New Year Greetings!

October 1, 2008

New Year Greetings!

Business students ask me if the financial world as we know it is ending. First, I remind them they are students with at least a year, perhaps three, before they need personally brave the professional market. I also say that Monday’s 7% decline is only a gray copy of the 23% decline experienced on the Black Monday of 1987. May get worse before better.

Students remind me that they are already employed at hedge funds, insurance brokerages and chic Manhattan eateries. They say business sucks.

I tell them that the business cycle is real---housing is weak, perhaps to weaken further. Since the housing sector leads the ups and downs of the economy, business activity measured by employment will continue to decrease. With extensive home foreclosures in California and Florida and for sale inventory increasing nationwide, there is no clear sign of a bottom. Moreover, the prospect of higher interest rates is a big negative for all assets, as are property tax increases of the sort Mayor Mike Bloomberg proposes.

It’s going to be a lumpy Christmas. The consumer is not buying durables; business is slowing production; investment is apt to decline. Unemployment, now at 6% is likely to increase.

The bigger question: what is the shape of the recession? Will it be the sideways correction characteristic of the early 1990’s or the more severe contraction, as measured by double-digit unemployment, of the early years of the Reagan administration (early 1980’s)?

My hope is that it will be the more severe type, since I think it important to fully purge the effects of the lax underwriting and lending. I want to see a reinforcement of moral hazard criteria. I want to see the elimination of adding value by obfuscations, of bonuses paid for notional profits, of enormous legal fees for meaningless opinions. I want to see the private equity guys scream.

And I think they will. Hedge fund strategies inevitably involve leverage. Even a contra-strategy, perhaps betting on a rate rise, is diminished by a higher cost of funds. And, given deficits in budget and trade and the latest round of monetary exuberance, I do see higher rates!

Hedge funds, particularly the equity sort, are bull market strategies. Since 1992, private investment values have increased at least as fast as the public markets. The gain has been compounded by attracting additional investment capital. I expect the private capital pool to contract as the consequences of accelerating insolvencies and frozen prime brokerage accounts reverberate. To be sure, some investors may be sufficiently nimble in selection and trading that they continue to earn outsize profits and outsize fees. Most won’t.

Mild or severe, the downside duration is probably two years, at most. Homebuilding actually began declining in 2006, so a 2010 pickup seems reasonable. But the market will move up earlier.

I encourage my students to think that, like Clinton, Obama will use the first years of his administration to establish some degree of fiscal sanity and let The Invisible Hand impose Creative Destruction.