The prevailing view on Wall St. seems to be that the stock market has put in a solid bottom with the rescue of Bear Stearns. We disagree. We believe that there are few if any signs of a significant trough at this time. Historically, at major market bottoms the economic downturn along with its potential depth and duration is fully recognized, conditions are expected to get worse, investors give up on seeing a recovery anytime soon and price-earnings ratios (P/E) are below their long-term average. This is not the case today. The majority of investors appear to believe that the credit crisis has passed. In addition a large number of observers still feel that a recession will not occur while many of those that do concede a recession think that it will be exceedingly mild and recover in the second half. P/E ratios remain at the high end of their historical range. These are not the kind of investor attitudes that create major bottoms and great buying opportunities.
What the Bear Stearns rescue has accomplished is to prevent an immediate systemic collapse of the U.S. and global financial system and decrease the probability of it happening in the period ahead—although even this is far from certain. However, the vast majority of bear markets occur without the threat of systemic collapse, and the probability that it won't happen this time is no reason to get overly sanguine about the market. There are still plenty of credit problems ahead while the recession and associated downward earnings revisions are still in their early stages.
The credit markets are still fragile and are there are hundreds of billions of dollars of debt not yet written off, some of which may come as major surprises as has been happening since August. An estimated 40% of subprime mortgage loans may default in the next two years in addition to defaults on non-subprime loans subject to rate resets. This will throw millions more homes onto the resale market forcing further major price declines. Additional defaults in other areas such as commercial real estate, auto loans, credit cards and student loans are also a strong probability. Today, in his testimony before the U.S. Senate, New York Federal Reserve bank President Timothy Geithner said "Nevertheless, we still face a number of challenges ahead. The seeds of this crisis took a long time to build up, and they will take some time to work through.Liquidity conditions in the market are still impaired and the process of deleveraging remains underway. And this will amplify the headwinds facing the U.S. and global economy."
In our view the market is not only discounting the end of the credit crisis, but a second half economic recovery as well. This is not likely to happen. The greatest credit crisis since the depression and the biggest housing bubble in history will not end with a piddling little recession and a mere 20% decline in the stock market. The economy has already stalled out and plunging home prices and deleveraging of credit will make the recession either longer or deeper or both. The rosy view of the consensus is amply illustrated by S&P's tally of analysts' bottom-up operating earnings estimates for the S&P 500 index. Simply put, they are looking for second-half earnings to jump an astounding 42% from a year earlier. These estimates are sure to be slashed substantially, and the market reaction will not be pleasant.
