Tuesday, October 28, 2008

Morning Post.

I heard yesterday a couple of times this statement which gave me pause: The stock market is forecasting a very serious recession.

Our blog friend, NG, also notes this in the comments section which I think deserves highlighting:

I was listening to a credit fund manager today...

He said that the credit market is currently discounting that 90% of high yield bonds will default. He went on to say that such a rate of default was not even achieved during the 1930's depression.

At such levels by historical norms, this would equate to a DOW of no more than 5000. So either the credit market is right or the equity market is right and the credit market is overreacting.

To the first comment of the market's forecasting ability, I have a one word response: NOT! I do not believe, and I will NEVER believe that the market is a very good prognosticator of anything but rather a barometer of the market participants' current emotion. Accordingly, it makes sense to me now, having seen a full cycle (except for recovery), why markets go up higher than you think (optimism) and why they go down further than you thinking (fear). Somewhere in between there is some rationality.

Some may gasp at that statement, and it may be wrong. But if one is to take issue with it, one has to answer this question: If the market is in delevering, and delevering by its nature means forced selling of assets, then how is that a prognostication of anything? In my simple head it is cause and effect (credit contraction=liquidation). If the market had been prescient, then so many would not have been locked in the jaws of this massive delevering shark.

To be sure, credit is the lubricant of business. So it is fair to say that the contraction in credit, IN ADDITION to the unwinding of the currency arbitrage (carry trades), will have a deleterious effect on economies of the world. Not only are companies delevering but consumers.

Accordingly, the credit markets SEEM to have a better handle on the risks in the credit markets. But let's face it, they were were not so hot in pricing risk in the thick of the CDO orgy. Otherwise, the credit markets would not have allowed a less than 200 basis point spread between these toxic instruments and treasury bonds. Were these market participants any less affected by the optimism? No. They drank from the Kool-aid cup, too. So, I'm going to say that the credit market's collected viscera is gripped by the same fear as market participants.

I remember during the last bubble. I was not a conscious watcher of the markets. Not a whit. But I do remember scratching my head at the calls for "the new business model". The new business model valued sales growth over profitability growth. I would just scratch my head, because I knew that ultimately, a company has to be profitable to survive.

Certainly the appetite for stocks was so voracious, that one could float any sort of crap and have it gobbled up. The band always gets tired at some point and has to take a break. And when the music stops, then the whirling dervish dancers (creditors + investors) catch their collective breath and have an "Oh Shit" moment. (Those are never pleasant). Damage assessment and retrenchment begin immediately.

An astute investor does not dance, but rather maneuvers with great purpose and extraordinary alacrity through the crowd of dancers. Naturally, s/he has one eye to the exit. I don't claim to be an astute investor. I've not mastered the maneuvering, though I've successfully had my hands over the ears to not hear the music. At some point one has to declare, "This is nuts, but there is money to be made!" I'm still working on trying to hold my reticence in abeyance while seizing opportunities. But, that is part of my development.

So we have this final phase to watch for, the bottoming and subsequent resumption (hope!) of the next bull market. I cannot believe that a bottom is formed out of this violence, but rather, it will be formed out of dullness. Until some normalcy comes into the credit markets, potentially, we will be at the continued the mercy of of the great unwinding. Again, the tide charts mean little in a Tsunami.

I'm also mindful of Selden's comment that the news is always the most bullish at the top and the most bearish at the bottom. I'm also mindful that the news has been consistently getting worse--and for those subscribing to this aphorism were those who thought that Bear Stearns was the bottom. Bear Stearns was only the beginning.

Employment numbers and the unemployment rate have the ability to take this market down. But I'll make this prognostication: We'll see the same amount of "the worst is behind us" on these numbers throughout the next year. I think that we'll see the consumer hunker down for a good long time--years. Why? Think of the bolus of baby boomers who just saw their wealth obliterated? So the most affluent age group, is the one that has the most to fear now: reduced housing and portfolio wealth coupled with Social Security and Medicare uncertainty.

Not a difficult conclusion to come to.


Glenn_in_MA said...

ahh...I so want to say you're wrong about the market NOT being a forward looking discounting mechanism but I can't because of your well thought out logic (plus I don't have a satisfactory answer to your question!!). Logic is good, along with common sense...at least they have served me well. I need to think about your thought process a little longer however, before I agree. :) Darn the markets...why do they have to be so fasinating?

Leisa said...

Glenn--I guess ultimately it comes down to symptoms vs. root causes. The root cause in the market is very much a function of liquidity (whether it is rising or contracting). Stocks and other asset classes respond to that.

The potential opportunity (or fallacy) is being able to correctly gage the direction of future liquidity. I don't see that increasing in a meaningful way soon. If I'm wrong, then the market is going to take off without me.

Glenn_in_MA said...

...I suspect the market will not be taking off without you!