Thursday, July 1, 2010

A Tough But Effective Way to Fix the Economic Crisis

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07/01/10 Laguna Beach, California – Another day, another dismal performance on Wall Street.

The Dow Jones Industrial Average coughed up another 96 points yesterday – increasing its loss for the year’s second quarter to a hefty 1,082 points. In percentage terms, the Dow fell 10.0% during the quarter that just ended, which was only slightly better than the S&P 500’s 11.9% shellacking.

This is not the script the Wall Street seers had bestowed upon us when the year began. Back in February, Goldman’s Abby Joseph Cohen (remember her?) predicted that the S&P 500 Index would reach 1,300 by the end of 2010. Here at the halfway mark, the S&P sits at a 9-month low of 1,030.

An optimist might observe that the current S&P 500 level contains one “1”, one “3” and two “0’s – just like Cohen’s S&P 500 target price. Nevertheless, these digits would require a re-alignment – and a 26% rally – if Cohen’s prophecy is to come to pass.

To be fair to Cohen (or at least, less unfair), lots of Wall Street prognosticators were issuing bullish forecasts at the beginning of the year. Thomas Lee, US equity strategist for JPMorgan Chase agreed with Cohen’s 1,300 forecast, while the equity strategists from UBS, Deutsche Bank and several other investment firms pegged their forecasts slightly below 1,300. (Pimco’s Mohamed El-Erian was one of the lone dissenting voices with a prediction that the S&P would fall in 2010. So far, so bad.)

“Why is the stock market falling?” enquiring minds want to know. The answer, in all likelihood, is that the market should not have been rising in the first place. The “Credit Crisis of 2008” is not an archived historical event. It is an unfolding drama that includes the “Credit Crisis of 2009-2010.”

Maybe the worst is over, maybe it’s not. But whatever the case, crisis conditions persist. In fact, this crisis, like a virulent disease, is continuing to manifest itself in various forms and in varying intensities.

Even though the “high fever” that placed the US investment banks in ICU has abated, a sovereign credit “rash” has popped up on the other side of the Atlantic. Secondary symptoms include the incessant nausea of mortgage defaults, the septic shock of contracting consumer credit and the vertigo of soaring T-bond prices.

These symptoms tell us that we’ve still got a very sick patient on our hands…and that the recovery will not be easy. This patient suffers from life-threatening exposure to debt. The cure is known, but it is painful. In fact, in the early days, the cure can feel much worse than the disease. The cure often subjects the patient to sovereign defaults, currency devaluations, deep recessions, high unemployment and sharp reductions in standards of living. Eventually, however, the patient feels better…and goes on to live a healthy and productive life.

Consider the bizarre contrast between the successful World Cup teams from Central and South America and the unsuccessful teams from the Developed World. “The 2010 World Cup has started to feel more like a macro-economic metaphor than a sporting event,” we observed in Monday’s edition of The Daily Reckoning. “Of the six G-7 countries to field teams in this year’s World Cup – France, Italy, United Kingdom, Japan, Germany and the United States – only Japan and Germany remain.

“Meanwhile, all four nations from the core of South America’s Mercosur economic zone – Argentina, Brazil, Uruguay and Paraguay – remain in the competition. Indeed, Uruguay has advanced to the quarterfinals for the first time since 1970.”

As the World Cup has proceeded, the up-and-comers of South America have continued to dominate the has-beens of the Developed World. So, just for kicks, we prepared the chart below, which places the World Cup’s results-to-date in an economic context.

World Cup Economies

For starters, the “Round of 16” teams from Central and South America possess much better national finances than the teams from the Developed World. Uruguay, for example, has a lower debt-to-GDP than the US, England or Japan.

This “analysis” means nothing, of course. It is the ultimate faux science. That said, your editors were fascinated to discover that the six Central and South American nations that advanced to the “Round of 16” have an average debt-to-GDP that is only half as large as the average debt-to-GDP of the Developed Nations in the Round of 16.

What’s more, the four teams with the worst national finances failed to advance to the quarterfinals. These results probably indicate nothing important or relevant about the state of the world’s finances. But wouldn’t it be funny if these results meant something? Wouldn’t it be interesting if the 2010 World Cup foreshadowed unfolding economic trends?

Don’t rule out the possibility. The 2010 World Cup is all about the failure of established powers and the emergence of new challengers.

Global investors, are you listening?

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