Even With the Bailout, We Won't Find an Immediate Bottom

By Eric Roseman

Morals aside for just a moment, I'm going to ask the practical question about Paulson's proposed bailout...

Could Paulson's Troubled Asset Relief Program (TARP) put a floor on this bear market? Many investors think it would. Yet, as Congress delays passage, the economy and especially the mortgage-backed market continue to bleed.

According to investment research courtesy of Merrill Lynch, previous government orchestrated bailouts of the financial system have not resulted in immediate stock market gains. In fact, history suggests there's more pain ahead even if Congress does change its mind.

You see, just because a central bank expands credit doesn't guarantee policymakers can eliminate deflation across all facets of finance, consumption and industry. This process could take years.

Japan went through a similar crisis just 10 short years ago. It's true, the U.S. may not repeat Japan's experience, but it still points to difficult economic times ahead for America - especially as the fight to kill deflation takes every last drop of inflation-inducing monetary expansion.

The S&L Crisis Provided a Taste of What's to Come

Even here in the U.S., a bailout doesn't always work immediately. After the government created the Resolution Trust Corporation (RTC) in 1989 to bail out the Savings & Loans in the United States, stocks didn't form a bear market low until late 1990. The economy didn't bottom for another two years and housing values kept declining until 1993.

The U.S. market needed several more years to really find its footing following the S&L bailout. But the problem with this historical comparison is the current credit crisis is far more lethal than the S&L debacle. Before it's over, this crisis will cost American taxpayers at least US$1 trillion...maybe more.

In inflation adjusted terms, the proposed bailout will cost at least three times more than the S&L rescue cost (US$350 billion in 2008 dollars). Honestly, it could be even more if you take into account that real estate prices are still declining.

That's an important caveat because the Paulson plan aims to provide a fund to pool all distressed mortgage-backed securities. But it's actually impossible to place a price tag on this bailout until real estate prices bottom. That means it's probably going to be more.

The proposed rescue now is ultimately highly inflationary for the United States. This will all lead to massive credit inflation as the Fed and eventually other central banks flood the system with dollars.

Yet the short-term battle is against deflation. Right now, rapidly declining asset values are delaying any meaningful recovery for stocks, although I do see a possible "relief" rally coming in 2009. Beyond that, it's hard to make a case for a new bull market in U.S. equities.

Japanese Deflation and the Cost of Inaction

Similar trends in Japan show the long-term effects of price deflation and the Japanese government's inability to grow inflation during the "lost decade" of the 1990s.

In some ways, Japan has been "lost" since the Nikkei peaked in early 1990. The Nikkei Index remains almost 70% below its all-time high almost 20 years ago. Currently, the Dow Jones Industrials Average is down 22.5% from its all-time high.

Can the same phenomenon happen in the United States after this credit crisis?

The United States is fighting an incredible bout of deflation right now, much like Japan in 1990. Real estate deflation is especially difficult to stop because it affects the entire economy, including individuals, corporations and especially the banking system. This is exactly what happened in Japan. The only major difference now is Congress' willingness to act fast and avert severe deflation.

The Japanese economy didn't bottom until 1999. Stocks have staged several unimpressive rallies over the last decade and remain well below their all-time highs. Despite incredible printing and money-supply growth over the last 15 years, the Japanese haven't completely licked deflation.

What's shocking about the Japanese financial crisis is that it took another five years for the stock market to bottom after they passed their RTC model in 1997 and introduced the broad-based financial services reforms.

Japan is by far the world's premier example of failed monetary expansion. You could argue that Japan has never really emerged from deflation with price levels barely above 0% over the last few years and new signs pointing to renewed deflation as the economy slumps yet again.

Central Banks: Print Fast, Print Hard

Paulson, unlike Congress, wants to throw everything the United States has into fighting the deflation afflicting American banks right away. And Bernanke - a scholar on monetary policy - understands the cost of inaction from examples like the Great Depression (when the Fed failed to address deflation until the latter half of the 30's) and Japan's lost decade.

History strongly suggests that any delays or lack of sufficient funds committed to blasting away at deflation can be painful. So in my mind, one powerful bailout could potentially help us find the bottom of this crisis at least in the short-term.

Instead, dollar-cost-averaging for the long-term is a great value-based strategy now, especially for younger investors. For everyone else, stick to income-producing or equity-linked investments that spin off income. Also, as credit markets eventually stabilize, look to huge values in investment-grade corporate bonds now yielding almost 7%.

This is not the time to bet the farm on stocks. Deflation - the environment of rapidly falling prices and the contraction of lending - will continue to inhibit earnings growth and domestic consumption for the next several months or longer.

Deflation is here and it's real.

Stock position: None.

Comments

[Pauly B:]

Great article.

We need more than a bailout we need stimulus. With all the trillions sitting on the sidelines in markets around the world what would happen if they cut cooperate, capital gains, and individual taxes? Answer:

You would have money pouring back into equities and revenues increasing in the treasury and businesses expanding. I think its a trade those sitting in cash would make.

This bill not only will hit us in taxes but at the grocery store too.

2008 Oct 02 08:40 AM

[Carl Spackler:]

Right on! We are looking at a great delationary spiral as money is sucked out to the economy by a loss of leverage.

2008 Oct 02 10:01 AM

[Econ 101:]

Inflation helps debtors by providing cheaper money to repay debt.

Deflation helps creditors by making debtors repay in more expensive dollars.

So if you save and keep debt reasonable you are a fool. The government (Hank Paulson) now decides who stays solvent and who goes out of business. is it any wonder why Goldman (his old firm) stays on top?

Why are the democrats (Frank, Pelosi & Reed) so supportive? What is their payoff? Are they so corrupt that the banks own them too.

Silly question, huh?

2008 Oct 02 11:20 AM

[Nick B:]

Actually it's a misconception that Japanese authorities did not respond quickly to the problems of over a decade ago. Monetary authorities cute rates just as quickly as the Fed. This was followed by brief positive growth in the mid-1990's. Many Politicians and American market participants are in denial about the parallels of the Japanese debacle and can’t bear the thought that we repeat the same mistakes. .

2008 Oct 02 11:26 AM