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    Posted November 19, 2008 by

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    Why stocks will keep on falling

    I will try to explain in non-technical economic mambo jambo why stocks will keep falling towards Dow 5000 or even 2500 as long as America's leaders don't recognize the root cause of the economic problem. It is how investors and banks assess credit risk, how they value assets, and how that affects consumer spending and behaviour. For a couple of decades consumers, businesses, and governments across the world have been spending based on debt leverage rather than income. Banks provided "free credit for all" backed by bogus casino style debt backed "securities", which they thought made them safe, and led them to turning a blind eye on credit worthyness. This has brought about market bubbles in homes, stocks, derivatives, other assets, and also in the total consumption of goods and services backed by easy consumer credit. More importantly, it has created a debt trap for all that can only be avoided as long as growth is the outlook. The average American household has piled up around $120'000 while income has declined during the last year. On a monthly basis, the average American household spent just about $500 more than their income. If credit is now assessed in a "sound and safe" manner all of a sudden, it not only means that consumers can't spend their $500 above their monthly income any longer, that shift in credit assessment leads to consumers being maxed out and FORCED to reducing debt and building equity instead of relentless spending. That portion of cutting debt is about the same as the portion of excess spending, meaning about another $500, which totals to a difference of just about $1000 per month for each American household. This sudden shift in an economic paradigm is leading to a whopping contraction of 27% or more in consumer spending, and changed the consumers' landscape for years to come. It can't have escaped anyone that oil prices are down by almost 40% from its peak, food has stabilized, cars are given away with unprecedented incentives, house prices have been cut in half, everything ever needed is on sale way ahead of Christmas, and income has not changed. They call it Deflation. However, sales keep on pointing down. Where are the shoppers? If you understand the above, than you have no trouble in understanding why the markets keep on contracting. Trillion dollar bailouts are not going to be changing the new, old way of assessing credit. It is the consumer that needs the bailout, not businesses or banks. The consumers are not waiting for prices to go down more. They simply can't spend. So, how far down is it going to go? There are a few things that could be done to counter the problem at the consumers' breakfast tables. However, first I would like to try to make it clear to you what such a change in assessment in credit and the lack of outlook for growth means for stocks. If banks have changed their assessment of credit risk and are not providing subprime loans any longer, a few hard questions need to be asked in terms of their outlook in respect to asset valuation: a) why is a company worth a double digit multitude of its revenue? b) how can a company that does not even create revenue be worth billions? c) why pay $1000 for shares that return $1 of dividends? The answer to that is: the outlook WAS on growth (DOW14,000). Alan Greenspan called it "a period of euphoria". If the outlook is NOT growth, but instead stagnation, downsizing, recession, Depression, whatever you may call it, the value assessments in the same order as above are much different: a) a fraction of revenue, or a single digit multitude of profit. b) asset or nominal value (businesses with losses a fraction thereof). c) about between $10 and $100. It is not only the consumer that is over-extended but businesses as well. Most are debt laden, if not catastrophically leveraged to the point where only growth could be the saviour. Downsizing is going to be the norm for a few years, and that will lead to extreme financial stresses for many businesses. If you reflect a few minutes on this, you will quickly understand that stocks in an outlook of a shrinking economy are still overvalued in a hefty manner. If there would not be margin trading (trading with borrowed money), I would suggest that the bottom might be sitting around DOW 5000. However, the lower the stock market is going to be pushed the more accelerated you will see margin calls and forced sales. It's a vicious cycle. In that light DOW 2500 seems quite optimistic. The economic changes lead to a fundamental shift not only how credit is assessed but also how businesses are valued and margins are a bullet train behind the decline. I don't want to bore you with repeating the threats to the economy from the derivative market bubble. In short, that's a $500 trillion tsunami in motion, and governments all over the world are trying to throw a few trillions at financial systems without properly assessing what is going on. Fear does not help now (although even Greenspan said that he was in shock) Emergency and stimulus packages have to be focused on raising disposable income and providing incentives for growing equity. Extending jobless benefits, increasing food stamps and tweaking capital gains taxes do not address the problem. The disposable income/debt expense gap needs closing with emergency measures in order contain the crisis in the short term before addressing the fundamental issue of income/debt ratio in a long term approach. It is like turning back the clock a little. In my article series about an economic stimulus (starting with economic stimulus (1): the disabled consumer at http://www.ireport.com/docs/DOC-132064) I have outlined what needs to be done and each item on its own is not going to be enough to bring the consumer back into the stores, as radical as they may sound: * abandon income tax altogether and replace it with sales tax (about 8% state, 12% Federal will do) * mandate modification of interest rates on credit (mortgages and consumer credit) - banks don't do enough * change basic healthcare into a government backed plan at $100 per month per family with high deductibles and sliding scales (extended coverage by private businesses). * increase minimum wage from $8 to $10 an hour and to $13 within another year * provide government incentives for private equity building. This proposal is much more effective than the $1.5 trillion already spent or spoken for into the financial industry. Please comment. I am addressing questions, if I can. H.R. Tschudi, economist and entrepreneur, Vancouver
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