Since 9/11, a pall of pessimism has covered the U.S. Polls show
that between 60 and 85 percent of Americans have believed that
the U.S. is in a recession or would go into one the following
year. But from September 2001 through August 2008, those polls
were wrong.
Nonetheless, the failure of Lehman Brothers, with its ripple
affect on money market accounts and confidence in the U.S.
banking system, finally made this prognostication a reality. The
U.S. entered a real recession in September. Rather than a
prolonged recession, however, or one that is worsening, we’re
seeing a temporary “V” shaped recession caused by a sharp,
fear-driven slowdown in the turnover of money, or velocity.
Even though real GDP expanded at a 2 percent annual rate in the
first half of 2008, the latest conventional wisdom is that the
recession we find ourselves in today is either a continuation of
one that began a year ago, or a recession that will last a very
long time. The difference between the optimistic and pessimistic
reading of the current situation is huge. If it is a “V” shaped
recession, then the markets will recover quickly and strongly. If
the U.S. is in a prolonged and deep recession, then the markets
could fall much further.
Clearly, short-sellers have bet heavily on the latter being true.
Short interest in October reached an all-time high, and it is
clear that coverage of the economy by the mainstream business
press has sided with this view. The argument that investors must
eventually capitulate to the downside, and accept prospects for a
deep and prolonged recession, is the conventional wisdom of the
day.
But events are more likely to unfold in a much more positive way.
With a “V” shaped recovery on the way, and corporate earnings
unlikely to drop by anywhere as much as the bears believe, it
will be the shorts that must capitulate in the months ahead. As a
result, a “melt up” in equity values is much more likely than a
further “melt down.”
ESSENTIALLY, WHAT THE U.S. is experiencing is a crisis of
confidence. The Conference Board’s Consumer Confidence Survey
fell to an all-time low of 38 in September, lower than its level
in 1980 when inflation rose above 14 percent and unemployment was
surging. This is irrational.
But it is understandable because the survey accounts for the
period immediately after the President of the United States went
on national TV and said people could lose their pensions, jobs
and homes. This was hyperbole designed to gain support for the
$700 billion bailout bill.
Financial markets are healing, in part because the government has
finally put so much money into them that they can’t help but
heal. Moreover, they are healing because the problems at hand
were never as bad as many have thought, even though securities
fell to levels that priced in one of the worst economic
calamities since the Great Depression.
Much of the problem was due to mark-to-market accounting. While
it may work well within a one or two standard deviation event, it
breaks down, and actually accentuates problems, when the world
faces market liquidity and pricing issues on the severe tails of
the distribution. A $300 billion problem of bad loans has morphed
into disaster three or four times as large. In addition, mistakes
by the federal government in the early going of the current
crisis, which included not suspending mark-to-market accounting
rules, made U.S. financial market problems much worse.
MY VIEW OF WHAT has happened is completely different from the
conventional view. Market pundits argued that when oil prices
rose above $40 a barrel, the consumer would be wiped out. But oil
went to $60, $80, and eventually $148. Yes, car sales suffered,
but overall consumer spending continued to rise. It was in
September, when panic over the viability of the banking system
set in, that consumer spending was undermined. And by that time
oil prices were falling sharply.
Another fear was that slumping housing prices would undermine
consumer spending. This did not happen either. And still others
have argued that the world is so wildly leveraged that an
unwinding of this would create financial market mayhem. Nouriel
Roubini, one of the most bearish forecasters around, predicted
that it was going to get so bad that governments around the world
would eventually be forced to close financial markets for a week.
The odds of this actually happening are very remote. What finally
killed the consumer was not high oil prices (even though it did
hurt car sales), or falling house prices, or tightened credit
markets. What finally killed the consumer was fear. Fear that
money market funds and bank accounts were not safe. Fear that
credit would not be available. Fear that stock prices would
continue to plummet.
The good news is that this fear will not last long. The bailout
scheme put in place by the government, especially the support of
the commercial paper market in late October by the Fed, has
stopped the deterioration of the banking system and begun to firm
up asset prices. It would have been easier and cheaper to suspend
fair value accounting rules, but the government would not do
that.
Don’t misunderstand: mark-to-market accounting should still be
suspended; but that would be gravy at this point. Within the
artificial accounting restraints the government has created,
enough money has finally been injected to contain the problem.
STILL, IT IS CLEAR that many do not share this optimism. And why
should they? Short-sellers have made a bundle in recent months.
But we are now at a point of over-confidence on the short side.
Irrational pessimism has set in, and just like a bubble to the
upside, this downside bubble must eventually burst.
The short-sellers and pessimists were right about a recession and
large stock market declines, but for the wrong reasons. The
markets fell apart because of accounting rules and ham-handed
government intervention, and this is what undermined confidence
and led to a drop in consumer spending.
The key thing to remember is that while the U.S. financial system
may have taken a beating, it has not completely broken down. The
Great Depression was caused by a massive deflation and the
destruction of money as thousands of banks failed. Today, the
Federal Reserve has more than doubled its balance sheet to a
whopping $2 trillion and the Treasury has drawn a line in the
sand, essentially taking any more large bank failures (for
accounting reasons alone) off the table.
And every time the Fed injects money into the system, the economy
reacts. The money will find its way into the economy and a sharp
recovery in spending will begin quite quickly. And when the
velocity of money actually increases, the injection of money into
the system will be like gasoline on a fire.
When that happens, short-sellers will have nowhere to run. But
because they have grown overconfident, it will take some time
before they fully capitulate. In the process, the markets could
have a spectacular run to the upside. Already, we have seen this
in Japan, where the Nikkei rose 26 percent in just three days.
Look for a “melt up” in the months ahead as irrational pessimism
finally must give way to reality.
