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The Inoculated Investorhttp://inoculatedinvestor.blogspot.com/
The Appropriate Sports Metaphor for the State of the US Economy
How many times have you heard the question about what inning we are in when it comes to certain aspects of thefinancial crisis? The question can apply to the housing bust, stock market correction, consumer de-leveraging cycleor anything that ostensibly has an identifiable beginning and end. While I am a baseball fan, I don’t think the baseball comparison fits quite right. See, there is no halftime in baseball. Between innings and during the seventhinning stretch, there is some time for players and fans to catch their collective breaths, but these are short breaks thatdon’t allow for substantial rest and reflection. This is why I think a football analogy works much better. So, in anattempt to provide some lighter commentary than usual, the following is my analysis of the first half, the half timespeech by the coaches, and what the second half may have in store for the US economy.
The First Half 
Well, what can I say? The first half of the crisis was pretty ugly. I am going to arbitrarily deem the beginning of “thegame” as June 2007 when the two Bear Stearns hedge funds that were heavily invested in subprime securities startedto waver. Of course, this was just the tip of the iceberg but when they eventually failed it was kind of like when theother team returns the opening kickoff for a touchdown. It is immediately demoralizing to be down 7-0 in the firstminute but you know there is a lot of time left in the game so you don’t get overly worried. Unfortunately, the rest of the first half was no better and included the following trends and debacles (in no particular chronological or importance-based order):
1.
The failure of Freddie Mac and Fannie Mae that required them to be taken over by the government; anevent that added significant and seemingly ever-growing liabilities to the US’s balance sheet
2.
Bear Stearns looking as if it would be forced to file for bankruptcy until the Fed and JP Morgan (JPM)stepped in to rescue the firm. This proved to be the first of many major government supported takeovers
3.
The decision to allow the failure of Lehman Brothers that caused the commercial paper markets and moneymarket funds to just about collapse. This led to an extreme dislocation in the global capital markets andsignaled the end of non-bank holding company investment banks4.The rescue of AIG by the government in an attempt to protect against a total market meltdown and saveAIG’s counterparties from being mortally wounded
5.
Major FDIC action when it came to banks such as Washington Mutual, IndyMac, Bank United, NationalCity, and Wachovia (just to name a few) that caused the insurance fund to decline dramatically
6.
Massive redemptions at hedge funds that resulted in forced selling of any and all assets and helped leadassets that were deemed to be uncorrelated to move in the same direction
7.
Increased consumer deleveraging that has precipitated higher savings rates and diminished consumptionthat have both had a tremendous impact on corporate revenues and earnings
8.
Significant housing price declines caused by a full blown foreclosure crisis, massive over supply, limitedamounts of mortgage credit and previous extreme price increases in bubble markets
9.
The Fed being forced to buy US Treasuries and mortgage backed securities in an attempt to provideliquidity to a market that had been crippled by the destruction of the shadow banking system. As a result,interest rates have fallen to near historical lows
10.
The US government’s backstopping of everything from money market funds to the dodgy assets of investment banks (as well as increased FDIC deposit insurance limits) in an attempt to stop modern day banks runs from happening
11.
A peak to trough decline (at least so far) of the US stock market from October 2007 to March 2009 of over 57% (1565 to 666 on the S&P) that coincided with unemployment reaching as high as 9.5% (so far)
12.
A crash in oil and other commodity prices that sent stock markets in export-dependent countries tumblingand led to a drop in world trade that mirrored some of the worst declines last seen in the Great Depression13.The bankruptcy of GM and Chrysler as well as a number of well known retailers, with many more filingsexpected before this crisis is over Just like those seen ESPN, these highlights just give you a sense of how the game has unfolded. There are probablyanother 25 things I could list, but I thought 13 was an appropriately unlucky number and believe that the above listencompasses most of the dominant events and themes of the past 2 years.
 
The Inoculated Investorhttp://inoculatedinvestor.blogspot.com/So, if that was the first half, then where are we now? This is where I am going to provide my two cents and makesome prognostications that will inevitably have some elements that are right and some that are wrong. But the purpose of this exercise is to help people think about what the near term effects of the ongoing crisis could be.Accordingly, the answer to the above question is that we are currently in the locker room at half time. Just before theend of the half, we were able to score a touchdown to make the game just a little closer. We are still down by 3touchdowns but there is some optimism in the air. Specifically, there have been a number of seemingly positivefactors that indicate that things may be turning in our favor:
1.
The remarkable recovery in world stock markets and the tightening of bond spreads for everything fromhigh yield bonds to AAA credits
2.
The increase in commodity prices and the (somewhat muted) return of global trade
3.
Fed expansion of its balance sheet that has helped keep interest rates low, stimulate the economy, andinduce mortgage refinancing4.A cessation in the free fall in housing prices and a potential bottoming in housing starts
5.
A slight recent downtick in the unemployment rate and decelerating job losses
The Second Half 
After a very inspiring halftime speech by our coaches (Bernanke and Obama), it is now time to run back onto thefield for the second half. As a country we have seen what the abyss looks likes and have been at least temporarily pulled backed from it. Halftime has given us the opportunity to reflect on the events of the past few years and thisreprieve has allowed us to get our second wind. Many of us are understandably more optimistic than we were previously as it appears that due to the fact that we are going to receive the forthcoming kickoff, the ball is literallyand figuratively in our hands. But, my concern is that there is not going to be a Gatorade shower in our near future.At least not in this version of the game. When it comes to the economy I have deep fears that there are somenecessary structural changes that must occur before we see a sustainable recovery. I plan to detail those moreexplicitly in an upcoming post. But for now, let me list some near term, second half themes that I think are likely to play out. Some are favorable and others are not. Some are new and others are continuing storylines. But on balance Ifear that they will all combine to limit productivity increases, positive GDP growth and further appreciation of stock markets (13 more for good measure).
1.
Losses on commercial real estate loans and commercial mortgage backed securities will put increasing pressure on property values and bank balance sheets and lead to more turmoil in the financial system
2.
Unemployment will continue to rise but U3 (the headline rate) will not reflect the true rate. Instead, U6 (therate that reflects under-employment) will be the one to pay attention to while keeping in mind that peoplewill also be dropping out of the job market due to the difficulty in finding a job and thus may not becounted in headline statistics
3.
The impact of unemployment will lead to even higher default rates on consumer credit and mortgages,especially as the impact of the stimulus wears off. This will require continually higher provisions and lossrecognition at banks and only exacerbate the lack of credit in the market as banks continue to cut consumer and business credit lines
4.
The household savings rate will continue to rise as people forego consumption and focus on rebuildingtheir balance sheets. Debt paydown will also be a priority, which, in combination with higher savings, willlead to lasting drop in demand for the goods and services that companies offer and consequently limitrevenue and earnings growth5.After a free fall in inventories that lasted into Q2, inventories will slowly get rebuilt as cautious companiesdip their toes back into the water. As a result, this component of GDP will stop being such a drag and may be a positive in the coming quarters
6.
Measures such as Cash for Clunkers and an inevitable increase in auto production off of a low base willhelp boost GDP temporarily
7.
After foreclosure moratoriums have ended and banks are no longer able to forestall recognizing losses andmeaningful mortgage resets re-appear, there will be more pressure on housing prices and bank balancesheets that is likely not currently reflected in the stock prices of homebuilders and regional banks. In the
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