Raw Finance

Since the U.S. stock market seems to be taking a breath today (other than the usual last minute hedge fund liquidations that cause a 200+ point drop) after another round of selling in the world markets over the weekend, now may be a good time to discuss some key aspects of the economic crisis and their effect on the state of the stock market.  It appears that based on certain technical characteristics compared to other bear markets, especially the 1929-1942 bear market, today’s bear market is poised for a rally.  Now, as I have mentioned repeatedly, I do not intend for this blog to be a primer on how to play the stock market.  Rather, I prefer to offer technical economic analysis of long-term trends to help my readers with their personal financial decisions.  So, by mentioning that the market may rally soon, I am not suggesting that anyone immediately throw one’s entire life savings into stocks, or any money for that matter.  One should always be mindful of one’s tolerance for risk, both emotionally and financially, when taking a shot at timing the market.  Also, as always, the investor should be judicious about which stocks the investment is being placed with.

If history is a guide (and it usually is), this rally may last anywhere from six days to six months, and it could result in a market upswing of up to 66 percent (such an event occurred in 1932), however, a more typical bounce from these rallies is between 14 and 18 percent.  For those who like to time the market, this is an opportunity.  For the typical investor, however, I would recommend using the rally to exit the market.  The reason for this recommendation is that history also shows that after the rally there usually follows another drop to lower lows than those before the rally.  We will likely be able to recognize when the rally is about to fail by simply looking at market headlines and listening to the Wall Street cheerleaders.  They will tell us that we must buy stocks or we will miss out on the rest of the rally, and that if we miss the rally, we will never again have the opportunity to buy stocks at so “cheap” a price.  That is your signal to sell.

Well, that’s all the market commentary I can stand, so let’s get back to the economy.  Increasing evidence of corporate defaults and seemingly no end to the decline in housing prices are two key weaknesses in the economy and also reasons why any stock market rally will eventually be sold, followed by a more severe drop.  The Wall Street Journal ran this article noting an increase in corporate defaults on loans for the purpose of purchasing technology.  The article notes that some large technology companies are now offering loans to their clients because financing firms are tightening their standards in response to the rise in defaults.  If the cost of borrowing to purchase tech equipment increases, or such lending disappears, this is one more constraint on economic growth.

The falling price of housing is still a serious issue, though it has taken a back seat lately to the more immediate credit market freeze. But until housing stabilizes, we cannot begin to think of another bull market.  Over at VOXeu, Keiichiro Kobayashi has authored an article comparing Japan’s economic crisis that began in the late 1990s to the current situation in the United States.  While no two crises are ever the same, even within the same country, Kobayashi’s comparison of Japan’s land price movement to the U.S. housing price decline is startling.  I have reproduced the charts from the article below, but for those interested, I really recommend reading the entire article; it’s not that long.

Figure 1. S&P Case-Shiller US national home price index

Figure 2. Official land price in Japan

As Kobayashi points out, U.S. housing prices may not revert to their long-term growth rate until 2011.  But if Japan’s experience is repeated here, we could find ourselves in a housing market crash that could bring us much closer to the conditions experienced during the Great Depression.  However, before we all take to the streets to panic, let us understand that the current government intervention in housing and credit markets, with more likely to come, was completely absent in the run-up to the Great Depression, thus making our current crisis much different and, most likely, much less painful – but painful nonetheless.