Jack McHugh engages us in this delightful thought experiment:

>

"Let’s try a little thought experiment to examine just how well stock prices reflect what’s happened this year. 

Imagine it is January 1, 2007, and you have just been given the following information about what would unfold during the first 8 months of the year:

– Oil prices would rally back to over $75/bbl;
– The dollar would drop against every major currency;
– Corporate earnings would benefit from the greenback’s slide and continue to post double digit gains;
– The housing industry, instead of bottoming, would continue to slide all year;
– Home prices would actually be down in many major cities;
– Over 90 mortgage lenders would cease operating and the survivors would be on life support;
– The origination of subprime mortgages would all but cease;
– All but prime, conforming mortgage loans would be either hard to get or very pricey;
– Private equity deals would soar in the first half, but come to a halt after July 1;
– Some prominent LBO deals would have to be "eaten" by commercial and investment banks;
– The leveraged loan market would see stress;
– High yield bond spreads would widen markedly;
– Commercial paper would come into question and ABCP conduits would be in jeopardy;
– T-Bill yields would plummet into the 2% area before rebounding to fed funds minus 85 bps;
– LIBOR would actually rise from +10 bps to fed funds to +45 bps to fed funds;
– Loans for all second tier credits would either be very costly or unavailable;
– Prominent hedge funds would either blow up, face losses, or have investors seek redemptions;
– Volatility, as measured by the VIX, would triple from 12 to 37, before settling in the mid 20′s;

Given the above information, where would you expect the major stock averages to be in relation to their closes on December 31, 2006?  Ah, you need more information about how the authorities responded, right?  Well…

– The fed funds rate would still be at 5.25%, but the discount rate would be down 50 bps

– Regulators would be seeking ways to allow delinquent borrowers to remain in their homes

Now, given this admittedly limited information about market moving events and governmental responses to them, where would stock prices be?  Down 10%, 20%, perhaps? 

The answers are:

* The Dow is up just about 8% for the year
* The S&P is up just about 6% for the year
* The NASDAQ is up just shy of 10% for the year

If you are surprised, you are probably not alone.

As to whether stock prices have fully factored in the withdrawal of credit described above, it may depend upon whether or not the promises made by Chairman Bernanke and President Bush ever come to fruition (and how quickly). 

Judging just by the price action to date, however, it seems Mr. Market has decided there is little or no chance that either the markets or the economy experience anything but peace and tranquility for the rest of the year. 

Then again, the old gentleman didn’t see all the housing troubles coming in the first place. How can we be sure he so clearly sees the proper solution(s) will be applied in the future?"

>

Great stuff. Thanks, Jack.

Category: Credit, Derivatives, Investing, Markets, Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

45 Responses to “A Thought Experiment”

  1. Mike M says:

    Mr. Market has been, for some time now, asleep at the wheel.

  2. scorpio says:

    peace and tranquility today, tomorrow, in fact for all time…. unless of course a Democrat were elected President. then, a depression.

  3. Heads are definitely in the sand. It’s not that unusual though. I remember the prime rate had to drop from nearly 20% to 14% before the bull market in 1982 finally got going. This situation seems to be the reverse, but over an even longer timespan. There seems to be a huge under-estimation of the effect of the credit crunch on the housing situation. The loss of all of the marginal demand from the sub-prime borrowers is going to have a large impact on home prices. The domino effects will be felt world-wide.

  4. michael schumacher says:

    You forgot to add the one MAJOR factor that is the SOLE reason for where the market is today:

    CHINA

    That is why we are up when most indicators have pointed (and have been pointing) down.

    Simplistic?? yes

    Please make me wrong…however that is the only rationale explanation( that I can come up with) as to why we are still less than 4% from the all time high and our credit system has imploded.

    Think Olympics and then election (although I really think that once the olympics are over…it’s really over since the chinese have less and less motivation to prop up our market.

    Can’t have any analysis without the China factor…..

    Ciao
    MS

  5. Werner Merthens says:

    Alan Greenspan found the answer over a decade ago:

    I think it was inexplicable exuberance or something similar.

  6. wally says:

    I see that no ‘good’ stuff is listed, so the list is really meaningless, isn’t it?

  7. michael schumacher says:

    why don’t you come up with a list wally…

    I’m sure you can find things out there to counter the reality of it all…….LOL

    Ciao
    MS

  8. skateman says:

    China 2007 = Japan 1989, but maybe even worse given the utter destruction of their environment.

