Sunday, November 23, 2008

the meltdown


Here is where things stood in the financial markets at the end of the day Thursday.

First, the stock market.

On Thursday, the S&P 500 fell 6.7% in one day (after having fallen by 6.1% the previous day) to 752, its lowest level since 1997. (The S&P 500 is a better, broader measure of the stock market than the Dow Jones Industrial Average. The Dow only includes 30 large stocks and is price-weight averaged, unlike the 500 stocks in the S&P index which are market-weight averaged.) On the way down, it passed the low of 777 that it set in October of 2002 during the last bear market. It’s now lower than it was before the dot.com/tech/telecom boom, the NASDAQ market crash and the post-2003 bull market that sent stocks to record heights. It was down 52% from its peak of 1565 set in October of last year. As of Thursday, $8.3 trillion in stock market wealth had been erased in the US in just the past 13 months. If the year ended on Thursday, the S&P 500 would have been down 49% for the year, the worst annual decline in its 80-year history. (The Dow has been around longer – since 1896. In that time it has had ONE year with a bigger decline – that was its 52% decline in 1931.)

(An interesting Depression-era note: It took the Dow 25 years – until 1954 – to again reach the level of its pre-1929-crash high on an inflation-adjusted basis. A lost generation for investors.)

Globally, investors have erased more than $33 trillion in stock market value this year.

But the credit markets were even scarier.

When people pull money out of riskier investments like stocks or bonds, where do they put it for safety? Treasury bills. As more people seek the safety of Treasury bills, the higher their price and the lower the yield. On Thursday, the yield on the two-year Treasury note dropped below one percent (to 0.97%) for the first time EVER. (The yield had been as high as 3.11 earlier this year, in June. Had you held those notes throughout 2007 you would have earned a return of 7.5%.) Yields on two-, five-, and 10-year notes and 30-year bonds all dropped to their lowest levels since the Treasury began regular issuance of those securities. Rates on three-month bills dropped to 0.02% -- essentially nothing. The equivalent of storing money under your bed.

The two-year breakeven rate (the difference in yields between inflation-linked bonds and nominal bonds) was minus 4.09%, suggesting that traders are betting that the US economy will face deflation over the next two years. That reflects the
1% decline in consumer prices in October, the largest monthly decline since World War II. The producer price index fell by an even larger amount in October – 2.8% – the largest monthly decline since that measure was created in 1947. Once you get into a deflationary environment, it gets REALLY hard to turn things around. No one wants to invest now to generate lower cash returns in the future. Consumers hold off as long as possible on purchases to take advantage of falling prices. And the Fed loses its ability to stimulate the economy through interest rate cuts when rates go negative. That is what economists refer to as a “liquidity trap.” When Japan fell into a liquidity trap in the early ‘90’s, it took a couple of decades for that country’s economy to climb back out.

The financial markets are reflecting activity (or the lack thereof) in the “real” economy. On Thursday it was reported that the number of people filing
new unemployment claims during the previous week reached a 16-year high of 542,000. (Bush finally dropped his opposition to an extension of unemployment benefits, and on Thursday Congress approved another 13-weeks of benefits for those who have already exceeded the previous 26-week limit.) Even before the big losses of this month, the US economy had already shed over 1.2 million jobs this year.

Fed officials lowered their growth estimates for 2008 from a range of 1 to 1.6% previously to zero to 0.3%. Fed estimates for 2009 dropped to a range from a contraction of 0.2% to growth of 1.1%.
Goldman Sachs was even more pessimistic. They slashed their fourth quarter 2008 economic growth forecast from a negative 3.5% to a negative 5% (at an annualized rate). For first two quarters of 2009, they are forecasting declines of 3% and 1%. They are also forecasting unemployment reaching 9% by the fourth quarter of next year. (An interesting Goldman note: Their share price is now down by 54% since Warren Buffett invested $5 billion in the firm only seven weeks ago.) Shares of Citigroup fell more than 50% this past week alone, as they announced layoffs of 52,000 employees. (The New York Times has a very long article today on the decline of Citigroup.)

Last week, the price of oil fell below $50 a barrel, down from a high over $147 in July. While a drop in oil prices would ordinarily be considered a good thing for the economy, in this case it reflects a pessimistic forecast for economic growth and hence oil demand. (It also suggests a large speculative element in the run-up of prices earlier in the year.)

To summarize, everything that you DON’T want to go up is now looking like a hockey stick on the charts. And everything you DON’T want to go down is dropping off a cliff.

For example, the differences over time between rates on corporate bonds and risk-free Treasury bonds look like this:




And here is the trend in retail sales:



That 8.8% real decline in retails sales in October was the largest since records have been kept. (Consumer spending constitutes 70% of GDP in the US.)

It is easy right now for me to imagine scenarios where things get a lot worse. It is hard to come up with scenarios for things bottoming out any time soon.

This is my big worry right now. The US is “over retailed” (i.e., we have far more retail sales capacity than we do sustainable demand). That suggests a lot of retailers will be going out of business. Right now, a lot of them are barely hanging on hoping that a decent fourth quarter (holiday sales) will save them. To do that, they are slowing or stopping altogether payment to suppliers. But as the chart above shows, we know the fourth quarter is going to be disastrous. That will drive a lot of retailers under. And because their suppliers, too, have been barely hanging on and have been strung out by their customers, a lot of them will also go out of business. And no one is going to be getting a line of credit to save them – the credit markets have dried up. In other words, this is more likely the beginning of the bad news, not the end of it.

On the other hand, I don’t see what stops the free-fall right now. What’s the scenario for a turn-around any time soon? It’s hard for me to come up with an even-remotely plausible scenario.

Making matters worse is the fact that President Bush and Treasury Secretary Paulson have essentially checked out and it is still two months before Obama is sworn into office. That is an eternity under current circumstances.

All of which suggests, President Obama and new Congress will need to take very dramatic action immediately upon taking office. Previous forecasts and plans are irrelevant.

More on what to do in my next post.

2 comments:

Doug S. said...

Time to send in the proverbial helicopters?

Anonymous said...

Russ,
The unemployment rate in California hit 8.2% last week. From the Los Angeles Times:

"Reporting from Los Angeles and Sacramento -- California's unemployment rate soared to a 14-year high in October, hitting 8.2%, and economists predicted that it could rise substantially over the next year and a half.

The state's economy shed 26,400 people from its payroll last month, raising the total number of lost jobs to 101,300 since October 2007, the California Employment Development Department reported Friday."


1http://www.latimes.com/news/local/la-fi-caljobs22-2008nov22,0,2153451.story
--Max B. Spensive