Monday, May 5, 2008

It ain't easy being a bear

Actually, I hate it. In fact, I'd rather not consider myself a bear at all, and I'd like to think that perhaps it's more the circumstances of my involvement with the financial markets than any disposition of my own that has led me down this dark path. Or maybe it's just the history of the facts. Greg Ip comments in the Journal today that history suggests that while we may be late in the credit crisis game, we are sure to be early in the economic weakness game.
The economic fallout from a crisis depends on how much underlying economic factors -- such as consumption, investment and asset prices -- are out of whack with their fundamental determinants. The 1987 stock-market crash and the near-collapse of hedge fund Long Term Capital Management in 1998 threatened the heart of the financial system. But the underlying imbalances were largely limited to the financial markets themselves: stocks overvalued relative to earnings in 1987, and excessive hedge-fund borrowing in 1998. Thus, once the Federal Reserve's rescue operations had mitigated the threat to the financial system, the economic fallout was limited.

The current crisis is different. For several years, U.S. home prices and home construction kept climbing past levels considered sustainable. Homes became collateral for trillions of dollars in borrowing. That depressed savings, inflated consumption, fueled rapid lending and loosened loan standards.

When home prices stopped rising, the diciest mortgages began to default, triggering the crisis. But even now, prices are above most estimates of sustainable levels, and household saving has barely picked up. Even if the Fed's bailout of Bear Stearns Cos. in mid-March proves the apex of the crisis, as some think, the economy could still contract as consumers adjust to lost wealth and reduced access to credit.

Interestingly, all this means that we are in a special situation where we can predict the economic future. Normally you simply can't do this. We all know about the business cycle, but it's irregularity, and the complexity of the system, normally don't allow us to utter more than the truism, "Unsustainable things tend not to be sustained." It's easy to see these things getting built-up, but they always seem to go on much longer than one would expect, and it seems impossible ever to call the top just right.

Right now is different. The US economy WILL weaken. The world economy WILL weaken. We understand both the backdrop and the trigger. This is as close as you can get to predicting the future. We may not know exactly how things will play out -- whether inflation, a stock market crash, (more of) a dollar crisis, China descending into chaos, or what -- and we do not know how deep the recession will be, but we can be sure that the next year or two will not be pretty. This is exactly what the credit crisis is telling you. This crisis of confidence is the leading indicator, and happens before anyone has lost any real money.

All of this would be moot, I think, from an investing point of view, if you could show me the undervalued asset class. Who cares about the economy if you can buy assets for sufficiently less than their worth, or great assets at approximately what they're worth? But where are these assets now? You can make the US market look mostly fairly valued, but you really cannot make it look cheap without stretching the bounds of credulity. The same would apply to Europe. And emerging markets are 50% above their historical valuations, perhaps for good reasons, but certainly not for reasons of precedent. Knowing that the economy will inevitably weaken, lacking any tempting asset class, what is an investor to do?

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