I still love the bears. Never heard of " climbing a wall of worry". Or a few customers we still have called BRIC or $3.5 Trillion in money market funds earning less than 2%. Where do you think that money is going to go guys?. You guys are the most wonderful contrary indicators. Give us a name to short. Have some balls. Or did you notice that short interest is at an all time high. Sometimes shorts have to cover. eg. thats called buying. I hope you fear mongers have acted on your fears and are short, but mostly you are all noise.

2008 Jun 05 06:26 PM

[icandoitdon:]

ok, here's a couple of short ideas:

short WB and BAC

WB is a badly managed firm without a leader (probably a good thing come to think of it). dividend will be cut for the second time following an increase last year. bought golden west financial, now worth a fraction of its purchase price. oversold; wait for rally before shorting. don't short if rally doesn't come.

BAC is paying for something (countrywide) they could have got for free and were too dumb to know it, even after witnessing the swindling of the fed by JPM. dividend will be cut.

by the way, earning 2 percent with no risk in an uncertain economic environment doesn't bother me in the slightest. have you heard of options writing to pad returns? or how about using some of that cash parked in money markets to pick up prime lakeshore or mountain property on the cheap from the debt-burdened souls who finance everything and own nothing.

you talk like stocks are the only game in town. they aren't.

2008 Jun 06 12:34 AM

[peg_investor:]

User 188963,
there is a reason the 3.5T money are sitting in the money market funds earning less than 2%; what do you suggest? Throw them out on the garbage? Better earn 2% (or below inflation & bleed) than lose 30-50% in 1-2 years by buying overvalued merchandise.

2008 Jun 06 02:30 AM

[icandoitdon:]

hey user 188963.....where are you today? buying band aids at your local wal mart?

don't worry about it....it's just a buying opportunity for those stocks that are about to climb that "wall of worry."

2008 Jun 06 09:35 PM