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How to Get Rich Investing in Stocks by Riding the Electron Wave

U.S. Economic Recovery Goldilocks or More Gloom and Doom?

Economics / Recession 2008 - 2010 Mar 11, 2009 - 09:18 AM GMT

By: Money_Morning

Economics Best Financial Markets Analysis ArticleWilliam Patalon III writes: When it comes to the U.S. financial crisis, it's tough to know just what to think or who to believe these days. If you want an example, just look at yesterday (Tuesday). Citigroup Inc. ( C ) Chief Executive Officer Vikram S. Pandit revealed that the embattled banking giant was having its best quarter since 2007 , and said that he's confident about Citi's capital strength - statements that unleashed a flood of speculation that the worst of the banking crisis is over.


Citi's shares zoomed more than 38% yesterday, and put a charge into U.S. stocks in general: Rebounding from a 12-year low, the Standard & Poor's 500 Index soared 6.4%; The Dow Jones Industrial Average jumped 5.8%, while the Nasdaq Composite Index roared nearly 7.1% for the day.

At the same time, however, a media report stated that several of America's largest banks - Citi, Bank of America Corp. ( BAC ), Wells Fargo & Co. ( WFC ), and JPMorgan Chase & Co. Inc. ( JPM ), - still faced “potentially catastrophic” losses from their derivative holdings, if the economic situation gets worse . The report by McClatchy Newspapers was based on the banks' latest regulatory reports and said that the banks' current net losses from derivative contracts had reached $587 billion as of Dec. 31, an amount that had soared by 49% in the prior 90 days alone.

Four of the banks – Citi, BofA, JPMorgan and Wells Fargo – have received nearly $145 billion in taxpayer-bailout dollars, the report states.

According to the McClatchy report, the disclosures - gleaned from documents filed with federal financial regulators - underscore the challenges banks still face as they attempt to navigate a deepening recession in which loan defaults of all types are escalating rapidly. U.S. regulators portray the potential losses as a “worst-case” scenario, noting that these possible losses “could be contained if the economy quickly recovers.”

But will it recover quickly? That's literally the trillion-dollar question. And while we can't answer that with any degree of certainty, we can paint pictures of several possible pathways the U.S. economy could take in its journey toward recovery. The three that follow are by no means the only possible scenarios that exist. But they do cover the broad gamut of what we might be looking at. And we tried to do a bit of handicapping with each scenario, as well. But, remember, they're just hypotheticals, which we've labeled as:

  • Goldilocks : A reasonably quick and painless (compared to what's already transpired) recovery, but a scenario that will pretty much require every variable to play out “just right.”
  • Gloom: A recovery, but one that takes a fair bit of time to play out, and which still leaves us with an economy that's susceptible to a “double-dip” recession.
  • Doom : The worst case, this one that takes years to work through, and one that could conceivably make the transition from the dreaded “R” word (recession) to the deeply feared “D” word (depression).

Let's take a look at Money Morning 's three possible views of the future.

The Good: The Goldilocks Recovery

Under our “ideal” hypothetical scenario, as our label implies, the bailout packages and stimulus plans engineered by the Bush and Obama administrations end up playing out perfectly. While it's true that the government has loaded trillions of dollars of debt onto the U.S. balance sheet with its stimulus packages, foreclosure-avoidance initiatives and bank-rescue plans - and has even swelled the deficit with revenue-slashing tax cuts - it all turns out to have been money well spent.

Even so, the turnaround doesn't take place overnight. In fact, given the complexity of what's effectively the most complex economic jigsaw puzzle ever conceived, it could take a year or more for even the first signs of the rebound to appear. So in the near term, given that reality, there may not be much to signal that this Phoenix-like transformation is actually underway.

A bit further out, however, in what we'll call the “intermediate term” - call it six to 12 months, if not a bit longer - sharp-eyed investors may see some of the first signs of a turnabout. The initial clue could well be a halt in the demoralizing, grinding decline in U.S. stock prices that gradually transitions into a somewhat sustained - albeit modest - rally. Since the stock market is essentially a big discounting mechanism, it tends to presage any rebound by about six months.

The U.S. banking sector will have stabilized. Write-downs will be pretty much at an end, lending activity will start to pick up and even banking profits will start to show some signs of life. Thanks to the increase in liquidity, companies will gradually see their businesses improve - with some of the bigger U.S. industrial companies perhaps stirring first, thanks to the infrastructure-related spending that's part of the Obama administration's stimulus plan.

Long-term is where the real benefits of this hypothetical scenario manifest themselves. The reason: Under this projected outcome, it turns out that the U.S. government has a Warren Buffett-like investing shrewdness. In return for some of the trillions in debt the government has taken on in an effort to bail out U.S. automakers, financial institutions (and whatever else may still come along … auto-parts companies, General Electric Co. ( GE ), and other, still-to-surface bailout-money suitors, for example), the government has acquired ownership stakes in a number of companies, including such financial-services heavyweights as Citigroup, Bank of America and American International Group Inc ( AIG ).

