<The excesses have been 75% worked out>
Some may dispute this conclusion.
Last I checked the NASDAQ still sported a p/e ratio close to 100. GE is "growing" at 16% and sporting a p/e ratio of 35. Cisco is still priced like it will continue growing at 60% for ever. It's clear that the excesses in the valuations of popular techs that form the backbone of most portfolios are far from worked out. Maybe if the NASDAQ falls another 50% from here, the excesses will be 75% worked out.
The US is running a trade deficit of $400 billion per year. This means that for the dollar to retain its value we need a net investment flow from abroad of $400 billion per year. How long will Europe and Japan continue to oblige us and what happens if they stop?
Finally, the consumer and business debt bubble is not only not worked out but is still expanding merrily. Consumer debt as a percent of disposable income is very near a record. A hefty portion of the new economy is based on huge telecom debts, and an alarming portion of them is becoming distressed. The stresses that will result if a recession extends for more than a quarter or two will make October 1998 look like a walk in the park.
Here is a nightmare scenario -- it is not probable, but it is plausible.
After a second or third .5 or even .75 drop in the funds rate, foreign capital flows into the US diminish. The dollar falls, long term interest rates (which are controlled by the market, not the Fed) rise substantially, the broad stock market follows the NASDAQ down the tubes. No more cheap mortgages, no more extra consumer money from refinancing and cheap equity loans, no more stock market wealth effect. Instead of boosting consumer spending the Fed action actually slows it. Construction of new homes falls dramatically. The recession extends beyond two quarters. Consumers cut back substantially, boosting their savings rate from zero to the long term post-war average of 8%, since the stock market no longer provides automatic "savings". This prolongs the economic slowdown dramatically (75% of the GDP is consumer spending).
An alarming number of business debt becomes distressed, because, unlike previous booms, the debt to equity ratios of business have actually deteriorated, because a number of them chose to buy back their stock with their boom profits, rather than retire some of their debt. In fact, some of them (e.g. IBM) actually increased their debt during the boom times to buy back their stock.
The Bush tax cut, new spending on education, the military (Star Wars redo), and assorted spending to buy Democratic support for the tax cut, combined with the recession, quickly eliminate the budget surplus, putting further stress on long term interest rates.
The dramatic slowdown of US imports results in an Asian crisis far worse than 1998. There have been no structural changes to correct the problems that brought about 1998 in Asia, and the US import boom that essentially papered over the problems has collapsed. China in particular experiences dangerous instability, and Japan slips into a near-depression.
Need I go on?
Kyros |
