How Bad Might It Get?

This credit contraction is still young, yet we already have the spectacle of a full blown seize up in the money markets which has central bankers flummoxed. Normally, you expect this sort of panic after a few major financial train wrecks and weakness in the real economy.

One can cheerily assume that all is for the best in this best of all possible worlds. that in our tightly-coupled, information suffused, low trading cost environment, things happen faster in the past,. What we are seeing is simply a compression of events that might otherwise take longer to play out. Sharp spike down, fast recovery, and if you aren’t a subprime victim, back to life more or less as before.

Albert Edwards, Dresdner Kleinwort strategist (and the man who coined the phrase, “The Great Unwind”) has the opposite view: that the fast trajectory down (at least in the credit markets; equity investors haven’t given up their faith) is due to the fact that the cognoscenti know that more is yet to come.

FT Alphaville gives us the key bits from Edwards’ latest report:

The strategist’s latest weekly missive, sub-titled Which domino will fall next in ‘The Great Unwind’?, should cause DK clients to pause and think…. We should cut to the chase:

Who knows whether this ends in global recession? But what is very clear is that the market is still attaching a minimal probability to the recession outcome. Our own economists’ probability of a US recession is 40%… In a recession we see large falls in profits of about 35% (especially financials) — an environment in which equity markets might half, Fed Funds and bond yields fall below they previous cyclical lows of 1% and 3.1% respectively and general carnage in leveraged risk investments. The risks to investors are so, so very asymmetric.

In an unusually long (and, we note, badly-edited) edition of his Global Strategy Weekly, Edwards meanders through the carnage already wrought, finding evidence at every turn for much more to come.

Some snippets:

The real carnage has been in the money markets that have been hit by the extreme levels of risk aversion by market participants – as evidenced by short dated Treasury Bill yields plunging due to their safe haven status. I think that things are much worse than most believe…

Despite flooding the market with liquidity and cutting the Discount Rate to calm things down, there is absolutely no reason that extreme risk aversion should dissipate. The levels of losses in hedge funds etc are the result of massive levels of leverage invested in risk assets which, in the main, have moved only moderately downwards. It is leverage and extreme levels of risk appetite that are the problem…

Are inverters now de-levered? If they were I would suspect that asset prices would be a lot lower than they currently are. There are lots of bodies still floating to the surface. I believe investor/lender risk aversion is highly appropriate given the way funds have been able to cover up losses with mark to model practices and the inability of rating agencies to see simulate the losses seen on assets in the even of a housing crash (which was wholly predictable)…

With banks one moment claiming they have no exposure to US subprime only to be found to be virtually bankrupt a week later, what confidence can investors as the stench of incompetence and cover-up now emanates from the financial industry.

And there’s more:

Most equity investors still have a touching belief that equities are cheap and hence will relatively safe during “The Great Unwind”..

This relative cheapness of equities has been cited as the reason for the crazy levels of corporate finance activity recently…(But) companies are now simply not in a position to borrow at the rate they were to fund these activities. The single biggest buyer for the US equity market is now been effectively slide tackled into touch…

If long-term earnings decline, as they did post-Nasdaq bubble, PEs will contract sharply even despite sharply lower bond yields. Equities are therefore not really cheap. It is an illusion.

And more:

Hence we have always forecast continued Ice Age multiple contraction in the event of a US economic downturn, whereas most commentators will forecast that there will be multiple expansion because equities are cheap and bond yields will decline. Hence in the next recession (which could be coming soon) a 35% decline in profits (say) could be accompanied by multiple contraction from the current 15.5X trailing earnings to say 12x. This would generate a portfolio wrecking 50% decline in equity indices…

This sort of forecast usually meets much hilarity, even with those few clients who are sympathetic to our arguments. But the assumption that the de-bubbling of valuations is over is that – just an assumption.

All of which leads Edwards to a bone-rattling conclusion:

What commentators totally miss is how incredibly fragile consumption really is. With mortgage lenders going bust by the day and the household sector hit by a barrage of depressing headlines it is entirely possible that further retrenchment in the obscenely high borrowing requirement will yet generate a economic slump which no-one will predict…This is the big domino that is yet to fall.

In case you see Edwards’ view that PE multiples could fall as a sign of a hopelessly depressive outlook, keep in mind that more even-keel types have also argued that equities are richly priced.

Martin Wolf, the Financial Times’ lead economics editor, pointed out in March that equities were considerably overvalued by historical standards. More recently, the New York Times’ David Leonhardt, using analytic methods advocated in the original bible of investing, Benjaim Graham & David Dodd’s “Security Analysis” also found stocks to be expensive.