  9. scorpio says:

    China is a linchpin of the argument: US capitalism has outsourced its cost structure and taken a huge chunk out of the middle in the form of CEO income and extra-normal profits to shareholders.

  10. techy2468 says:

    since wally brought it up, let me list the good stuff:

    1. upto $2 Trln can be deployed to prop the market/economy, every central banker in the world is in favor of a bull market (they dont want painful correction, but they dont mind inflation)
    2. china/india/brazil or other exporting countries do not want usa to go into recession, it will be more painful for them since they are still barely able to get bread to the table.
    3. most countries including Europe do not want the dollar to fall more, since thats making their exports expensive relatively. Since usa does not export much and everyone else do a lot of export.
    4. All the funds currently invested in stocks do not want to sell(to lower price to reflect the risk) because its mostly not their money (401k, mutual fund etc) and most investors who have put money into the market are like gamb-lers….the dont care about a 2-3% loss they think they can time the market and exit before it goes down 10-15%.
    5. i am getting into the belief that we may get rate cuts to prop the economy because no one other than oil producing countries are going to be bothered by falling dollar (most of them have pegged their currency to stop bleeding from export loss)

    6. There is a possibility that the data we have about consumer debt is not accurate, i have read that the DSR is just around 15%, which does not sound correct, so if it is right then consumer still has 85% of disposable income to support consumption.
    This is the biggest question of the hour: where does the consumer stand right now?

    7. Job market is still pretty good, if not for the credit market freeze hiring/expansion may have kept going on.

    its quite possible that business will reduced capex expecting a downturn, consumer may reduce consumption due to negative sentiment and high debt servicing cost.

    i still prefer to stay 90% in cash, no shorts and just 10% in mutual funds.

  11. Fred says:

    “If you are surprised, you are probably not alone.”

    Exactly! The market will spank the most people it can. There has been an abundance of negativity, and bets made against the market. The “crowd” is confused? Shocker.

    Yes MS, BRIC is a major influence in the global growth story. Billions of new consumers are buying stuff, and getting paychecks.

    They say it’s not the news you should watch, but the reaction to it — that counts.

  12. Owner Earnings says:

    “Markets can stay irrational longer than you can stay solvent.” Keynes

  13. techy2468 says:

    Fred.

    it would be so nice if the bulls started using reasoning and data to support their argument instead of plain rhetoric.

    why not you start a list of positive things supporting the current markets?

  14. Greg0658 says:

    techy2468 points out …
    ’2. china/india/brazil or other exporting countries do not want usa to go into recession, it will be more painful for them since they are still barely able to get bread to the table.’ endquote

    so then when USA does downturn they will finally be able to supply themselves with their time, energy and product

    there is your play marketeers – raw commodities and uncopyable machine repair parts

  15. michael schumacher says:

    techy-

    Fred can’t or won’t do that……

    I expect to hear (yet again!!) that CAPEX will save us, China’s consumers will save us (oh wait he’s already said that), and tech will save us. and a rate cut will save us as well.

    Yes PLEASE come up with a list that counters what was put up today……..going to be the shortest list you ever see.

    What most perma bulls fail to admit is the massive bullshit (ala these 300 point rallies) that come from nowhere are all the product of a system that is steadfastly in a state that is so far from reality they continue to just see it continuing for no other reason because…well it can.

    China=MM

    Was it a coincidence that Goldman Sachs bought over 1000 SP contracts on that thursday (before the fed cut the discount rate) at the low of the day?? How do you spell manipulation?? CHINA and Goldman.

    How many trips did Paulsen make already this year?

    Ciao
    MS

  16. Brian says:

    “3. most countries including Europe do not want the dollar to fall more, since thats making their exports expensive relatively. Since usa does not export much and everyone else do a lot of export.”

    Except the US is the world’s largest exporter and 2nd to Germany when only including durable goods. The weak dollar should have closed the trade deficits and increased foreign travel into the US. Instead the Chinese currency is artificially priced and few Europeans want to vacation in the US due to world affairs.

  17. Greg0658 says:

    Brian – ‘Except the US is the world’s largest exporter’ endquote

    Can a originator/middleman ratio be put to that statement?

  18. Les says:

    Guess it all depends on whether the market is a discounting mechanism or a mechanism for policy transmission.

