The bear market rally continues. Although it showed signs of weakness (after dropping sharply the day the Obama administration announced its latest auto industry bailout plans), it closed up over 3% by the end of the week. At this level, it has bounced up from the early march lows as dramatically as it did during the 1930’s, the last time we suffered from a colossal asset and credit bubble bust.
The main theme behind the rally is the idea that things are getting less bad. This second derivative reasoning assumes that, if the market looks far enough ahead, today’s slower rate of decline in the economic data portends the eventual rebound that must surely follow. Perhaps.
Not all of last week’s economic data looked less bad. The Case-Shiller housing index actually reported an accelerating rate of decline in the prices of homes, falling at a 19% yoy rate. The ADP employment change, at -742,000, was the worst of this crisis, to date. Initial claims jumped to 669,000–the highest since 1982; and continuous claims rose to 5.73 million. Nonfarm payrolls came in at a worse than expected -663,000. And the unemployment rate jumped to 8.5%, the highest since 1983. Both Chicago PMI and ISM services were also lower than expected.
Not very encouraging, but the equity markets didn’t seem t0 mind. For now.
The current issue of The Economist highlights the development path of a capitalist economy: at the end of the path, it blows up as a consequence of its prior success. A leading economist from the mid-1900’s, Hyman Minsky, argued that as an economy grows in size and drives down unemployment, it tends to create an overabundance of confidence. This leads to the problem where borrowers eagerly take on too much debt and lenders become blind to the risks of providing it. The result is that asset bubbles, in housing, in equity securities and even in debt securities, develop.
Borrowers end up borrowing more, against appreciating collateral, just to pay the interest on the rising debt levels. Later, borrowers take on a level of debt that exceeds the value of the collateral; they borrow so much, because everyone anticipates that collateral values will rise enough to be able to pay off the debt. Debt levels, as compared to total income and compared to total collateral values, soar to dizzying heights.
Then something pops. Often a small incident can start a violent process of reversing the bubble growth. Borrowers start to default, and collateral values plunge as borrowers (and lenders who take possession) rush to sell, putting even more downward pressure on prices.
This process describes what happened in the U.S. and much of Europe over the last 25 years, especially in the housing markets. Our economy created a massive house of cards that led to the illusion of massive wealth creation.
This was a giant Ponzi scheme. And because it took 25 years to create, the consequences are ominous: it will take years to correct, and it will be a large correction. So we have a long way to go.