For this rosy-rebound scenario, let's assume that the brighter-than-expected profit results that sent Citigroup's shares up more than 38% yesterday was the start of a broad-and-sustainable rebound by the financial sector. A market rally would fuel the upsurge in stock prices we mentioned, which in turn would boost investor confidence. With an improvement in investor confidence, there would also be a halt to the ongoing erosion in “derivative” valuations that keep bringing the banks back for additional bailout money. The credit markets would loosen up, lending and financing would accelerate, businesses could return to the growth track, and corporate profits would advance.

With profits on the mend, companies could cap the gusher of corporate layoffs we've been watching, and the record wave of job losses would end. That would boost consumer confidence, would ultimately increase spending, and would improve consumers' creditworthiness. The result: The group that accounts for 70% of the nation's economic activity would have enough income and borrowing capacity to put a floor under the housing market - the decline of which helped kick this economic mess off in the first place.

With the increase in borrowing, banks would watch their profits and market values climb, meaning investors might now have an appetite for their shares. And that could create a perfect environment for the government to begin utilizing its so-called “exit strategy” and begin cashing out of the private-sector holdings it took on as part of its bailout initiatives .

By then taking the cash it realized from those stock sales and using it to pay down some of the debt it amassed as a result of its stimulus and bailout plans, the U.S. government could become a major global private equity player - and clean up its balance sheet in the process. Under the right conditions, a big reduction in the government's current debt load could bolster the dollar, ratchet back inflationary pressures, reduce interest rates and further loosen credit. And if the initial public stock offerings (IPOs) are good ones - meaning the shares prices remain above their offering levels, or, even better, keep rising - they could end up adding to the general market bullishness.

If this scenario sounds like a “goldilocks” recovery, you understand the challenges inherent in this upbeat scenario. Given these rather long odds, here's how we're handicapping this scenario: Highly Unlikely, but not Impossible .

The Bad: Slow and Gloomy, but Could be Worse

Our second scenario is perhaps a bit more likely. Due to a kind of financial or economic inertia that's so prevalent in a major recessionary environment like this one, the downward trends in the housing market, asset prices and job cuts continue. That forces the federal government to push forward with the $11.6 trillion in financing commitments that it's so far made, but not fully funded. It's also likely to bring out new bailout candidates - and to attract some repeat customers, as well.

That inertia is a major problem, for it creates a vicious cycle that's hard to break free from. Take the job cuts. U.S. companies (and, increasingly, those in Europe and Asia, too) - fearful that the downtrend in profits and recessionary conditions will be with us for awhile - decide to get themselves into aggressive fighting trim, and carve off whatever fat they can find. Job cuts are the easiest way to cut costs en masse. So layoffs continue as long as the bad news perists.

But this creates an economic “Catch-22.” Companies cut their work forces to reduce costs and to hopefully preserve their profits and share prices. But they don't operate in isolation. Many other companies are cutting, too. Before you know it, the job cuts are running at a rate of 650,000 a month, and the unemployment rate has spiked far above what was expected.

Suddenly, nobody knows where the bottom is .

This creates a crisis in confidence for consumers. The consumers who have lost their jobs have to pull back on their spending. Consumers who are still working are now fearful for their own jobs, and stop spending, too. When the source of 70% of your economy has gone into hibernation, the impact will be both widespread and deep. Corporate profits take another hit, leading to more job cuts, leading to additional profit declines … you get the picture.

And the impact of this downward spiral isn't limited to corporate profits; in fact, it has a “triple-whammy” impact on federal finances at a point when the government can least afford it.

In a regular recession, the government typically shifts into deficit-spending mode for a time, willingly spending more than it's taking in so that it might “prime the pump.” But what we're facing today is hardly a regular recession: The government isn't just trying to prime the pump; it's trying to rescue the economy and keep it from sliding all the way into a depression. And it's taking a financial hit in three ways:

  • It's spending more than it's bringing in via tax revenue.
  • It's seeing its normal level of tax revenue gap down because of the big declines in personal incomes and corporate profits.
  • And, even with tax revenue way down, it's still actually going out and cutting taxes in an additional effort to jump-start the economy.

It's now generally recognized that the Bush tax cuts played a huge role in the burgeoning federal deficit and ballooning national debt. But it's also generally held that U.S. President Barack Obama has little choice but to cut taxes as he has.

Those tax cuts, coupled with the bailout infusions and the stimulus spending, will have a secondary effect, which again underscores why this economic turnaround will continue to be such a challenge.

Just days before the Obama administration officially took office, the Congressional Budget Office projected that the U.S. budget deficit would nearly triple from last year's $455 billion - and would reach a staggering $1.2 trillion . And that was even before President Obama unveiled his $787 billion stimulus, bank-rescue and anti-foreclosure plans - or other fix-up initiatives that are sure to surface in the months ahead.

To finance that deficit, the government will have to borrow - heavily. In a market in which credit is already tight, stepped-up government borrowing can have the unfortunate side effect of “ crowding out ” private-sector borrowers, meaning corporations will have to pay much higher interest rates for borrowed funds - if that money is available at all.