  19. SPECTRE of Deflation says:

    In today’s world, where ever the powers that be want it. The notion of a business cycle has been replaced with continuous asset bubbles. If this were the late 1970′s and early 1980′s, we would be in a much different place, but that was before a never ending Bull Market was needed to prop up the economy and the ridiculous asset prices we see today.

    Can you imagine for one minute that Paul Volcker would have played candy man to the markets the way Greenspam did for 20 years?

  20. M.Z. Forrest says:

    The US is a significant exporter and the trade imbalance numbers have been closing as of late due to increased exports. If you want to consider the US economy, you pretty much have to throw out the DOW and one is tempted to throw out the S&P 500. There is simply too much noise in the data. For example, everyone wants to talk about Ford’s domestic losses, but near 50% of their revenues are from overseas. They are growing marketshare in Brazil and Russia for example. That doesn’t matter to the assemblyman in Dearborn though. As to what we do export, you have software, airplanes, medical equipment, and a myriad of other things. This is why I would hold off on the apocolypse expectations.

    As for the view that there is a wide well of support for the dollar, show me the evidence over the prior 5 years of this. Even if we posit that there has been currency manipulation, which is entirely reasonable to posit, this just establishes that support is being eroded. The OPEC states are already moving heavily into the Euro. Russia has made clear that its position on the dollar is based on what is in its best interests, and Russia doesn’t have vibrant trade with the US. Their trade is primarily with Europe, and they are putting heavy pressure on Europe to reign in their inflation so that Russia can reign in its inflation. This is why you will continue to see divergence between the dollar and the euro.

  21. atlas says:

    Its called the Efficient Frontier, and near-perfectly diversified portfolios (like the ones noted) lie on this frontier. Most diversifiable risk is diversified away, so unexpected events confirned to one or two segments have minimal effect on price.

  22. Brian says:

    http://tinyurl.com/2pytnu

    The link is from the German Embassy in London. We still export a massive amount of agricultural and military goods, along with intellectual property, even if we don’t make easy-bake ovens any more.

  23. michael schumacher says:

    the “easy bake oven” has morphed into the “easy credit implosion” that is contained.

    Two more casualties of the contained containment:

    http://www.bloomberg.com/apps/news?pid=20601087&sid=aZkz_UtSTkP8&refer=home

    Who’s betting on yet another rescue of the market by the fed release in a few minutes??

    I am…too neat
    Ciao
    MS

  24. Red Ocean says:

    “I see that no ‘good’ stuff is listed, so the list is really meaningless, isn’t it?”

    There was one good thing on the list, namely:

    – Corporate earnings would benefit from the greenback’s slide and continue to post double digit gains;

    And this is no small “good thing.” If earnings continue to grow all is well. The market will not see the negative until it can see the negatives impacting the companies in the market and right now, it sees companies continuing to produce as if there are no negatives so why should the market care.

    Sooner or later this has to hit the companies that make up the market or else it just won’t matter.

  25. michael schumacher says:

    watch the SPY at the LOD……China will show up before the end of the day….

    Ciao
    MS

  26. Eddie says:

    Little tidbits that I’ve read and observed over the years that explain the US’s competitive edge both now and going forward:

    – They send us cars, we send them little pieces of paper.
    – While China’s still trying to figure out how to feed 1.2 billion people, we’re busy inventing iPhones, etc.
    – In India, working at a call-center is a ‘good job’. Here, it’s a dead-end job.
    – In developing countries arond the world, being able to eat at McDonald’s is a sign of prosperity. Here, it’s the opposite.
    – The trade balance, or ‘deficit’, does not take into account the thousands of very well educated and motivated people who immigrate into the US each year. The net plus in our favor is incalculable.

    Bottom line: despite the gloom & doom that’s been preached over the decades, the US is still the economic powerhouse in the world.

  27. dan says:

    BR, perhaps the market has responded to corporte profit growth exceeding expectations, accompanied by lower than anticipated L/T interest rates? Just a thought…

    ~~~

    BR: Nice call, Dan — As of 11/23/07, Corporate Earnings for Q3 down 8.5%

  28. Mr. Beach says:

    Was that a 30M+ trade on the SPY around 2:10PM?

