Money Sage

Obviously, we do not know the answer to this question. Indeed, the fairly widespread opinion among "experts" that a big rally is impending, and the view of the major market strategists at the big Wall Street firms that 2009 will be a positive year for the stock market may be vindicated.

Having said this, our view is very different. While an explosive short-covering rally could occur at any time, factors are accumulating which suggest another market meltdown, either before or subsequent to the next bear market rally (of which there have been at least seven since the start of the bear market 16 months ago). The most important of these factors is the GROWING UNDENIABILITY that the de facto collapse of the banking system, the intense credit contraction which has abated only minimally, and at the margins, and the crumbling U.S. and global economies MEAN MUCH, MUCH LOWER EARNINGS than Wall Street continues to predict. The allegedly low price/earnings ratios are a product of desperate imaginations, and clearly do not reflect a progressively darkening reality. Morevoer, dividends continue to be cut by an ever-broader spectrum of corporations. Moreover, it seems increasingly clear that prior years' corporate earnings were pumped up by the employment of a large amount of leverage, leverage which is now evaporating. This factor alone should suffice to puncture Wall Street earnings projections which continue to stoutly ignore this reality.

And then there is the matter of interest rates. The reality for the great bulk of investment grade corporate bond issuers is that the spreads between their bonds and Treasuries remain as wide -- or in many cases wider -- than that which obtained at the very depths of the Great Depression. Many corporations with sizable amounts of debt coming due may well be unable to roll over this debt, and may thus come into intimate range of bankruptcy. For those corporations which can roll over their debt, the extremely high nominal AND real rates of interest they must pay suggest very sharp, and in some cases, calamitous, compression of profit margins.

Finally, there is the matter of the back-up in Treasury yields. This is hardly a laughing matter. From their trough levels in December, the yield on the long bond has backed up more than 100 basis points, while the yield on the 10 year note has risen by nearly as much. By employing the rather simple methodology of elementary school arithmetic we arrive at the following conclusion: this Treasury yield back-up constitutes a 40-50% INCREASE IN BORROWING COSTS FOR LONG TERM BORROWINGS BY THE TREASURY. More significant is the perpetual and unchangeable reality that corporate bonds of even the most solid corporate issuers will always have to yield significantly more than Treasuries, which bear no credit risk. This is especially true during periods of financial crisis, obviously. The back-up in Treasury yields, unless reversed, will drive municipal and corporate yields higher, negating the modest recent decline thanks to the compression of spreads vis-a-vis Treasuries. A rise in overall borrowing costs in the current and likely future context of massive capital destruction, acute credit shortage, and intense risk aversion of investors cannot but impact earnings seriously and negatively.

Of course, the backdrop for the future course of stock prices remains the de facto collapse of the banking system and the non-emergence of any workable plan to resolve, or even ameliorate, this collapse. In plain English, no one as of this writing is yet willing TO ABSORB THE MULTI-TRILLION DOLLAR LOSSES WHICH WILL ULTIMATELY ACCRUE FROM THE COLOSSAL OVER-LEVERAGING, OVERSPECULATION, AND EXCESSIVE UNDERWRITING OF MORTGAGES AND MORTGAGE-BACKED SECURITIES, which crested,naturally, at the very peak of the bull market in real estate prices. Nor do we expect to see any taker of massive loss of last resort emerging. The political risk would be enormous, and our politicians and top office-holders are in dread of such risk. Consequently, the seemingly endless cost of temporizing, providing life support to the banking system, coming to one sector rescue after another (and then returning, again and again, for repeat rescues after the initial rescue money has run out), and maintaining a system of Zombie Banks a la Japan seems the likely outcome.

The economic and profit consequences of such a policy are quite clear, and they are not pretty. All we need do is look at Japan. Fortunately, our market seems to move much faster than theirs, implying a bottom sooner rather than later. While the chronology is better, it is far from clear to us that the real peak to trough decline will be a lot better.

Market psychology remains at Bear Market Stage II. Typically, the consensus of both experts and mass of investors during the initial phase of a bear market is: "What bear market? All we are having is a bull market correction." This psychology prevails until stock investors have lost a huge sum of money. Then, the psychology moves to stage II: It is too late to sell. This psychology currently appears to predominate. Stage II psychology typically remains in the ascendancy during the second stage of a bear market: it is a pretty reliable guarantor that huge NEW losses will be incurred. We are still far, far away from Stage III, which marks the last leg down: It is imperative to SELL NOW; stocks are a terrible investment, they will never come back. Anything is better than stocks.

This market has demonstrated, repeatedly, that it moves at lightning speed even as the analysts, market gurus, and advisors proceed at snail's pace, lagging so far behind the actual curve as to insure massive equity capital destruction.

We think, for all of these reasons, that the dominos are in place for another collapse, though we have no idea when this may occur.

Moneysage 2009 - copyright