Bear Trap?

THE BE YOUR OWN ECONOMIST ® BLOG

Wall Street bounced back today. The S&P 500 rose almost 30 points and the Dow climbed by nearly 300. A good day, indeed, especially after so much doom and gloom.

Does this mean the worst is behind us? Probably not. Market volatility has been high over the past year, and sharp down days will follow today’s upside. If we are in a bear market, investors should avoid being trapped by temporary saw-tooth patterns that provide temporary respites. It’s the trend that counts.

An article in today’s Wall Street Journal (http://online.wsj.com/article/SB120104941530008299.html?mod=todays_us_page_one), ominously titled, “Stocks Show Classic Bear Signals….,” said in part:

“The current market looks a lot like the beginning of past bear markets, said Paul Desmond, president of market-research firm Lowry's Reports in North Palm Beach, Fla. First, the most troubled stocks decline -- home builders and financial stocks in the current case -- and then others gradually get hit, including small stocks, retailers and technology stocks. Finally even stocks of strong companies are affected.

“As a bear market develops, Mr. Desmond says, trading volume and price movement get heavier and heavier for stocks that are declining, and lighter and lighter on the buying side, as more investors look for a way out. When the selling reaches a climax, the bear market is nearing an end, but Mr. Desmond says he doesn't see any sign of a climax yet.

"We feel we have been in a bear market since July. Everything that we have seen since then has just been a progression, almost like a disease that you are monitoring and the disease is spreading," he says. "We are still a long way from a major bottom."

For an academic treatment of developments, you should look at the January 14, 2008 draft of Carmen M. Reinhart’s (University of Maryland) and Kenneth S. Rogoff’s (Harvard University) “Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An International Historical Comparison:” http://www.economics.harvard.edu/faculty/rogoff/files/Is_The_US_Subprime_Crisis_So_Different.pdf.

The article begins by saying:

“The first major financial crisis of the 21st century involves esoteric instruments,
unaware regulators, and skittish investors. It also follows a well-trodden path laid down by centuries of financial folly. Is the “special” problem of sub-prime mortgages this time really different?

“Our examination of the longer historical record … finds stunning qualitative and quantitative parallels across a number of standard financial crisis indicators. To name a few, the run-up in U.S. equity and housing prices … large capital inflows closely tracks the average of the previous eighteen post World War II banking crises in industrial countries.”

The authors then assemble ample evidence that the U.S. recently trod a well-travelled path (the bubble) and can now expect to continue on the trail to financial crisis and severe recession.

Finally, CNNMoney’s web site (http://money.cnn.com/2008/01/23/real_estate/merrill_forecast/index.htm?postversion=2008012317) reported today that Merrill Lynch forecast a 30% decline in home prices – extending through 2010 - before the worst is over. Here’s a quote from the article.

“The brokerage believes that home prices are still far above historical norms when compared to other measures such as rent or GDP. "By our calculations, it will take about a 20 to 30 percent decline in home prices to correct this imbalance," said the report.

“Merrill Lynch believes that housing starts will most likely slide another 30 percent by the end of 2008 - a historic low.

The report says that the inventory situation only continues to worsen, as homebuilders are now looking at more than a nine months' supply. "The current supply/demand environment does not favor a swift recovery in the housing market, in our view," according to the report.”

If Merrill’s prognosis is correct – and the article did point out that the National Association of Realtors believes Merrill is not correct – there’s calamity in store. Households face a wrenching loss of wealth, and that will have dire repercussions throughout the economy.

Some believe that the boom in China and India will remain on track and pull us along before we fall in the ditch. Maybe…….. But you should be aware that these economies are probably at the tail-end of their own bubbles. When they pop, we will suffer too. Remember that their strength depends on heavy investment in plant and equipment and their ability to continually raise exports to the US. If their stock markets pop, investment will shrink. If the U.S. economy weakens, their exports will suffer. Recession, as well as expansion, can reverberate among nations.

The bear could go global.

© 2008 Michael B. Lehmann