    What was that?

    http://finance.yahoo.com/q/bc?s=SPY&t=1d&l=off&z=l&q=l&c=

  29. Matt M. says:

    Eddie & Dan,

    Are you sure your’re on the right blog? Stop trying to understand the other side of the trade. Don’t you understand the markets are rigged by the Fed and the evil hedge funds?

  30. SPECTRE of Deflation says:

    Barry, please Add to the list that the 5 largest securities firms are being investigated by the SEC Concernings Conduits and Off Balance Sheet activities, oh and also the Rating Firms as well. Blood in the water. [Per Bloomberg]

    “The U.S. Securities and Exchange Commission is “monitoring” the biggest Wall Street securities firms to gauge whether they face losses from investment vehicles that sold short-term debt, an agency official said.”

    The SEC, concerned about the collapse of the subprime mortgage market, is reviewing “contingencies that might place additional strains on the balance sheets” of investment banks, said Erik Sirri, head of the agency’s market regulation division, in congressional testimony today. “These include the potential unwinding of off-balance sheet funding structures, such as conduits.”

    Sirri’s SEC division is responsible for monitoring whether the affiliated vehicles threaten the financial soundness of the five biggest U.S. securities firms: Goldman Sachs Group Inc., Morgan Stanley, Lehman Brothers Holdings Inc., Merrill Lynch & Co. and Bear Stearns Cos. All are based in New York.

    Credit-Rating Probe

    The SEC is also probing credit-rating companies, which have been criticized by members of Congress, including Senate Banking Committee Chairman Christopher Dodd, for waiting until July to cut their rankings on bonds backed by home loans.

  31. techy2468 says:

    Brian:

    agriculture is subsidized, unless food prices dont rise over here in usa, we can say it is a good thing to export them.

    if ford makes profit from overseas sales, how much does that contribute to USA economy?? maybe 10% (profit comes home)

    ***– Corporate earnings would benefit from the greenback’s slide and continue to post double digit gains***

    again how much is corporate profit good from overseas earnings good for usa economy??

    and if the driver for overseas prosperity is us consumer himself…..i dont think even that is going to last long.

    example: if india’s currency appreciates another 10% (it should have by now if it was not pegged to USD) its IT sector will be almost dead….and they will start on the path to deflation and recession.

    same theory applies to all export dependent countries.

  32. Kurt Brouwer says:

    Barry. Nice litany of woe. This year is a perfect illustration of the phrase climbing a wall of worry.

  33. Kurt Brouwer says:

    Barry. Nice litany of woe. This year is a perfect illustration of the phrase climbing a wall of worry.

  34. fatMary says:

    MS

    i think you are spot on with that china stuff.

  35. techy2468 says:

    Eddie… as you said US is the economic powerhouse of the world.

    well thats a good thing and bad thing, because:

    its good becos every exporting country in the world is going to support us economy so that it does not slip into recession, their own life depends on us.

    its bad becos: if the data about us consumer being neck deep in debt is right, then its almost impossible for us not to go into recession irrespective of other issues. and if that happens whole world will be dragged into it, since no other country/region is strong enough to replace us consumer

  36. michael schumacher says:

    FM-

    the big question is how do we make $$ off it??

    THe market isn’t going straight up because they (Chinese) are sensitive to what our market looks for (technicals: MACD, oversold, MA’s etc) and we have to have some sort of pullback at times or we just would’nt believe it…right?? Well they know that too….

    This market will be rescued…..it has been for over a year so there’s no reason to think that it will not continue (the rescue bit) but it’s most certainly not fundamentally based as some would attempt to ‘splain it.

    BTW I think it’s totally funny that the market wants to show some sort of stability (at least they acted that way in the run up to the redemption deadline) and it ends up being so volatile that the work to stabilize it will have the ramifications of outflowing once the form totals are added up (it’s been strangely quite on that front as they all know what they have to sell against) or is the issue know the trillions of paper that comes due over the next month and a half??

    who knows but there are too many issues to fix in a system that is incentivized and has lost all semblance of rationale thought process simply because they need to collect those damn fee’s.

    Ciao
    MS

  37. David says:

    One may add- Russia and China: First Joint Military Exercises;
    Many people contend that the maneuvers were meant to send a clear message.

    “Cry “Havoc,” and let slip the dogs of war”. William Shakespeare

    P.S. The bottom-line, Buy US Bonds, This Is No Time for You to Take a Rest.

