With the credit situation still deteriorating and the economy softening it appears highly likely that we are heading toward a recession. This has not been discounted by a stock market that has complete faith that the Fed will ride to the rescue. In our view this faith is unwarranted, and the Fed will be unable to counter the significant forces that are driving the economy down.
The credit crisis, while now widely known, is far more serious than is indicated by the garden-variety 10% drop in stock prices. In a recent report Jan Hatzius, Chief U.S. Economist of Goldman Sachs, stated that the turmoil in global credit markets may force financial institutions to cut lending by $2 trillion and trigger a "substantial recession." He forecast home foreclosure losses of $400 billion to these institutions and that this would be multiplied ten-fold as companies that borrowed to finance the bad loans cut back on lending. The huge reduction in lending would amount to 7% of the total of all U.S. household, corporate and government debt. Hatzius added that "It is easy to see how such a shock could produce a substantial recession."
According to an article in today’s New York Times the reduction in lending is already happening. The outstanding amount of commercial and industrial loans plus commercial paper has declined from a peak of $3.3 trillion in August to $3 trillion in Mid-November, the most rapid percentage reduction since the Fed started tracking the data in 1973. The article points out that three recessions in the last 32 years were preceded by far smaller declines in lending. Nobel Prize winning economist Joseph Stiglitz also sees the strong probability of recession. Stiglitz estimates that homeowners extracted up to $950 million last year from their home values in order to finance spending. He stated "The game is over. As house prices are going down, people are not going to be able to take more money...The impact of that is going to be a very major slowdown, maybe recession."
Given the rapidly deteriorating economic outlook it is no wonder that Fed Vice-Chairman Donald Kohn suddenly hinted yesterday that the Fed may very well consider cutting rates at the December meeting. The only surprise was that the stock market was so surprised. Kohn was obviously reacting to continuing credit turmoil and further softening of the economy that the Fed utterly failed to anticipate only a few short weeks ago.
So apparent is the weakening economy that even the White House, today, reduced its forecast of 2008 GDP growth to 2.7% from a previous 3.1%. In issuing the statement, Chairman of the White House Council of Economic Advisors Edward Lazear stated "The housing market decline has been more significant than we expected". He also said that he expects the drag from housing to continue "at least through the first half of 2008" and that the credit situation has gotten "a little worse again" in the last few weeks. This is about as negative a statement as you’ll ever see from the White House, no matter who is in power.
In our view the stock market has not even come close to discounting the recession that is almost sure to come, if it has not already arrived. Even the consensus of private economists is still forecasting a 2008 GDP increase of 2.4%, not significantly below the estimate of the White House. In the last eight recessions going back 50 years the S&P 500 has dropped by an average of 30%, and in six of these instances the peak price-to-earnings ratio on trendline earnings was lower than today. Furthermore, don’t be fooled by sharp bear market rallies. The bear market of 2000 to 2002 was punctuated by five different rallies ranging from 10% to 25% while falling 50% overall. As pointed out by Investors’ Business Daily, Nasdaq’s nine biggest up days of all time occurred during the last bear market. Although the current bear market is also likely to be punctuated by sharp rallies, we believe it has a long way to go on the downside as the developing economic news worsens.
