The worst is not over for the economy or the equity markets

Barton Biggs,the legendary Wall Street investment strategist formerly at Morgan Stanley, this week indicated that the worst is over for the economy and the equity markets. As readers of this blog know, I disagree.

But, lets examine Barton Biggs reasoning. First, he argues that the Fed has finished easing. And when that has occured in the past, the equity market averaged a 5% rise in the subsquent three months and 12% over six months.

Second, he argues that we are close to the cyclical bottom in new home sales and construction.

Third, he argues that there is a huge amount of liquidity waiting to invest.

And fourth, he contends that stocks are cheap.

But, he also points out that financial services are "busted" and that there will be more writeoffs.

Now lets examine these arguments. In the past the timing of the beginning and ending of Fed easing was far different than in this business cycle. Typically, in the past, the Fed firming in response to inflation concerns brings on a recession. But, there are usually extended lags before that recession is recognized. That allows the recession to become more entrenched. The Fed then eases, only ending its easing when it is clear the recovery is underway. The recession in the meantime has surpressed inflation concerns. This time the Fed easing was preciptated and propelled by a financial crisis, not a recession. But, that does not mean that a recession will be avoided. This time the Fed did not end the easing because the recession ended. Rather, the Fed paused in its easing because the dollar decline in response to lower interest rates was contributing to inflation fears stemming from higher oil and commodity prices. Thus, it would be a mistake to assume that the end of Fed easing, even if that assumption is correct, signals an all clear on the economy and corporate profits. A consumer led recession seems virtually inevitable considering that the housing meltdown has made the consumer poorer, has reduced his equity, and his borrowing power. The rise in energy and food prices has reduced consumer spendable funds on discretionary purchases more than the tax rebates will increase it. Consumer confidence has plunged with these burdens, rising unemployment and limited earnings prospects. Wage gains are actually decelerating, suggesting inflation pressures are not being embedded in wages and therefor the consumer is being financially squeezed.

There is no basis for assuming a bottom in the home price and contstruction collapse is close. Home prices are down at least 10% from their 2006 peak and are expected to decline 30% or more under the weight of still rapidly rising home mortgage delinquencies,defaults and foreclosures. Recent home price declines, if anything, appear to be accelerating.

There is reason to doubt that there is a huge amount of liquidity just waiting to invest. Though the Fed has increased liquidity in the economy, banks remain concerned over extending credit. They and other distressed members of the financial community are still scambling to rebuild capital after the huge writeoffs of bad debts and losses. Barton Biggs' forecast of further financial sector losses, a view I share, would argue against there being both ample liquidity and an earerness to employ it.

Lastly, stocks are not cheap by any stretch of the immagination. True stocks have been more expensive than they are currently. But, that does not make them cheap. Indeed, every time the average price-earnings ratio exceeded 20, it has subsequently fallen to below 10, not just to the long term average of 15. There were negative or subpar returns in the 5, 10 ,15 and 20 year periods following the previous price-earnings peaks of 25 in 1901, 32 in 1929, and 24 in 1966. You can draw the appropriate inference from the price-earnings peak of 44 in 1999. We have, at best, been in a bear market rally. And past experience suggests it will either persist or revert to a true bear market.


Philip Braverman, Presdent
Braverman Economic and Financial Consulting
One Hewitt Square, Suite #249
East Northport, New York 11731