That will affect companies in one, or both, of two ways:

  • Companies will pay more for borrowed money, which will crimp their profits - and we've seen the unfortunate side effect of that.
  • Or it will make it too costly, or even impossible to expand. Indeed, companies that are “on the bubble” in terms of solvency, may not be able to issue the commercial paper needed to finance daily operations, meaning they'll be tipped into bankruptcy, and will have to cut still more jobs.

None of this will be good for stock prices, or for the banks, meaning the recession will continue to roll along. Eventually, say in 12-24 months, there will finally have been enough business failures, enough write-downs of bad debt, enough corporate layoffs, and enough foreclosures that the market will have hit bottom. With so much excess fat trimmed away, the now-reasonably lean economy will finally have shed the excess weight needed to start getting healthy again.

Under this scenario, the economic recovery will take time. Again, look for the stock market to recover about six months or so ahead of the economy's actual recovery. But expect the “rebound” under this hypothetical set of circumstances to be weak, long and slow. There's even the potential for a “ double-dip ” recession. Our take: Highly Probable, and Possibly Even Likely (in terms of the slow, drawn-out recovery) . As for the potential for a “double-dip” recession, we'll handicap that scenario as: Possible, But Too Soon to Call .

The Ugly: The ‘D' Word Becomes Part of Our Daily Lexicon

If there's one word that's universally feared right now, it's “depression.” And we're not referring to the emotional variety.

This scenario could start in a number of ways, and could typically require some sort of a “shock” to the U.S. economic system, although a depression could also grow out of the afore-mentioned double-dip recession .

The current financial crisis has a number of root causes. But a key element in virtually every one of those causes was something called the “ securitization ” market, in which all sorts of loans or pools of debt were repackaged and then sold off to institutional investors all over the world.
While securitization was the “transmission mechanism” that allowed the financial crisis to become a worldwide problem, it also became a central piece of the lending process, Reuters reported. When the securitization market broke down, it created a credit crunch that plunged the world economy into its current financial morass.

With the way the U.S. Federal Reserve and the U.S. Treasury Department have been functioning, they have taken the place of the securitization market, using the bailout programs to keep money flowing to the economy. But when those programs end, it's not clear the private sector will step in to once again take the leadership reins. The reason: Confidence has fallen so sharply that even those companies and consumers who can still get credit are reluctant to borrow and spend. That suggests the economy has more to contract.

According to the central bank's January survey of senior loan officers, 60% percent of domestic banks reported reduced demand for commercial and industrial loans. That's up fourfold from the October survey, when only 15% of banks reported reduced loan demand.

“The stuttering attempts to repair the banking and lending mechanisms so far by the new administration suggests that by late 2010, the specter of a second dip into recession will be looming large,” Merrill Lynch economist Sheryl King told Reuters .

The upshot: Without ongoing direct government financial support, Merrill expects the stock market to drop another 20%, and housing prices to fall as much as 15%. That combination will eradicate an additional $6.5 trillion in U.S. household wealth, on top of the $12 trillion hit consumers have already taken. U.S. unemployment will spike to 10%, King estimates.

Another possible shock could come from abroad. As the following graphic shows, foreign investors have become America's biggest creditors: China alone held nearly three-quarters of a trillion dollars in U.S. debt as of the end of last year, U.S. Treasury statistics show.

But what would happen if foreign investors suddenly balked at buying additional U.S. debt, meaning the United States couldn't continue with its current rescue strategies? That fear has grown in recent years, and with good reason: The U.S. dollar would collapse, and the fallout would be almost unthinkable .

Because it owes so much to overseas investors and governments, the United States has already seen a growth in foreign influence over its affairs , as the Fannie Mae ( FNM ) and Freddie Mac ( FRE ) saga demonstrated.

At the very least, to bring foreign investors back, the government would have to boost the interest rates it's offering on its debt to sky-high levels. That will lead to rampaging inflationary pressures, soaring government costs, and an unimaginable crowding-out impact on the private sector, creating the kind of economic “shocks” that could tip the United States from its current recessionary environment into something far deeper.

This would lead to additional declines in the housing market, as well as growing numbers of personal and corporate bankruptcies. Corporate profits would plunge, escalating layoffs and causing stock prices to plummet.

It's not a pretty picture. But the odds that it will get this bad are probably not that strong at this point, particularly when top officials continue to underscore that the government is committed to doing whatever is necessary for that not to happen .

Thus, our take on the super-steep recession, that actually threatens to become something worse, is this: Possible, but Probably not Likely at this Point.
For the country's sake, let's hope we're a gifted handicapper, at least on this last hypothetical scenario.

Money Morning/The Money Map Report

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Comments

Clark Jenkins
14 Mar 09, 15:18
The correct choice is: C
People seem to write off the Option Arm and Alt A loan resets as if they have already happened and now we are dealing with a new set of problems. Cut out the picture bellow and tape it to your refrigerator. Nothing will get better before 2012. Clark Jenkins FishGoneBad.com

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