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Posted on October 10, 2008 -
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By John Reizner |

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With the Dow Jones Industrial Average below 9000, we are witnessing an epic battle between the forces of a stock market crash and possible economic deflation, on the one hand, and the might of the Federal Reserve and government, on the other. We face frozen credit markets and a huge debt burden on our citizens and government that has built over decades as both citizens and the federal government have been living beyond their means. The final debt binge led by subprime lending and massive war spending by the government leaves little wiggle room for the consumer and government to bail us out, as happened after the 1987 stock market crash. Deleveraging of the consumer and government debt burden under this scenario may be a painful process.
Also, I believe the stock market is anticipating an Obama victory and a more radical agenda than has been forthcoming from the Democratic camp.
I see basically four scenarios that may occur as this crisis unfolds:
I have not written considerably about the possibility of a pure deflation in my articles until recent stock market events have raised the probability of that occurrence. The first scenario is a complete deflationary failure of the stock market and the economy, characterized by a stock market that in total may lose 90% from its peak in the near to medium term (I know that sounds improbable), a possible deflation of most asset classes, except perhaps gold, and an unemployment rate possibly in the high teens (or even higher). There is precedent for this belief, as demonstrated by the breakdown of the financial system following the 1929 stock market Crash. In this scenario, the stock market would continue to bleed until it is almost unrecoverable.
We have a situation now where price/earnings ratios on many stocks are well into the single digits because of the market decline, but with a potential economic freeze on growth, the earnings part of the equation may fall further, leading again to high P/E's. Also, DJIA bear market bottoms are sometimes characterized by the average itself yielding as much as 6% or more. Currently, it is approximately 2%.
The second scenario is that the actions of the Federal Reserve and the government would be enough to halt, at some point, the hemorrhaging in our stock market and free up credit markets in the next year to year and a half. If the housing market should clear the overhang of foreclosure sales (this could take some time), and banks start to prudently lend again to businesses and individuals, the economy may respond to all the Federal Reserve and Treasury measures in place to get our economy going again. However, the current Federal Reserve easing may produce a powerful revival of the inflation that is now abetting (because of the current slowdown) a year or two down the line. Gold, under this scenario, may reach unexpected new highs in the future. At some point the stock market, in this line of thinking, would rally but would not exceed the old highs until years of consolidation and range-bound trading had passed (similar to the 1966-1982 long term bear market). The current long term bear market began in 2000, after the technology bubble burst.
The third scenario borrows from the first two. In this case, the deflationary forces would win the battle against Federal Reserve easing and government action, at least temporarily. In response to a deflationary calamity, the Federal Reserve may run the printing presses until an inflationary recovery could take place. Gold may do well under this chaotic scenario.
The fourth scenario is that the Federal Reserve and the government manage to get the economy going again while containing the fires of inflation. This is obviously the most benign possibility.
I have for my own situation, enough funds to cover my mortgage and still have enough stocks to participate in a stock market rally, however ill-fated the rally may be. There was a stock rally in 1930 after the Crash of 1929, which many believed at the time was a new bull market, to their terrible disappointment. Events in the stock market will dictate my future actions. I am still holding my gold position, the Templeton Global Bond Fund, a portfolio of stocks and mutual funds (though less than before), and invested cash.
We need to have banks lending again to worthy businesses and individuals, and at the same time, working through the housing decline. The Federal Reserve and Treasury actions are a good start. Now we need to restore confidence in our markets. I am hoping that our next President will not abandon the capitalist marketplace entirely so that all of America may prosper.
In The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, Charles Morris insightfully describes how the orgy of hedge fund excess and high leverage on Wall Street helped lead to the current intractable credit crunch.


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