Fleckenstein/ The market's worst is yet to come
Contrarian Chronicles4/21/2008 12:01 AM ET
Now that a few Wall Street folks have finally dared to utter the word 'recession' aloud, most of the rest are assuming this downturn is practically over. Expect the bulls to stumble.
By Bill Fleckenstein
This week's Contrarian Chronicles focuses on the multitrillion-dollar question on Wall Street: Has the worst been seen, or is the worst yet to be seen?
The majority of market participants find themselves in the former camp (which, regular readers know, is not where I stand). They believe that because a handful of folks have now said the word "recession," it's nearly over. As a result, they say all the bad news we see is a function of what we "already know." Thus it has been discounted and should be ignored.
Similarly, they take confidence in the fact that the stock market reached a low in January, created around the Société Générale banking panic, and retested that low as Bear Stearns (BSC, news, msgs) supposedly almost took apart the financial system (which led the Federal Reserve to create the latest alphabet soup of funding facilities).
The combination of recession, massive Fed easing and those two financial panics has encouraged the bulls to think that we now have seen all we need to see before we have a bull market. Therefore, we should buy stocks.
Problems can't last, can they?
That glib notion has arisen because of the policies pursued by the Fed and then-Chairman Alan Greenspan over the past two decades, which led to the current sad state of our bailout nation.
Bulls have been conditioned by that ride, in Pavlovian fashion, to believe that anytime there is an admission of recession or any kind of panic, it will resolve itself positively in relatively short order, if not almost instantly. (They forget that it took a little time, between 2001 and 2003, to resolve the stock bubble. But that's a minor point.)
That same class of animal also believed that as the credit bubble initially burst, in the form of the initial subprime FPDs (first payment defaults), it would be limited to subprime mortgages and thus be contained.
Everyone knows how the story went from there. I believe folks in that camp never understood that the housing bubble was the economy, which is why they are now quite sanguine.
Listening to the speakers at a recent conference hosted by Grant's Interest Rate Observer, I found that some thoughtful people remain in the it's-going-to-get-better camp because it hasn't yet gotten all that bad. Perhaps they are right, but I don't think so.
I think the better arguments are made by those who understood what the unwinding of the credit bubble meant, who understood that it wasn't just subprime, who understood that it wasn't contained -- and, armed with that knowledge, realized the ramifications of that bubble's unwinding are quite large.
Video on MSN Money
Fleckenstein on CNBC: Grading Greenspan
Bill Fleckenstein and Doug Roberts of Channel Capital Research comment on former Federal Reserve Chairman Alan Greenspan's defense of Fed actions during his tenure.
Tear-downs in home prices
One such person is John Paulson, whose hedge fund made an enormous score, perhaps the biggest of all time, betting against subprime and the rest of the credit structure. His best guess, as articulated at the Grant's conference, is that when housing reaches a bottom, prices on average will be down 25% from the top, which is to say an additional 10% to 15% from where they have already fallen.
This is on average, mind you. Some locations will fare worse, others better.
If that happens, the ramifications throughout the financial system and economy will be sizable -- which, to repeat, is what I expect.
Continued: Bulls still in charge (for now)
As I point out in "Greenspan's Bubbles," aside from the lift given to the economy via the stimulus that came from the money homeowners extracted from their equity, the last recovery essentially wasn't one. And, given that about 40% of the job creation in that "recovery" was related to real estate, now that this source has been drained, there's no way you're going to convince me that the recession that comes out of that will be some mild event that is manageable, contained and pretty much behind us. It just makes no sense.
The recession after the equity bubble was milder than I would have expected, but that was because it was positively impacted by the beginning of the housing bubble. This housing bubble (as I pointed out while it was under way) was destined to leave bad debts in its wake, crippling both the lender and the consumer.
Bulls still in charge (for now)
Back to the multitrillion-dollar question: From a trading standpoint, one has to be cognizant of the fact that the folks who believe everything will be OK have more votes and more money than the folks who are in the other camp. (Witness how quickly General Electric's (GE, news, msgs) pullback was forgotten as folks latched on to Intel (INTC, news, msgs) having "made a number" that had been twice reduced.)
Thus the tricky part -- for me -- is figuring out when to express, by taking short positions, the bearish view.
Video on MSN Money
Fleckenstein on CNBC: Grading Greenspan
Bill Fleckenstein and Doug Roberts of Channel Capital Research comment on former Federal Reserve Chairman Alan Greenspan's defense of Fed actions during his tenure.
As the financial world supposedly teetered on the brink of demise on the back of the Bear Stearns collapse, I thought we were either going to have an enormous meltdown or, if it became clearer that the Fed had stemmed the tide, we would experience a big rally. As it became apparent that the latter was the case, I cut back my shorts (though I recently reinstated many of them).
What I can't know is: Once we get near the end of earnings season, will the bullish contingent once again run the tape back up because bulls are convinced the worst has been seen -- yet again? I expect they will. So I'll probably cover shorts during earnings season. Then I will look for one more rally to really short into.
The big money on the short side is going to be made when the bullish folks now awaiting the promised land realizes they're trying to look past not just some small ravine but a chasm as wide as the Grand Canyon. Once they understand that, we will see the combination of the stock market, the economy and the real-estate market feed on each other -- and we will finally experience the next time down.
When that will happen is not yet knowable, but as I have said, there is no doubt in my mind that this outcome is inevitable.
At the time of publication, Bill Fleckenstein did not own or control shares of any of the companies mentioned in this column.
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