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An Economy On The Edge

Apr 19, 2008
The credit crunch has demonstrated with painful clarity that the financial sector has become dangerously over-leveraged, to a degree that almost nobody realized before - partly because the normal metrics to measure leverage are pretty useless.

Fed Chairman Bernanke reported to the U.S. Congress on April 2, 2008 that the economy is in such shaky shape, that a recession is possible. But this isn't really a news flash. Many economists - looking at billions of dollars of bad mortgages, months of job losses, plummeting home and car sales and soaring gasoline and food prices . have concluded the nation is already in one.

But more important than whether the current downturn meets the definition of a recession (two consecutive quarters of economic contraction) is the question of how bad this is going to be.

No one knows for sure, not even Bernanke, making the situation a little like walking down a dark path and wondering whether that noise in the bushes is an angry dog or a grizzly bear.

Bernanle's frank testimony at a congressional hearing led to two conclusions:

1. If the U.S. is not already in a recession, it is flirting with one. Bernanke expressed some optimism, however, that the economy could start recovering later this year.

2. For all the recession talk, the more ominous threat lies elsewhere. Bernanke made it clear that the U.S. was perilously close to something far worse when Bear Stearns, Wall Street 5th largest investment bank, came within 24 hours of filing for bankruptcy protection. Had the Fed not stepped in with a controversial rescue plan, the viability of scores of other institutions Bear Stearns did business with worldwide would have been in doubt. That could have set off a cascade of failures that, as Bernanke understated it, would have caused damage "severe and extremely difficult to contain."

Rescuing a reckless speculator such as Bear Stearns is distasteful. But construing the Fed's action as a bailout for wealthy bankers misstates both the motive and the result. The purpose was to avoid a collapse of the world financial system, which would invite not recession but depression.

If the IMF (International Monetary Fund)is right, the credit crisis that began last year could turn out to be the most expensive financial crisis in history measured in dollar terms.

The Fund estimates that expected losses and writedowns on U.S. assets could total close to $1,000bn, compared with roughly $750bn total losses in the Japanese economic crises of the 1990's

However, relative to the US economy, these losses are substantially smaller - about 7% of gross domestic product compared to about 15% in Japan. There are also two other major differences. In the case of Japan, banks bore a considerable proportion of the losses. This time the IMF believes that nearly half the ultimate losses will be taken by non-bank financial institutions - including pension funds, insurance companies, government-sponsored enterprises and hedge funds.

Moreover, unlike in the case of Japan in the 1990's, a large - if hard to estimate - proportion of the total losses will be borne by financial institutions outside the U.S. The IMF estimates that European banks' expected losses on subprime loans and securities will come to about $120bn, only about $20bn less than US banks' losses.

Yesterday, April 10, 2008, the world's leading banks publicly accepted much of the blame for the financial crises, as the IMF slashed its estimates for global growth and warned that the US downturn would last longer than most people expect. The IMF said the US would suffer a recession this year, recovery would not begin until next year, and growth would remain well below trend even in 2009.

This offers a bleak outlook for growth in the US economy this year and contradicts the Fed's forecast that the economy will start recovering in the second half of the year and will grow above trend next year.

But nevertheless, the IMF forecast of slowing growth is damping the mood of investors on Wall Street and other stock exchanges worldwide. The financial markets are struggling for direction making it difficult to decide whether to take a bearish, neutral or bullish stance. And with oil and energy prices climbing to astronomic heights - on April 9, 2008, oil prices climbed to another record high of $112, 21 - nervousness will continue to prevail keeping investors on edge.

This will also not change just because the Dow Jones has days where it gains several hundred points because one swallow still doesn't make a spring! And what good is a hundred point gain when the market drops by 100 again the next day?! In the current market situation stocks have to be taken on their own merits - but do consider that this goes for short-term trading only! Not long-term trading - because in every market there are stocks that trade in the opposite direction.

We will have a better idea about the entire situation during the current U.S. earnings season that kicked off with Aluminium producer Alcoa on Monday, April 7, 2008, revealing that its net profit has halved due to the week dollar and higher raw material and energy costs.

Yours in Successful Trading

Ricky Schmidt
About the Author
Ricky Schmidt's website http://www.stockbreakthroughs.com was created out of frustration in trying to decode books, magazines and newsletters on the subject, which are supposed to be for beginners but are not because they're too difficult to understand. Too many "Big Words" and too much intelligent sounding grammar is used which is not very useful.
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