Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

 — from Shakespeare’s Hamlet

What a mess. Have you paid any attention to the financial news lately? Loan defaults, real estate foreclosures, falling housing prices, sub-prime mortgage losses, a declining stock market and an economy skirting on the brink of recession.

So how did we get here anyway? Before we can understand how we got here, we should first look at where we’ve been. And when we do that, we see incontrovertibly that the culprit responsible for the robust economic expansion of the last several years (RIP) is two-faced and duplicitous, wreaking havoc behind the scenes of today’s financial mess. And that offender has a name: Credit — and lots of it. Here’s the story.

Back in 2001 our country had the tragedy of suffering the terrorist attacks of 9/11 and the misfortune of a mild economic slowdown. In order to keep our economy from completely shutting down in the aftermath, the Federal Reserve moved to dramatically lower interest rates. And they were wildly successful. Pre-9/11 short-term interest rates stood at 6 percent. A year later, rates were hovering down at the bargain basement level of 1 percent. 

That unprecedented drop in the cost of money had its intended effects — but it had unintended consequences as well. Rather than a total economic collapse following the 9/11 attack, our nation recovered and recovered vigorously. That was good. But here’s the rub. Since the Fed seemed to misread the inherent strength and resilience in our economy following those interest rate reductions, it left rates at those low levels long after growth resumed. One obvious consequence was a red hot housing market, and speculators took note. Day traders decided that they’d like to be the next Donald Trump. And bingo — real estate became the new financial game in town.

As any wild child knows, after such a party the hangover is often proportional to the binge. And this hangover has been painful, to say the least.

In the spirit of déjà vu all over again, (sort of like it was here in Lafayette about 20 years ago), we currently have a front row seat to a price and wealth implosion that is truly world class. For an investment class that was supposed to never decline in value, real estate has just been miserable in many parts of the country.  

The fallout from this fiasco is painful. Keys have been mailed in, foreclosures have skyrocketed and bank REO officers have a new understanding of the term “job security.” The balance sheets of financial institutions that were involved in these real estate loans have taken a severe hit. Realized losses thus far have been an estimated $200 billion.

The market sniffed all of this out last summer. What has been happening in the stock market is the engine of growth for our economy — easy credit — has sowed the seeds of its own demise. It’s the realization that corporate earnings will not grow as vigorously as Wall Street had anticipated as recently as nine months ago, resulting in the adjustment in stock prices over the last several months. 

Here’s an interesting fact. When looking at the post-war recessions lasting less than 12 months, the S&P 500 stock has gained an average of 9.85 percent a year after the recession started. However, when the economic slumps have dragged on beyond 12 months it’s quite a different story. For those cases, the average stock market return a year after the recession started has been  minus-22.6 percent. From this point on, everything depends on to what extent the housing and credit collapse pulls down the general economy. 

The market’s response to this situation has thus far made sense. And if the market’s economic assessment is correct, then maybe the worst of this mess — as far as the stock market is concerned — is behind us. And what exactly is the market’s current assessment of the economic outlook? Well, I can tell you what it isn’t. In no way is Wall Street pricing in a recession of any consequence. Current Wall Street earnings estimates (upon which current stock prices rest) are quite robust. Wall Street is looking for a second-half earnings recovery on the order of 60 percent. That’s a far cry from the average 40 percent earnings decline that has accompanied the last few recessions that we’ve been through.

Which brings us back to our original question: Is it over? That depends entirely on the economy. If we do in fact have a recovering economy from here, then as far as the stock market is concerned, the worst probably is over. But if Wall Street is underestimating the extent of the ultimate economic damage inflicted on our economy by the unwinding of this credit and real estate bubble, then we may want to keep our umbrellas and rain gear handy.

Which brings us back to our original question: Is it over? That depends entirely on the economy, and Art Cashin, a long-time NYSE floor broker and CNBC commentator, recently gave a very thoughtful, succinct and wise answer to the question. Based on his 50-plus years of experience, he thought for a moment and then replied, “We should know by the fall.” I agree.

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ABiz Stock Watch
o Home Bancorp 22.89 0.00 (0.00%)
o Frank's International 17.21 ▼0.26 (-1.49%)
o IberiaBank Corp 64.13 ▲0.08 (0.12%)
o LHC Group 23.74 ▲0.38 (1.63%)
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o Twitter Inc. 49.95 ▲0.28 (0.56%)
o Gannett 31.43 ▲0.19 (0.61%)
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