Thursday, November 13, 2008

The Next Two Months: A Most Dangerous Time for the Financial Markets

We're now in the interregnum, with a Democratic President-elect to replace the Republican lame duck two months from now. The Republicans, grumpy about being clobbered in last week's elections, aren't eager to take up Democratic initiatives, like a bailout of GM. Treasury Secretary Hank Paulson has put the $700 billion bailout plan on hold. About $290 billion of it has been committed to supporting banks and other financial institutions, primarily through capital infusions. Another $60 billion is authorized to be spent by Treasury, but remains uncommitted. The rest of the funds, $350 billion, cannot be spent without further approval by Congress, and Paulson doesn't plan to ask for it. While the Federal Reserve and Treasury can use existing authority to lend to and invest in financial institutions, there won't be any significant new initiatives by the government until Barack Obama is sworn in.

In today's hyper volatile stock market, two months is a lifetime. The market dropped 17% in October. What will November be like? Within the past two and a half weeks, the market rose almost 20%, dropped 14% and then rebounded 7%. If there's one thing we've learned in the last six months, it's that we have no idea what will happen tomorrow, let alone next week or next month. This year, entire nations--like Iceland, of all places--have become insolvent. All the major investment banks in America have disappeared or been converted into commercial banks. Almost all major commercial banks in America have received capital infusions from the federal government. AIG, the nation's largest insurance company, has been virtually nationalized. The U.S. government, by taking control of Fannie Mae and Freddie Mac, effectively runs the mortgage business in America. Europe is on the ropes, with the Euro dropping like a rock against the dollar. Oil prices have been manic depressive. The recession, in America and overseas, promises to be worse than we expected yesterday.

Today's 552 point jump in the Dow may appear positive at first glance. But it seems to be mostly speculative frenzy. Not only did stock prices rise, but so did oil and wholesale gasoline prices. That doesn't make sense, since an increase in energy costs would only depress an already weakened economy. However, this kind of price activity could be explained as bottom fishers buying up any asset that has recently dropped a lot--in other words, speculation. Some market mavens claim there is a floor to stock prices at the 8,000 level of the Dow, because the market has twice hit that level this fall and rebounded. But it's risky to believe in talismanic stock index levels. Looking at the underlying economics makes more sense.

Good things could happen during the next two months. The sharp drop in oil prices may stimulate consumer spending, which is now lagging badly. Perhaps--just perhaps--truck sales might increase a bit, giving GM, Ford and Chrysler badly needed profits. The stronger dollar may bring in foreign investment, supporting U.S. stock and other asset prices. Japan and China may infuse capital into the IMF, which could lend it out to smaller nations with faltering economies and soften the worldwide recession.

Bad things could happen during the next two months. Consumer credit is tight and could easily get tighter. Consumers have started to realize that they haven't necessarily never met a debt they didn't like. They're deleveraging. That means lower consumption, which will lead to higher unemployment.

GM could go into bankruptcy. The outcome of such a bankruptcy is extremely difficult to game out. It's possible GM could successfully reorganize. But it's also possible that, with the auto industry severely burdened by overcapacity, GM wouldn't be able to attract enough new capital to effectively reorganize. The uncertainty of the situation would probably depress stock values, since the market hates uncertainty.

Housing prices could continue to drop. There is no reason to think that they've bottomed out. The Bush administration's latest mortgage relief proposal might help 10% of the homeowners who are underwater on their mortgages. And it wouldn't help those that are already in the foreclosure process, which includes a lot of homeowners. Mortgage rates are, if anything, rising.

Corporate earnings could fall more than expected. That's certainly been commonplace in the third quarter of 2008, as the nation and the world have slipped into recession more quickly than initially thought. Beginning in early December, we'll start getting indications as to how the winter earnings season will go. Much more information will come out in the two weeks before the Inauguration. The picture might be grim.

Thus, the next two months will be a most dangerous time for investors. There will be plenty of risks and no hope of any new major government initiatives to offset the risks. Don't think today's 7% market jump means much. Buy stocks, if you're feeling bold or your investment horizon is way off in the distance. Don't invest anything you can't afford to lose. At the same time, don't lose heart. There's nothing about the current economic crisis that tells us the U.S. can't recover. Recovery may be a ways away. But things were a whole lot worse in the 1930s. This, too, will pass.

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