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Wall Street Falls After Slide on Global Markets

Bud Conrad
Chief Economist, Casey Research
Friday, October 24, 2008 1:00 PM

U.S. stocks plummeted at the opening bell this morning as investor fears of a global economic recession intensified.

In early trading, all three indices are down more than 4 percent. The Dow Jones industrial average is down 4.2 percent, or 370 points, while the broader Standards & Poor's 500 was down 4.5 percent or 41 points. The tech-heavy Nasdaq was down 4.4 percent, or 71 points.

The big drops are foreshadowing a miserable day in trading and raise the risk that the sell off could force regular trading to be halted. The New York Stocks Exchange temporarily halts trading for set periods of time when losses reach pre-set levels -- a drop of at least 10 percent in most cases.

Bud Conrad, chief economist at Casey Research, a personal investment advisory firm, was online Friday, Oct. 24, at 1 p.m. ET to discuss what today's market decline means for the nation and individual investors.

A transcript follows.

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Bud Conradr: Hello,

I am Bud Conrad Chief Economist at Casey research. I take the long view of identifying the big picture of where our economy is headed to see how to invest.

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Bud Conrad: Today opened in panic as world stock markets crashed, first in Asian being down about 9% and then in Europe with similar extremes. The Futures market was locked limit down with no trading at 550 Dow points down. It looked like we were headed toward 1929 crash.

But markets are stabilizing. Trading is not disorderly with the Dow now only down 300

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Baltimore, Md.: Warren Buffett says he's buying lots of stock right now, which is probably a great idea considering the state of the market with lots of bargains out there. However, what should we be buying? Banks/securities because they're so undervalued and beaten down, blue chippers because they never fail, techs because they're still the wave of the future, foreign because it can't be as bad as it is here, or something else?

Bud Conrad: I would not be recommending hardly any stocks right now. The great imbalances in our economic system are still with us: Too much Debt of all kinds: Government Household (mostly mortgage) and international(Trade deficit induced by oil. Retiring baby boomers insure future government deficits.

Until I see the government working on these underlying problems, rather than bailing out the single financial sector, I would say we still have more problems ahead.

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Chicago, Ill.: Hey Bud, yesterday Greenspan admitted there had a total collapse of the intellectual edifice. Do you see the pendulum swinging back to Keynes and his great disciple Hyman Minsk? How long will that last?

Bud Conrad: Great point of view! Being an economist, I can be critical of our profession. Neither Bernanke or Paulson got it even close to right in 2007 when I was extremely worried abut the collapse in sub prime as rolling over to the rest of the credit market. It did. The cisis is now even worse than I expected it to be.

The Pendulum has definitely swung, and Minsky's view applies very much to the current situation.

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Herndon, Va.: I have an interesting hypothesis for the root cause of all this mess and it isn't Wall Street mortgage-backed securitizers, homeowners who bought too much house, mortgage brokers who gave out silly mortgages, or the housing market in general. I think that the price of oil caused everything to fall. Basically oil cost consumers too much, which cascaded into higher food and consumer prices. Those price increases in turn caused consumers to begin defaulting on credit and mortgages and then that cascaded into the system and got us to where we are now. Had oil started its slide to where it is now back in Dec. 2007 we wouldn't of had nearly as many people defaulting and probably no crash. Your thoughts?

Bud Conrad: I like your theory and I'm sure the linkage you point out of oil being so high causing slowdown contributed to the current collapse.

But it isn't the most important driver of the current mess. It is the 80 year high of too much debt everywhere, and the unwinding of that debt in the style of what happened in the 1930 and in Japan after their great credit bull market in 1989. Both were at debt leverage extremes, and both required over a decade to recover. This will be different but starts with the same causes.

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Bud Conrad: I like to look ahead try to find the next story. Casey Research saw the housing and credit crisis and predicted big government bailouts. But even I am as surprised (Not quite as much as Greenspan) at how much more serious both are than I expected. So looking beyond the current situation, we should realize that the bailouts take time to have their effect, and next year the budget deficit will be double the worst we have ever had. The deficit will pressure the dollar, as the government borrows to pay for it all.

The situation of Debt Deleveraging is analogous to the 1929 collapse, but the bailouts are much bigger. The programs already in place will be about $4 trillion world wide.

The result for the long term will be weakening of world currencies, leaving gold as the safe haven in a long term play.

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Mt. Vernon, Va.: What impact do you think falling oil prices will have on recessionary pressures? Might the turnaround be quicker than expected because so many business models were built around $120 plus bbl oil, rather than $60 or lower?

Bud Conrad: Yes the lower oil will help consumers, but we are beyond easy fixes. I predicted a financial crisis, but not this big. I predicted a government bailout but not this big. I talked of Bernanke being between a rock and a hard place, meaning that he could either take his job seriously and defend the dollar's purchasing power, or he could succumb to the politicians and print money to help bailout the economy. From knowing his previous writing on how the Fed did not print enough money during the 1929 depression I knew that he would take the money printing road.

There is much more financial stimulus and printing to come.

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New Jersey: I think the U.S. population has in general simply become too poor to support an economy based on middle class consumption. Even before these problems, people were borrowing too much in relation to their incomes. Home prices are still way too high compared to incomes. So any solution which relies on supporting home prices is not going to work, as Americans dare not borrow more money, and they cannot afford homes at current prices.

The financial landscape is going to have to undergo serious fundamental change -- e.g. health care is going to have to go to some level of government funding paid, with current health care premiums going to fund it.

The current system is broken. I don't see how fixing the financial sector by diverting more money to it can help, when the problem is that people are too poor to borrow more.

