Bad Assumptions

by Michael Panzner, Financial Armageddon. February 4, 2010

Yesterday’s ADP National Employment report revealed that nonfarm private employment fell an estimated 22,000 in January, the smallest drop in two years. Not surprisingly, the data cheered those who believe a slowing rate of job losses means a recovery is around the corner.

Regardless, the data I found interesting is the employment trend by size of firm. While the financial crisis has forced many employers to restructure and downsize, the segment of the economy that has received the most support in terms of bailouts and other government assistance, and which has had the best access to bank loans and other sources of funding, has been at the forefront when it comes to cutting staff. In contrast, small businesses, which have been squeezed on all sides, now employ more people than they did ten years ago.

0204.01

One of the many (dubious) assumptions that Wall Street rocket scientists made before the housing and credit bubbles burst centered on what mortgagors would do if the economy hit a "speed bump" (back then, of course, the conventional wisdom was that severe downturns had been eliminated by expert policymaking, reams of academic research, and the wisdom of the ages).

Generally speaking, they believed that homeowners who ran into financial trouble would behave in the same way that others had before them -- that is, they would make sure the mortgage bill was among the first to be paid each month.

As with the notion that house prices never go down, this theory turned out to be wide of the mark. In fact, a recent study found that a growing number of consumers “are giving greater priority to paying credit card debt than making a mortgage payment, showing increased financial duress,” according to Reuters. “As the economy climbs out of the worst recession in decades and unemployment remains high, financial strains have forced consumers to prioritize monthly debt payments in order to maximize cash flow.”

0204.02

Since the financial crisis began, many ivory tower economists have argued that it doesn't really matter how much debt the U.S. takes on in the name of "rescuing" the economy, because the current output gap, among other things, means there is little risk that it will lead to inflation.

However, as was the case before the house of cards "unexpectedy" fell apart, many of the so-called experts can't see the forest for the trees. Among other things, they don't seem to understand that there are limits to what creditors will put up with, not to mention the fact that there are other economic risks besides inflation.

Indeed, as the following graph illustrates, those European nations that have spent too freely and borrowed too much are suddenly discovering there’s a price to pay for their profligacy. With the market price of insuring against default increasing rapidly, Portugal, Greece, Spain, Italy, The United Kingdom, and Austria, among others, will find it increasingly difficult to remain in control of their economic destinies.

0204.03

To be sure, not all of the basket cases are based outside our shores. In the United States, there are plenty of municipalities -- not to mention the federal government itself -- in financial distress because of poor planning, corruption, misguided policies, and a failure of leadership. Here again, more and more investors and creditors are putting their money where their mouths are and saying: “enough is enough.”

0204.04

In the U.S. and around the world, banks, brokers, and insurers have either tracked or led the market higher and lower over the past several decades. In the summer of 2007, for example, the S&P financial sector touched its all-time high and then rolled over, anticipating a similar move in the S&P 500 index five months later. In March of 2009, the sector and the overall market hit their lows within days of each other. In October, financial stocks topped out once again, and have since fallen to multi-month lows in absolute terms and relative to broader benchmarks. Sounds like we should be paying attention.

0204.05

Finally, while many commentators have suggested that the latest bout of weakness in stocks and other financial assets stems from a sudden aversion to risk, I think it is more than coincidence that two economically-sensitive indicators, the Reuters/Jefferies CRB Commodity Index and the Baltic Dry Index, a gauge of shipping rates, are also breaking down. Seems to me the markets are telling us something else: “here comes the double-dip recession.”

0204.06

Stocks ended sharply lower, hurt by a bigger-than-expected jump in weekly jobless claims, fears of a brewing sovereign debt crisis, and aggressive selling in financial shares.

At the close, the Dow Jones Industrial Average slid 268.37 points, or 2.6%, to 10,002.18. The S&P 500 Index slumped 34.17, or 3.1%, to 1,063.11. The Nasdaq Composite Index fell 65.48, or 3%, to 2,125.43.

April gold futures tumbled $49 to $1,063.30/oz., while the U.S. Dollar index rose 0.7%. Ten-year Treasury yields declined 10 basis points to 3.61%, while December WTI crude oil futures fell $3.84 to $73.14/bbl.

Michael Panzner

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