Insights & Advice

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Stay on the Sidelines

Today should have been another meltdown in the markets. It certainly happened overseas where overnight Japan lost 9.6 % while Europe closed off about 5%. The losses in the U.S. markets were “only” 3 plus %. You will most likely read or hear that the markets held and that a bottom is forming. Don’t believe a word of it.

The reason given for this latest rush to the exits was anxiety over a worldwide recession. As I’ve written before, the longer the credit crisis continues the worst the impact on global economies. Clearly the credit crisis is far from over. It seems that not a day goes by without another announcement of the government stepping in to bolster, save or bail-out one entity or another. This week the Treasury and Fed announced plans to bolster money market funds through a facility coordinated by JP Morgan Chase. The Fed is loaning unlimited funds to three European central banks; Treasury Secretary Paulson is expected to announce the treasury is extending its program of buying stakes in money center banks to regional banks and even insurance companies.

“At this rate,” said one cynical client, “the government will own the entire financial sector.”

That I believe is an accurate prediction. For more on this subject see yesterday’s column “Twenty First Century Capitalism”. Between the U.S. and foreign governments a virtual tsunami of money is cascading into financial markets world wide and still the panic continues.

Currencies are experiencing wild swings, the dollar is soaring, gold is plummeting (along with every other commodity) and some less developed countries in Eastern Europe have joined Pakistan in seeking help as their financial structures begin to unravel. And yet, the freeze-up in the credit markets have been thawing up until today. Experts have been confounded by the seeming contradiction between the easing of credit conditions and the continuing sell-off in the markets.

The answer, I suspect, is in the assumption that we all had: if credit conditions eased then the world’s borrowers (both commercial and individual) would once again resume borrowing. That does not appear to be what’s happening. Here’s why.

I need a new box spring and mattress. A certain wholesale company through the internet is offering a super firm, queen-size Sealey-Posturepedic mattress set delivered for under $1,000. It’s a good deal but my wife just lost her job. I expect unemployment is going higher so I’m also worried a little about my own job. Although I have little debt and could use my home equity loan to make the purchase in this environment I want to reduce not add to debt. Although we are in a good financial position, my 401(K) is not making any money nor are my IRAs. Given the overall economic uncertainty and the on-going credit crisis, we decide to continue to sleep on our years-old lumpy mattress and wait and see how the markets and economy play out. So I pass on the sale.

Now, imagine there are millions of Bill Schmicks making the same decision all over the world. From the company’s point of view it’s clear that sales of mattress sets are dropping. So maybe they don’t need as many delivery guys. There are lay-offs. At the same time, the purchasing agent does not add more mattress sets to their inventory. That means there is no need to borrow money to finance that inventory in the short-term credit markets. Given the on-going turmoil in the credit markets, interest rates are still prohibitively high anyway. So it’s probably better not to take the chance and wait until demand picks up. After all, this company is cautious because it too has been burned by the credit crisis. The company’s stock has lost half its value in the last six months. Its pension plan has been hammered in the stock market and its financial department is forecasting a recession.

At the end of the day, a self-fulfilling cycle develops: loss of consumer confidence, a decline in spending, and finally an economic slowdown. If this continues (as it has) a recession becomes inevitable. And that my dear reader is where we find ourselves today. How do we reverse it? The short answer is to give you and me the confidence to go out and spend again.

“Okay, I’ll buy that argument,” says I, “but you go first.”

“No way,” you say, “you go.”

“No, you go.”

“No, you.”

And so it goes…

Posted in A Few Dollars More, At the Market