    WWII song-

    *Buy, buy, buy, buy a bond.

    And by and by,

    The bonds you buy will bring you victory.

    Buy, buy, buy, buy a bond.

    And you’ll be standing by the victory arch

    When Johnny comes marching home again.

    Oh, you should need no request,

    For after all, you know that you’re investing in the best,

    Till the lads come back again,

    Back the old attack again,

    Buy, buy bonds.

    This is no time to say you’ve done enough.

    This is the time to really do your stuff.

    And even if you can’t be a soldier in the ranks,

    You can be the guy that helps supply the guns and planes and tanks.

    This is the time for you to do your best.

    This is no time for you to take a rest.

    The enemy is reeling and his morale is low,

    So now’s the time to fall in line and deal the final blow.

    Buy, buy, buy, buy a bond.

    And by and by,

    The bonds you buy will bring you victory.

    Buy, buy, buy, buy a bond.

    And you’ll be standing by the victory arch

    When Johnny comes marching home again.

    Oh, you should need no request,

    For after all, you know that you’re investing in the best.

    Till the lads come back again,

    Back the old attack again,

    Buy, buy bonds.*

    Source: Courtesy of National Archives and Records Administration, Recorded Sound Division.

  38. SPECTRE of Deflation says:

    MS

    i think you are spot on with that china stuff.

    Posted by: fatMary | Sep 5, 2007 3:17:36 PM

    Ditto on your thought. MS, a very good point. The problem is that there are so damn many to keep track of. Did we include the unwinding of the carry trade? :>)!

  39. Frankie says:

    “peace and tranquility today, tomorrow, in fact for all time…. unless of course a Democrat were elected President. then, a depression.”

    LOL!

    Study after study have shown time and again that stock market performance has very little to do with the party affiliation of the White House occupant.

    Why don’t you take a hike toward to post within one (or several) of the numerous neocons blog and stop stealing real estate screen on this blog where people are trying to have intelligent discussions.

    Francois

  40. alexd says:

    It is not the danger coming at you that you can see that is a problem. It’s the thing that most do not notice that causes the carwreck. Were stuck with it. Outlier effects are by their nature are obscure before the fact , and oh so obvious after the fact.

  41. Antoine says:

    The Pig-men are absolutely desperate to keep the markets up, however they cannot do this forever, they will be forced to capitulate, and in the process canabalize each other.
    Time and again I’ve seen oceans of borrowed money step in and stabilize a mkt. rout, it will eventually fail cause you can’t deny the dawn!
    Let’s look to the flip side! the mkt. goes up and rallies….um on what….hope and faith….I think not! everything is looking awful and getting worse by the hour…tick, tick, tick…..

  42. The Other Hand says:

    Bad enough that rising profits are damned with faint praise in the list (supposedly attributable only to a weak dollar). But worse, neither the blogmeister nor his minions bothers to mention that the rate on the 10-year is at 4.5%.

    I have been very sympathetic to the view that housing will drag the economy into recession. Maybe those fears will soon be realized. But so far, no recession, higher profits, and low long rates. What more do you need to explain the bull run? Be glad we fraidy cats aren’t drowning even deeper in the sea of green.

  43. DavidB says:

    A lot of those points made are about symptoms. They are the result of the rising cost of credit. Why is credit rising? Because business(especially multinational) is good and pricing is easy. Thus the fed and the CBs of the world have to raise rates to keep the economy from overheating. The markets are reflecting the overheating and the credit market symptoms are reflecting the Fed’s effort to reign in the market

  44. freejack says:

    “Who’s betting on yet another rescue of the market” – MS

    Is this a new ‘tool’ for the CBs?

    http://en.wikipedia.org/wiki/Sovereign_wealth_funds

    Anyway to track activity?

  45. Professor6Pack says:

    I have learned quite a bit reading all the financial blogs. All the posts and comments are clear, well thought out, and rational. The only problem I see in ALL the positive leaning economic analysis is the assumption the world is rational. From my limited experience of 53 years on this planet I have come to the conclusion most humans are quite stupid and insane. Organized humans are extremely insane. One small proof- Northern Rock is part of the organized British banking system and they have been lending money at 125% of a homes value. That is insane. Another proof- America has been fighting the longest and most expensive war in it’s history against one man that is holed up in a cave or dead. The recipe I found works is a tablespoon of positive and a cup of negative.