What This Is All About

Here is the latest BIG PICTURE REPORT by briefing.comUpdated: 03-Nov-08 09:19 ET When the stock market is down, everything is viewed in a negative light. Every explanation for why the market is down is accepted -- even when it is wrong. This article provides a review of the facts and what has caused this bear market. The problem is a liquidity crisis within the financial sector, and the tremendous uncertainty that has produced. Correcting this will take time. The Recession Misconception The stock market is not down because of recession.The fact is, the economy has not yet entered recession. First quarter real GDP was up, and second quarter real GDP was up. Third quarter real GDP was down at a fractional 0.3% annual rate, but one minor down quarter doesn't rate as a recession, and we expect that to be revised to a slight positive with the next GDP report (due to a conservative estimate on net exports).There have been plenty or periods of weak economic growth similar to 2008 or worse that produced nowhere near the stock market decline that has occurred.If analysts had known back in February (when recession calls started) that first, second, and third quarter real GDP growth would average near 1%, there would not have been calls for the type of stock market decline that has occurred.Granted, it is hard to point out that this has not yet been a recession. An analyst that said that on TV the other day was practically screamed at by a journalist. It certainly "feels" like a recession, but that is in part because the stock market is down. That circular reasoning is well accepted.Nevertheless, the fact remains that the stock market is not down because the economy has been in recession. Earnings Surprises Earnings growth has been surprisingly good, at least outside of the financial sector.Excluding the financial sector, third quarter earnings will be up about 10% over the same quarter last year.Excluding financials and energy, earnings are about flat. That is not great, but it is also not that bad.That covers a period of extreme turbulence and a year which was widely assumed to be a recession. Yet, earnings for a vast array of major companies were up in the third quarter at rates that normally would be considered strong.This includes the following major companies, with year-over-year operating earnings growth in parentheses: Coca-Cola (16.9%), Johnson & Johnson (10.4%), IBM (22.0%), United Technologies (16.2%), Cisco (21.2%), and Intel (12.9%).The only real earnings problem has been in the financial sector -- and that has been huge.Weak earnings simply are not the cause of the broad stock market decline that has occurred. All stocks have been dragged lower by the huge problems in the financial sector, not necessarily by their own earnings trends. The Energy Crisis Another factor that did not cause the stock market crash was the energy crisis.This would have been contested several months ago, but is now well accepted. In early July with oil at $145 a barrel, there was a great deal of talk that high energy prices would lead to overall inflation pressures and that the stock market was down in part because of this and expectations of associated higher interest rates.That was clearly wrong. The talk has suddenly turned to deflation rather than inflation. High oil prices were a problem, but the impact was vastly overstated.The stock market did not crash because of high (or low) energy prices. The Credit Crunch Myth It is often assumed that there is a credit crunch. In terms of the classic definition, this simply is not true.The H.8 data clearly show that throughout 2008, commercial and industrial loans to businesses have continued to rise at a steady pace. Normal businesses have been able to get credit, at least until recently.Commercial and industrial loans have risen every single month since late last year (except for a flat month in August) and are up strongly each week in October. Loans ARE being made. The companies with the strong earnings growth, as noted above, are not having trouble getting credit.The real problem for credit availability has been solely within the financial sector. Hedge funds, brokerage funds, and companies investing in commercial real estate have hit the wall in terms of access to credit. There is a huge problem for financial firms.Yet, the stock market is not down because there has not been enough credit available to "normal" businesses. What This Truly Is The factor causing the stock market decline is a LIQUIDITY CRISIS.This started with the decline in prices of mortgage-backed securities. That reduced financial company earnings, and forced write-offs of these securities.The firms that created the secondary market for these securities then backed out completely, and demand for mortgage-backed securities plummeted.That led to a vicious circle of further price declines, further write-offs, a further contraction in the number of buyers in the secondary market, further price declines, and so on.That in turn led (in part because of mark-to-market requirements) to reductions in the capital base of many financial firms.Firms became uncomfortable extending credit to financial firms that were becoming less stable.A crisis in confidence in the credit markets developed in which financial firms could not get short-term funding. That led to the demise of Bear Sterns, Lehman Brothers, hedge funds, and other financial traders.As these problems spiraled out of control, the Fed and other central banks flooded the credit markets with easy credit. It hasn't helped. Fear became overriding, as evidenced in the Libor and other short-term money market rates.A moderate decline in the stock market turned into a crash.This in turn has now led to such dramatic talk of global recession and depression that in many ways the talk has become self-fulfilling.The wealth effect will probably now lead to recession.The stock market crash has been because of the liquidity crisis.It was not caused by recession, a credit crunch, higher oil prices and runaway inflation, or earnings problems.Previously, we had hoped that a resolution to the liquidity crisis would lead to an improved outlook for the stock market. We still feel that would have been possible if the original, simple Paulson plan to buy mortgage-backed securities had been implemented far sooner.Now, unfortunately, the liquidity crisis has led to the likelihood that economic and earnings problems will develop.Nevertheless, it is important to retain a clear understanding of what has, and what has not, caused the stock market crash.What It All MeansAnalysis of traditional fundamentals hardly matters at all at this time.The economy, earnings, energy problems, and credit availability have all been much better than widely perceived. Just because the stock market is down doesn't confirm that these fundamentals are in terrible condition. It simply isn't true.When will these factors matter again? That is hard to say. There clearly is value in stocks -- if stability returns to the global credit markets within the financial system.Yet, there are now fundamental problems that are developing. Economic growth will be sluggish, possibly well into 2009. Earnings growth will slow because of the economic slowdown, and will be worsened by the now strengthening dollar.The outlook for the stock market therefore depends on one's time perspective.For those in 401k plans for the long term, this will prove a great opportunity. This low period of stock prices simply means acquisition over time at bargain prices.For those looking to recoup lost value within a few years, the outlook is problematic.Stocks are now at levels where a 10% increase in stock prices in a single day hardly seems noteworthy. It is very possible that a classic year-end rally develops, followed by strength into early next year.The S&P 500 could rise a seemingly spectacular 25% over a period of six months. Yet, that would still leave the index at 1210, well below the level of a year ago. The degree to which such a move is good news depends on the time perspective.Summary: The stock market is down because of a liquidity crisis that has created a great deal of uncertainty about the short term and the long term. The issues that have developed could take years to work out.Even as the economic and earnings fundamentals work out over time, if these uncertainties are not resolved, the market could take years to reach its previous highs. That may not be a problem for those with long-term horizons buying stocks now, but it could be a problem for those under water at current levels.--Dick Green, Briefing.com