Tell Me Why I’m Wrong to be a Pessimist

by JDH on November 29, 2008

After watching market action this week, should I be an optimist, or a pessimist? The optimists will tell you that, for the week, the Dow gained 9.7 percent, the S&P 500 was up 12 percent, and the Nasdaq was up 10.9 percent. Great news, eh? The pessimist will tell you that November was a very bad month, even with the gains of last week, with the Dow losing 5.3 percent, the S&P 500 falling 7.5 percent, and the Nasdaq off 10.8 percent.

The optimist will point to the fact that we are now up against the short term down trend line, and therefore a break to the upside could indicate a short term rally.

Of course, the pessimist will show you a longer term chart:

Longer term, it’s quite obvious we are in a bear market. We are well below the 50 and 200 day moving averages, and there are lots of down trend lines to break before the market can be said to be going up.

As you know, I am a pessimist, and I have yet to see any indication that things will change in the near term.

We live in a credit based economy. Since the bottom of the last depression in 1932, we have lived in a society based on credit. It all started with FDR’s New Deal, where government deficit spending was used to create jobs in periods of high unemployment. A Keynesian approach would perhaps work if governments would run deficits during recessions, but then pay off those debts completely during boom periods. Unfortunately, human nature being what it is, the surpluses in boom times are never enough to repay the recession era deficits, and we are left with permanent government debts in most, if not all, industrialized countries.

Individual consumers are no different. It is not at all unusual to meet someone heading into retirement with a mortgage on their house, or with credit card debt. We follow the government model of deficit financing for our entire lives. Now we are paying the price. The “price” is the interest we are paying on past consumption, and it is a significant drain on all of us.

Sadly, as the credit bubble implodes, we may well be facing a deflationary period. We most certainly are now in a period where prices are falling. The price of oil is down two thirds from it’s peak of a few months ago. Gold and most other commodities are also down, as the recession shrinks demand. Real estate prices are collapsing in many parts of the world.

Falling prices lead to more falling prices. If I want to sell my house I have to drop the price because there are limited buyers, which causes a further drop in prices. It’s a vicious cycle. If consumers expect prices to continue falling, they stop buying in anticipation of future price decreases. It becomes a self fulfilling prophecy.

Even worse, we are in a credit bubble, where most of us, including the government, are carrying too much debt. I can’t refinance my mortgage at the bank, because the security for my mortgage, my house, is now worth less than it was when I got the loan. The sub-prime crisis in the United States has been well documented. Less well known is the mortgage crunch happening in Canada right now. In most cities house prices are at their lowest level in over two years, so anyone who bought a house within the last two years has lost money. Even worse, some mortgage lenders are pulling out of the market. A big American mortgage lender moved into the Canadian market two years ago, and last month begin notifying customers that they will not be renewing their mortgages. These “sub prime” borrowers can’t find a mortgage lender to replace their existing mortgages, and many of them will end up losing their houses.

As prices fall and debts become more expensive to repay, the risk of default increases, and bankruptcies increase. In Canada, personal bankruptcies increased by 30% in September, 2008, as compared to September, 2007. They are only up 7% year to date, which means the number of bankruptcies filed has accelerated significantly in the last few months. That’s bad news for the economy.

And bad news for the economy is bad news for the markets.

Now, many of you may agree with everything I have just said, but you may counter with the thought that “it’s all baked in”, meaning the collapse has happened, and the worst is over.” Perhaps, but what indication do you have that the worst is over?

Do you believe that the real estate market has bottomed?

Do you think there will be no more government bailouts?

Do you believe that the automotive industry is back on track, and won’t need to restructure?

Do you believe we have avoided the credit card crunch, where banks experience massive bad debts on their credit card portfolios?

I don’t. I believe it is more likely that the real estate market is not anywhere near the bottom, that there will be more government bailouts, that at least one of the “Detroit Three” will fail, and that over the coming months banks will report massive losses on their credit card portfolios (requiring more government bailouts, of course).

Then, as the massive government spending works its way into the system, we will get to experience inflation, which will mess everything up once again.

For 2009, I am, therefore, a pessimist.

Of course, I could be wrong. I may be wrong. I hope I’m wrong. But if I am wrong, what am I missing? Where is the flaw in my logic? What is the piece of information I am not considering that will turn everything around?

Let me know on the Forum, since I would prefer not to be a pessimist.

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