Although the Fed's move to facilitate a sale of Bear Stearns and to allow investment banks access to the discount window and accept non-Treasury collateral may slow down the liquidity crisis near-term—and even this is far from a sure thing—there are still major problems ahead. The latest action does not address the underlying credit problems, does not improve solvency and does not stop housing prices from declining significantly. The rescue of Bear was spurred by the knowledge that the firm was counterparty to some $10 trillion of over-the-counter swaps. If Bear collapsed the chances were great that these contracts would not be honored, leading to a giant domino effect on the global financial system with dire consequences for the world economy.
Although that event has been staved off for the moment we are still not out of the woods. Eight million home owners currently have houses with market values less than their mortgage debt. With inventories of both existing and new homes at record levels and home prices still far out of line with income, a number of mainstream economists are looking for an eventual house price decline of 25% from the peak. This could lead to another surge of homes with negative equity and as many as 2 million foreclosures in 2008, leading to a negative feedback loop resulting in even lower prices, more problems with structured finance securities, additional rounds of write-offs by financial institutions and a long and severe recession.
Even now it appears that we have entered a recession. Although the Philadelphia Fed index was cheered today for coming in ahead of expectations, it was still a miserable minus 17. Except for the prior two months it was the lowest reading since late 2001, and the breakdown indicated weak manufacturing conditions, paring of inventories and slower capital spending. In addition, major economic sectors that are reliable recession indicators appear to have turned down. Retail sales have dropped in two of the last three months and are down 0.8% since November—and this is in nominal, not inflation adjusted figures. Industrial production has declined 0.4% since July. Payroll employment has now dropped for two straight months, something that only happens in recessions. A substantial decline in home prices from this point will make matters much worse.
The Fed alone cannot do much more at this time to prevent economic and financial conditions from getting a lot worse. Chairman Bernanke virtually concedes this point when he asks the administration and Congress to come up with some kind of plan to reduce mortgage debt on homes with negative equity. We think that Representative Barney Frank's tentative proposal along these lines together with some hints that the administration may be willing to negotiate indicates that something may eventually be done to accomplish these objectives, although there is obviously still a great deal of resistance to any taxpayer involvement. In any event we think that the process of reaching such an agreement will be time-consuming and messy, and that the outcome is still in doubt. In the meantime it is likely that the economy will go through a lengthy recession.
In sum we believe that the credit crisis is not over and that the economy is in poor shape. Still, for the umpteenth time we heard some "expert" on TV today saying that the market was cheap at only 13.5 times forward-looking earnings. How does he come up with this figure? He divides the current S&P index by the consensus 2008 estimate for bottom-up S&P 500 operating earnings of $98. There are at least two big problems with this. First, to get to $98 for the full year, year-to-year earnings would have to soar by 43% in the second half, an increase that we think is close to impossible given current conditions. Second, consensus reported earnings—which we prefer over the phony operating earnings—are estimated at only $71. Using this figure results in an estimate P/E of almost 19, which is at the top of the range for 71 years prior to 1997. In addition when we consider that when bubbles burst the stock market generally bottoms at closer to 10 times earnings, it appears far too early to call an end to the decline at this time.
