Markets Haven't Yet Properly Digested the Bad News

Includes: DIA, QQQ, SPY, XLF
by: Max Fraad Wolff

Share prices and corporate fortunes are being riled by the rediscovery of long known and recently denied basic facts. GM (NYSE:GM) and Ford (NYSE: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