The ultimate game changer – why 2009 will be worse than 2008 (part 1)

In the last 2 weeks it seems that the bulls are coming out of the woodwork. Don’t get sucked into the idea that you should chase this rally! What may appear to be a light at the end of the tunnel is probably a train. No one seems to have a good idea of what earnings might be, yet all of a sudden, bullishness abounds. Very well managed companies are guiding down multiple times early in a quarter, with no improvement in sight, yet the fast money crowd doesn’t seem worried.

I’ve watched the credit bubble popping events unfold in the context of a volatile history. I’m cognizant of the fact that is has never paid to stay very bearish for long as America is a remarkably resilient nation – we’ve overcome Herculean challenges like the depression and WW1 and Korea and Vietnam and oil embargoes and gulf wars and internet bubbles and more. However, none of these challenges compare to what decimation this credit bubble popping has wrought.

I view the stock market game as a probabilistic field of sorts. We effectively consider what’s known and unknown and try to estimate the expectancy of the potential outcomes with our incomplete information. Looking at what’s happening economically is scary – the pace and magnitude of decline in economic activity and leading indicators has been historic.

Perhaps an arguably crude analogy can put this in the proper light. The first analogy I could think of is the initial phase of hurricane Katrina. Strong winds struck and rattled a lot but the damage appeared to be well contained and surmountable initially. It wasn’t until the insurance in the form of a levy failed that we realized that we were in a heap of trouble and needed to do something about a potential catastrophe turning probable, however, we had no reference point to help us understand the magnitude and the duration of the destruction and its painful aftermath.

Today the big question revolves around how bad earnings will get and what the nature and timing of a recovery might be so we can decide whether the market is cheap or expensive relative to such a base case scenario so we know how aggressive we should be and how much market risk we should take on. The idea being that if we reasonably estimate/approximate what the next 12 months earnings yield and longer term growth rate might be, we can also craft reasonable expectations of what the central tendency of stock prices might be in the year or two ahead.

What’s more is that none of the bulls seem to have a clue as to how and when the personal incomes and corporate earnings (which I assume would support a sustainable stock market recovery) is likely to manifest. And it also seems as if everyone is expecting that multiples should be similar to what we’ve experienced in recent history, despite the glaring fact that the game has changed such that when the growth needle moves noticeably it wont be very significant unless we start from lower bases still.

In prior bear markets and recessions, much damage was done but the lifeblood of markets, (ie. Liquidity and credit) remained in tact. Credit markets remained functional and countercyclical monetary and fiscal policy acted upon the supply side and demand sides of the economy and helped get the cogs of capitalism turning again. Textbook Keynesian dynamics – when consumers and the private sector lack the will or ability to spend, Uncle Sam increases everyone’s allowance and the Fed makes financing your spending easier and cheaper.

Meanwhile, the banking system facilitates stability and an eventual recovery as enterprising Americans take advantage of apparently depressed asset prices, goods and services prices, labor prices and capital prices. That, more or less, is how the cycle plays out and a new growth cycle is born in the ashes of the last bust. The key here is that the banking system is willing and able to facilitate commerce and inject the lifeblood of the economic growth to markets. It’s not only about keeping otherwise viable businesses solvent with the help of credit; but also sowing the seeds of economic expansion which yields jobs, income, wealth creation, and improved asset prices.

The credit bubble that has popped changes the game more than most appreciate. Many think it is a matter of time that things return to whatever normal they thought was in the markets but I’m afraid that is more than a tad presumptuous. Our economy is in a literal downward spiral and the conventional countercyclical remedies are either impotent or insufficient to mitigate the seemingly exponential headwinds because the banking system has become dysfunctional and permanently impaired. Life as we knew it is over because the real pie is actually much smaller than anyone thought and it will not grow like it did in the past because credit, lending, saving, risk taking and investing behaviors will change for a generation. You are likely to see less, more costly credit, more saving itself constrained by real income, less risk taking and less, and more conservative investing.

If you further consider that the government sector may not spend as much as everyone thinks; the outlook dims even more. It seems that everyone thinks that the federal government will spend without limit and backstop anything and everything such that a recovery is likely to come much sooner than leading economic indicators seem to suggest. I hate to burst your bubble but I think that as conditions deteriorate further in the next 3-6 months, it will become increasingly clear that government spending levels are also unsustainable and the focus is thus likely to turn to smarter/more efficient spending which will “shift priorities” and “limit waste”. So a lot of the incremental new deal type spending is likely to be offset but budget cuts elsewhere. Additionally, I think many are underestimating the extent of belt tightening at the state and local level.

At the same time individuals are likely to voluntarily and involuntarily curtail spending because the game of lending anything to anyone is also over. A great deal of economic activity happens because credit is available – no credit means that business, spending or investment doesn’t get done. A generation that was enabled to spend well in excess of its means will have to learn how to save. People will still want to buy houses, cars and other big ticket items but the no money down game has changed such that saving will increase which is good longer term but obviously will defer consumption accordingly. Surprisingly few Americans have the ability to put 20% down on a $300,000 home. One of the scariest things (because I don’t know how to quantify it) is the idea that in order to manage the massive credit expansion from a personal balance sheet perspective, the pie must continue to grow meaningfully. This generation has accumulated very significant debt service burdens which are obviously unmanageable from a cash flow perspective but also will act to crowd out future spending and investment. This is likely to act as an another albatross of sorts; especially if baby boomers try to salvage whats left of their retirement nest eggs/prospects by saving more.

Yet market pundit after market strategist after CNBC guest seems to think the “THE” bottom is in. Very oversold in the context of time such that a very sizeable rally on the order of a good stock market years returns sure, but “THE” bottom? I doubt that very much – it’s possible but highly unlikely in my view. I certainly wouldn’t bet on it because I think it’s much more likely that the next big move from here is NOT up. Don’t believe the hype! Focus more on managing your risk instead of missing out on something unlikely to happen. Stocks don’t typically do well when guidance and estimates are being missed.

I’ll be back soon with some more ideas which I hope make my points clearer and also a few ideas both long and short that I think can do well to make your stay in the house of pain more comfortable. To be continued (in part 2)….