No bottom yet in equity and home prices, credit crunch, deflation or recession pain

Despite signs in the futures market of an equity market rally Monday on the new G-7 and EU coordinated policy initiatives, there is still almost certainly more financial and economic pain to come.

The cyclical lows are virtually certain to be still ahead in the equity price indicies. This dire forecast is despite the steep declines of 18 percent last week in both the Dow and S&P 500 indicies, the worst one-week recession decline since 1933. Over the past twelve months, the Dow is down 40%, while the S&P 500 is down 43%. These twelve-month percentage drops now exceed the total cyclical equity market decline associated with every post World War II recession with the sole exception of the 45% drop in the Dow from January 1973 through December 1974. But that decline was extended over 23 months, not 12 months as in the current more precipitous drop. Moreover, that cyclical equity market decline hit bottom only four months before the recession ended. In the current recession, the economic decline is only now intensifying significantly and is likely to extend for a number quarters, quite probably through all of 2009 and perhaps into 2010. Given a typical 5 months between the end of the drop in equity prices and the subsequent end of the recession, it would seem to be far too soon ahead of the probable end of this extended recession for the cyclical decline in equities to come to an end. Even an optomistic view that put the end of the recession this Spring would place the bottom of the equity market decline at year end.

The current widespread and increasingly proliferating credit crunch and housing debacle are far more reminiscent of the the 1930s depression than of the typical post World War II recessions. If that is even an approximate template for the current cycle decline in equity prices, we are in for a further steep slide. In the March 1937 through March 1938 period the Dow fell 49%, while between September 1929 and July 1932 the drop was an horrendous 89%. Considering that despite colossal mistakes currently, we are still doing far more things right now than in the Depression. Thus a judgement call would suggest an equity price drop far closer to the 49% than the 89% ends of that unpleasant spectrum. But, that does not imply that prices will continue falling in a staight line. There are almost always sptacular bear market rallies on the way to the bottom. And sometimes those short-covering rallies are so virulent as to be mistaken for a cyclical turnaround.

To some observers, equity prices are already low enough to be considered highly attractive. And for some stocks the lows might even be in place, especially for some financials. But that is not a sufficient reason for the overall stock market decline to come to its cyclical end. Certainly not when the decline in corporate profits is projected to accelerate amidst an intensifying global recession, a consumer and business spending contraction, a worsening housing slump, a yet to be alleviated credit freeze and a commodity price slide.

Perhaps most worrisome is the historical precedent that seems to dictate that whenever the ten-year lagged average of the price-earnings ratio of the stock indices exceed 20, as they have in recent years, this measure ultimately falls to 9 or below. That was the experience following the above 20 price-earnings peaks in 1901, 1929 and 1966. And it is likely to also be the experience currently. To repeat that pattern would require a substantial drop from here, especially considering that corporate earnings are also receding.

The dividend return on equities is also still well below its historic mean, let alone the traditional rule of thumb rule that calls for buying equities only when the dividend return is 6%, and selling when the divdend return declines to 3%.
The dividend rate of return is still far from that traditional buying trigger.

As if this equity market plunge and the consequent loss of wealth was not enough of a source of financial and economic distress, the banking system is frozen. Because bank deposits are not completely insured, banks are fearful of an unanticipated run by large depositors (in excess of $250,000), as has occurred with investment banks , hedge funds and insurance companies. That risk encourages banks to conserve cash and short term assets instead of expanding lending. The reported US Treasury proposal to temporarily insure interbank lending would certainly help free up such lending. The injection of Government funds in the banking system would also help shore up bank solvency. However,there seems to be no end to the array of problems besetting the financial markets and the economy despite the desperate efforts of the authorities to solve them. Thus, I am far from optimistic over likely sustained rally prospects for the equity market or an early recovery in the economy.

Philip Braverman, President
Braverman Economic and Finance Consulting
One Hewitt Square #249
East Northport, New York 11731

E-mail address: philipbraverman@Gmail.com