Stocks and the Credit Market Crisis

Is the sub-prime meltdown bad for stock prices?

Is the spread of the sub-prime crisis to the commercial paper market bad for stock prices?

Moneysage, after analyzing these questions from every angle we can conceive of hereby offers his conclusions: the credit market crisis is VERY FAVORABLE FOR SELECTED STOCKS AND FOR THE OVERALL STOCK MARKET.

Well, dear reader, we presume that your immediate response will be: Hey, Moneysage, are you nuts, or are you merely an idiot?

Neither, we hope.

Our assesssment is based upon the following elements:

(1)The credit contraction, and its all-too-predictable worsening in the face of FED paralysis (thinly disguised as sober "policy") will INEVITABLY produce a significant DECLINE IN INTEREST RATES. Indeed, this is already a very powerful trend well underway in the Treasury market. Yields on the benchmark 10-year Treasury note have already fallen 100 basis points (1 full point) from the June peak. This constitutes a nearly 20% DECLINE in market rates. Moreover, further declines are a near-certainty, as the credit crisis impacts ever-more powerfully and ever-more obviously on the real economy.

(2)The FEDERAL RESERVE is being dragged, kicking and screaming to be sure, to CUT the overnight rate. Their gross failure to correctly assess the seriousness of the crisis and to comprehend its uncontainability by mere central bank verbiage instead of decisive action insures that FED cuts will be deeper and last longer than anyone currently anticipates, as the lagged impact hits the economy with far greater force than would have been the case had they acted like a central bank instead of an ivory tower debating club.

(3)The relationship between falling interest rates and stock prices is crystal clear, having been demonstrated in cycle after cycle for as far back as there are records. Stock prices rise as rates fall; the valuation of stocks INCREASES faster than earnings DECREASE. Of course, there are profound differences among INDIVIDUAL STOCKS and DIFFERENT MARKET SECTORS. When a company goes broke, its stock goes down to zero. It is beyond rescue from lower interest rates. Companies which experience severe earnings declines or move from profitability to heavy loss (homebuilders, thrifts, mortgage companies, certain retailers, etc in the current cycle) will witness massive declines in the price of their stocks which no decline in interest rates can possibly offset.

(4)There are RARE occasions on which the down-cycle in interest rates will NOT produce a rise in the market, but may actually accompany a SEVERE BEAR MARKET IN EQUITIES. There are two types of situations in which this may occur:

(a)if a general economic DEPRESSION ("D" word, not "R" word) develops causing a total collapse of corporate earnings, massive unemployment, and significant price deflation;

(b)if stock prices are overvalued by ORDERS OF MAGNITUDE when the economic downturn begins.

(5)There are only two occasions, if memory serves, in which these conditions were present, and, consequently, where a severe BEAR MARKET in stocks took place DESPITE the onset of the downward rate cycle: 1929-1932, and 2000-20002. In the first case central bank policy errors produced the worst Depression in American economic history, generating massive losses for businesses virtually across the board (although motion picture stocks rose 1000% in price during the Depression, as profitability soared with the entire country frantic for escape). In the second case, the BEAR MARKET began when the major large capitalization stocks (the S&P 500) was selling at 45x forward earnings, THREE TIMES today's level.

(6)Our bullish expectations for stock prices this round DOES DEPEND UPON ONE VARIABLE, HOWEVER. We do assume that the FEDERAL RESERVE will drive the overnight rate down sharply and flood the banking system with liquidity, thereby precluding a general economic depression.

(7)For those who have been reading this blog regularly, our careful analysis of the FED is well-known. For new readers, we suggest that you review these analyses. Briefly, we do not believe that the current central bank policymakers have either the guts or the independent political base that would allow them to RESIST THE RAPIDLY MOUNTING MARKET AND POLITICAL PRESSURES TO EASE MONETARY POLICY ADEQUATELY.

(8)We cannot EMPHASIZE STRONGLY ENOUGH THE CRUCIAL IMPORTANCE OF PROPER INDIVIDUAL STOCK SELECTION in order to capitalize on the forthcoming bull move in stocks WITHOUT EXCESSIVE RISK.