One of the reasons for the divergent views as to what a “normal” PE multiple is that the 1990s market featured high multiples for sustained periods, even though nominal interest rates were higher than, say, in the 1960s. That period was sufficiently protracted so as to bring up long term averages.

If the 1990s multiple expansion was due to greater global stability (the end of the Cold War, better information management that kept inventory swings from worsening slowdowns, deregulation) then it is likely to be more representative of current values than, say, the 1970s. But if you see the 1990s boom as fueled by overly accommodative monetary policies, we are due for a reversion to the mean, or even a correction beyond that.

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  1. burnside

    I share Edwards’ general perspective, though when considering a next ‘domino’ I see CMBS a worthy candidate, on an equal footing with consumer retrenchment. Odds are we’ll have both.

    Probably you’ve addressed the subject already (?) but, IIRC, commercial mortgage defaults generally follow residential with a lag of some five to eight months, so we should be beginning to see negative numbers there, or will see them very soon.

  2. Dave L

    With respect to PE ratios, another bearish point to be made is that corporate profits are at record highs as a share of GDP. This makes direct comparisons with other period PE ratios suspect, to say the least.

    In the contest between reversion to the mean and this-time-it’s-different, my money is always on reversion.

  3. Anonymous

    The ’90s were fueled by low oil prices. The late housing boom represented a massive build-out of infrastructure designed and nicely adapted for that past cheap-oil era. (huge homes, long commuting distances) That boom was bought on credit.

    Now, as oil gets ever scarcer and dearer, our residential infrastructure no longer makes sense. Creditors may not know the reason, but they do sense that long term none of this infrastructure is worth even half its current price. They have taken their marbles and gone home. Permanently.

  4. dis


    Brad DeLong thinks the Fed should cut and will cut

    The Federal Reserve is now focusing on what Larry Meyer calls “liquidity tools” to make sure the market for short-term credit functions despite concerns about counterparty risk and collateral values. The Federal Reserve hopes that it can handle the current situation without having to ease monetary policy–that its liquidity tools will do enough, and that it won’t feel forced to rescue market liquidity by cutting interest rates and thus giving what it fears would be an unhealthy boost to spending. (I think the Federal Reserve is wrong here: the fallout from the current liquidity panic means that a year from now we are likely to wish that the Federal Reserve had given a boost to spending today.)


    I feel uneasy about a cut. Even if the economy slows down he should tread carefully. I would only support a cut if the data shows that the economy is has started to or is on the brink of starting to contract, or if there is deflationary pressure. I don’t think were there yet although we might be there next year.

    More on Brad’s comment here

    Would love to hear your take.

  5. Yves Smith


    Happened to see your pointer to DeLong (thanks! and let me give a very off the cut take:

    I believe reactions like his show that even very smart people are missing what is afoot here. As Robert Shiller has been saying for some time, we have had a very large housing bubble. This isn’t just a subprime problem. That simply happens to be where people are getting killed because they bought, highly levered, at the peak and on top of that (except for the fraudsters) have zero net worth to fall back on.

    In other markets, you can debate whether the term “bubble” applies (Jeremy Grantham thought it did), but you have overpriced assets due to overly cheap credit: equities, commercial real estate, emerging markets.

    Now as credit is repricing, the assets are repricing. The two go hand in hand. But because consumers in the US have been spending their appreciated housing via home equity loans and refis, the deflating of housing in particular is going to affect the real economy.

    As my hero Ian MacFarlane said, monetary policy is a blunt instrument. Perhaps I am missing something, but I don’t see how you can keep the real economy from suffering without enabling (and worsening) the bubbles.

    And I think Roubini is 100% correct when he points out a big part of the crisis aspects of this is we have information problems (opaqueness means no one, including the regulators, knows where the dead bodies lie) AND we have a solvency issue (some of these creditors are so far underwater they can’t be salvaged). Throwing money at this won’t solve either of those problems.

    So I hope Bernanke sticks to his guns. But I fear he is no Volcker. And (for those of you old enough to remember the stagflationary 70s), there was a consensus that inflation was a huge problem that needed to be solved. The controversy was whether Volcker’s remedy, of cutting money supply, would work and was worth the pain.

    There is collective denial (per DeLong’s view) of how pervasive and pronounced asset inflation is, and hence a failure to recognize that dealing with it involves pain and disruption.

  6. Yves Smith


    Actually, I have mentioned your point only indirectly, by pointing a couple of times to Fitch reports saying that lending practices in commercial estate have been frothy, in a worrying parallel to subprime. But your observation well taken: residential housing generally takes in on the chin in a downturn before commercial.

    Dave L and Anon’s points are also valid. A buddy of mine who comes from a real estate family has predicted that we will see a trend to smaller, more fuel efficient houses, closer to cities, and that a lot of McMansions will become white elephants.

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