Let's try to pull a Feynman (that I should be so good) and do the current crisis in three parts.
1. The end of the era of easy credit and fraudulent lending has brought about a crisis in banking, that has as its backdrop shoddy credit underwriting of mortgages and the multiplication of those risks, through the use of derivatives. The fall in housing prices is also affecting the prime market and the commercial market. All these things are putting enormous strain on banks.
This may "cost" the market 15-30%, from the market's recent highs. I'm guesstimating that about 15%-18% of that has already occurred, with the rest ... justifiably likely only in the event of collapse of the US's financial sector.
2. The normal credit creation process has been interrupted, because of a lack of confidence that financial partners are sound and because of a massive financial sector deleveraging that is going to, as people seek safety.
This may cost the market only a small amount, but a spike in energy and food prices has further crimped the outlook. That crimping means even less confidence, to the point that people start to think that a global recession is on the way.
A recession discount might run to 15-20%, from pre-recession highs. The discount for a super-severe recession would be more, but it's too facile to imagine that the whole world is going to melt, even though you can certainly scare yourself to death, if you want (it's always the scariest when the roller coaster rounds the top, and you feel like you are looking into the abyss, right?).
3. Last, the markets always revalue to the 'worst case' scenario, when bottoming out. The equity risk premium has shot up to its very long-run value of somewhere around 9.5% (measured at S&P500 @ 900). This is the prospective return on equities that is demanded for investors to assume the extra risk of them.
Most of this amount is already caught up in the discount for part two. It might be another 10%++, depending on how things go. Despite being very open ended, this part is not completely unbounded, however. Still, you don't want to see rampant pessimism or free-fall. It's important that fundamentals 'take over' at some point on the way down (or up).
When you add those three up, you start to see why we are where we are, in terms of market revaluation, and think that the bottom is coming, soon. We've discounted a crisis and a global recession and now we are fiddling around with how much people are going to panic as the market finds a bottom and whether there is a lot more of the banking crisis still to come, i.e. whether we are closer to to the high-side of the estimate or the lowside.
Thursday, October 9, 2008
Fireside Chatting Stock Market Investors
