Thursday, November 20, 2008

Roubini Tells The Way It Is

The Latest Bear Market Sucker's Rally Has Gone Bust as We Are Headed Towards Stag-Deflation
Nov 19, 2008
With major US equity indices free falling over 6% today Wednesday, ending below their October lows and now being back to 2003 levels the latest bear market sucker's rally is now officially over. A cacophony of delusional bulls – including allegedly savvy investors such as the Sage of Omaha and other luminaries – were spinning for the last month the fairy tale that markets – especially equity markets – had fallen so much that a bottom had been reached and that this was the time to start buying equities. Some of us never believed this self-serving spin and warned repeatedly that both equity markets and credit markets had further severe downside risks (20% to 30% lower for equities).

So the brief sucker's rally is over and a reality check is now dawning on markets and investors. Expect this financial crisis and economic recession to get much worse in the next 12 months before it gets any better. We are nowhere near a bottom for housing, the U.S, economy, the global economy and financial markets. The worst is ahead of us rather than behind us.

Now the latest brief bear market sucker's rally has gone fully bust and conditions are getting again “fugly and fuglier” in the real economy - US and globally - and in financial markets, both equity and credit markets. Other shorter and shorter-lived bear market rallies may occur again as desperate policy authorities – especially monetary ones - try to get out of their policy hat other voodoo rabbits of more desperate and unorthodox policy measures as we have already effectively reach the zero-bound for the policy rate and a liquidity trap (the effective Fed Funds rate has already around 0.3% for weeks now while the target rate is formally still at 1%). And the risks of a stag-deflation – that I have been warning about since January – are now becoming conventional wisdom as even Don Kohn is now talking about the risks of deflation.

And in this downward race between equities and credit it is not even clear anymore which asset class is undervalued in relative terms: both are free falling so fast with credit spreads rising through the historical roof for both high grade and high yield (and CDS spread also headed towards new heights) while equities are falling to new lows. Credit still looks cheap relative to equities as a massive surge in corporate defaults as currently priced by credit spreads would certainly wiped out common equity even more than debt.

In early October I predicted – in an interview for Tech Ticker – that the Dow could fall towards the 7000 level by next year and that US equities would fall by 50% relative to their 2007 peak. Such predictions were considered too bearish and extreme at that time but, at the rate at which equities are falling now with this acceleration of a savage deleveraging by leveraged institutions (and even disorderly sell-off by many unlevered players too), the Dow may reach the 7000 before year end rather than in 2009 and we are getting close to a 50% drop in overall equity prices from their peak.

In my next piece I will discuss in more detail how we are now close to the deadly “Bermuda Triangle” of a liquidity trap, price deflation, debt deflation and sharply rising defaults.

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