The Big Picture - Macro Perspective on the Capital Markets, Economy, Technology, and Digital Media

Jim Welsh of Welsh Money Management has been publishing his monthly investment letter, “The Financial Commentator”, since 1985. His analysis focuses on Federal Reserve monetary policy, and how policy affects the economy and the financial markets.

In his March 2007 letter, he warned that a tightening of lending standards by banks represented a sea change that would lead to a slowdown in the economy before the end of 2007, and more credit losses for banks. In October, he noted that technical weakness in the U.S stock market, combined with an economic slowdown would be bearish for stocks. In December 2007, he warned, “Most investors really don’t understand the credit creation process, and as a result, don’t comprehend the scope of this crisis, or the Fed’s limited ability to deal with it. It really is different this time.” In his March 2008 letter, he forecast a rally in the S&P to 1420-1440, before the bear market in stocks would resume. His analysis provides a unique blend of fundamental and technical analysis:

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This is what passes for analysis these days:

The two longest recessions since World War II lasted 16 months (1974, 1982). Since this one started in December 2007, it ’should’ bottom around April 2009. But since this recession may be a bit worse than those two, it may bottom a few months after April. And since the stock market usually bottoms six months before the economy bottoms (although I don’t know what the market was discounting in October 2007 when it reached all-time highs!), now is a great time to ignore any bad news, and use any weakness to position your portfolio for the coming bull market.

Getting run over by the bear market was not good. But missing the new bull market would be worse.

Normally, this scenario would probably play out. The Fed has cut rates to near 0%, and a huge stimulus plan is coming that will combine tax cuts and infrastructure spending. What’s not to like? My concern is that credit availability is still severely constrained. According to Reuters Loan Pricing Corp., U.S. loan issuance plunged from $1.69 trillion in 2007 to $764 billion, a drop of 55%.Investment grade loans fell 52% to $319 billion, while leveraged loan issuance dropped 57% to $297 billion. Most of the contraction in lending occurred in the second half of 2008. Although that is no surprise, it means that we entered 2009 with no evident improvement. In addition, the credit market remains dysfunctional. Securitization of bank lending is down by more than 75%, the volume of commercial paper being traded each week is down by more than 25% (even after recent Fed purchases), and the volume of asset backed commercial paper is off 40%. Lending standards are extraordinarily high and won’t be easing anytime soon, since banks have another $300 – $600 billion more in losses to absorb. None of this seems to matter to most analysts who merely need to count off 16 months from December 2007 to ‘know’ when the worst recession since the 1930’s will come to an end. Since lending is still getting tighter, I can’t fathom how a recovery kicks into gear in 2009. And when actual lending does begin to improve, the improvement will be gradual, and hardly supportive of a solid economic recovery.

Finally, I haven’t heard a single analyst mention how excess capacity will be a growing problem, not just in the U.S., but all over the world, as GDP contracts in many countries. Excess capacity will force companies worldwide to reduce investment spending, cut payrolls, and increasingly compete to retain market share by lowering their prices. All of these factors should do wonders for corporate profits. HA! The wake up call will come, not at 3am, but when it becomes obvious that China has many of the same problems we do.

Investors believed Bear Stearns marked the bottom in March 2008, presaging a second half recovery in 2008. The stock market to rallied in April and May, as investors looked past any short term negative news, convinced better times lay ahead. It wasn’t until it became obvious that there would be no second half recovery in 2008 that the market began to fall apart in June and July. So, in the short run, it doesn’t matter if the economy does bottom in the first half of 2009, or not. Investors have convinced themselves that selling now on bad news would be a mistake, which brings in some buying and short covering after each dip. The April/May 2008 rally lasted 9 weeks. This suggests that the market will be on borrowed time after the end of January. More importantly, I think those counting on the recession ending within 16 months or so are delusional.

Jim Welsh