Bud Conrad: The population in total is not particularly poor, but the distribution is very skewed toward a very rich few with the Middle class (and underclass) suffering no real wage growth in a decade.

You bring up a great point: How can Obama pay for universal healthcare if we have committed $2 trillion to bailing out the financial sector? If he wants his social programs, something else will have to give. My guess is that the new programs get added on and the the deficit gets even worse. You can make up other scenarios like slowing the bailouts or adding taxes, but all revolve around an over indebted government and that leads to a weakening dollar (in the longer term.)

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Chicago, Ill.: What do you think about the huge dollar surge over the last month or so? For a while I thought the dollar was risking it reserve currency status. Is this rally a blip(temporary flight to quality) or a reversal of the long term downward dollar trend?

Bud Conrad: I was surprised by the dollar recovery after pointing out its fundamental weakness for 6 years. There are several answers: One is that the other currencies have their own flaws, as seen in the Euro area of differing government fiscal policies: the PIGS: (Portugal, Italy Greece Spain) have big deficits and are not supported by the other members. Another is that the dollar had moved so much that there wasn't a good Purchasing Power Parity. Hotels cost too much in Paris.

But the most interesting examination, that applies to the Yen even more, is unwinding the "Carry Trade" where Hedge Funds borrowed in the lower interest rate countries to invest in other things like long commodities and short financials, and leveraging greatly. That worked until it collapsed. Then the unwinding required finding dollars and yen to pay back the leverage. This is still happening with probably half the 800 hedge funds on their way out of business and a trillion of holding evaporated.

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Laurel, Md.: The U.S. economy is pretty resilient and adaptable. If an outsized financial sector has been proven unsustainable, what will the next "era" in our economy look like? I don't believe it will just "stink." We'll find better ways to deploy all our resources. What do you think that will look like?

Bud Conrad: We have years of pain ahead. This is not your ordinary recession with inventory reductions and then a move backup. This is Credit unwinding of great magnitude.

But an area that will still be with us is the need for big quantities of energy from sources other than fissile fuels. This is not an easy area, but if any of the new ideas becomes viable against the diminishing supplies of traditional fuels, there could be huge winners. A source Vinod Koshla, who spoke about is plans this week at Stanford.

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Fairfax, Va.: So things look better now?

Bud Conrad: Several have asked if this is a buying opportunity, or since they are looking at the long term that they should not worry. I disagree with those comforting views. THe Japanese market hit a high of 38000 in 1989 it is now at 8,000. Our stock mnarket is flat for the last decade.

Her is what is happening:

The Budget deficit will be between $1 trillion and $2 trillion next year. The highest we have been is $412 billion in 2004. Not since World War II have we had a deficit as high measured against GDP. That level will be about 10% of GDP. Borrowing a trillion will affect the Treasury market that has about $5 trillion debt publicly held. Foreigners have been buying most of our newly issued Treasuries since 1995. They have been recycling our trade deficit. Our Trade deficit has been big enough to supply foreigners with the dollars to invest in our Treasuries. But the Budget deficit is now likely to be double the Trade deficit, leaving a demand for credit of half a trillion that isn't easily provided, because US households do not save to invest.

THIS WILL LEAD TO INFLATION AND HIGHER INTERST RATES. The safe Haven in such an environment will be gold.

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Harrisburg, Pa.: Jeremy Siegel of the Wharton School has written how the stock market has increased at an overall average after inflation rate from colonial times to recent times of 6.8 percent. This even includes surviving several depressions. Has this new economy changed the dynamics of the market that it will no longer continue fluctuating, but doing so along an average annual increase of just under 7 percent, or should we be hopeful that, in the long run, the market will return to this average?

Bud Conrad: Jeremy is an academic (like myself adjunct at Golden Gate University) and has contributed to the understanding of earnings and long term investment.

But on the issue of buying and holding with expected returns of 7% on average, the theory misses the kind of experience we are having today. The Great Depression saw 90% losses. I mentioned Japan at 75% loss so far. Investment requires going into many markets.

For example, I recommended Corn in August 2006 because I saw the demand for ethanol. It tripled and on leverage of 20 to 1 on the commodity exchange that was a great play. I recommended shorting Soybeans On August 1 this year and that turned into a 400% return. (trade now closed)

My recommendation beyond gold, is to look for the return of inflation from the huge $2 trillion budget deficit next year, leading to higher interest rates. 3.6% 10 year Treasury is just off 40 year lows, and the likely of full fledged loss of confidence in the dollar in a decade is much higher than 3.6% IMO. There are many complex ways to make that play

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Evanston, Ill.: Ah, you're a gold bug. Why is gold crashing despite the central banks of world printing money like wild fire. The Fed balance sheet has doubled in the past and the money supply is roaring yet gold is down. Please explain. Could gold see 500 again?

Bud Conrad: Gold is just about the level of a year ago when this crisis started. About every asset from houses to stocks to base metals is down around 30%. The reasons to hold gold have gotten stronger, as the government debases the dollar by $2 trillion deficits in the bailout. The blow up of leveraged investors has caused some of the speculative investors in gold to pull back.

We have the odd situation that most gold shops that sell physical coins and bullion are sold out, yet the futures market that is so wildly quoted, is down from earlier in the year. I think this is a buying opportunity brought on by deleveraging and fear that the recession will be deflationary. We are in deflation now, but my radar looking over the hill says that by next year the loss of confidence in paper currencies will bring an huge spike in the safe haven. I trust gold a lot more than the paper alternatives.

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Bud Conrad: Gang,

It has been great fun!

Thanks to all who participated and do take some time to look at the long term perspectives that I have tried to suggest.

I write for www.caseyresearch.com, and you can find more there.

Bud Conrad

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