S&P 500 will fall to 500 in 2009

October 8, 2008

On September 11th I wrote here:

“If conditions remain as they are now, if unemployment continues to rise, and financial markets remain in their present panicky situation, I’m convinced that we’ll get further rate cuts from the Federal Reserve.

How soon will this be? The timing will not be decided by data or by the central bank itself, but by markets. If the terrible state of the financial markets continues in its present shape, the Federal Reserve will have to act rather soon.

I believe that they will cut a few times before 2008 is over.”

Today central banks have reduced rates by fifty basis points in a joint action, which was joined by the People’s Bank of China in an independent move. VIX, on the other hand, rose to another all-time intraday record of 58.36, breaking the previous record for the second time this week.
From the Fed:

“For release at 7:00 a.m. EDT
Joint Statement by Central Banks

Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability.

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

Federal Reserve Actions
The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent. The Committee took this action in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures.

Incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation.

The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-3/4 percent. In taking this action, the Board approved the request submitted by the Board of Directors of the Federal Reserve Bank of Boston.

Information on Actions Taken by Other Central Banks
Information on the actions that will be taken by other central banks is available at the following websites:

Bank of Canada
Bank of England
European Central Bank
Sveriges Riksbank (Bank of Sweden)
Swiss National Bank”

Of course, all this is aimed at reducing panic in financial markets, and it will have an effect on the severity of the crisis in some of thiese nations. But it will neither ease the credit crisis, nor prevent bankruptcies, because it’s too late by now. I called for international intervention many times, but central bank action alone is not enough, because the difficulties in interbank markets, and credit markets in general are not born of any clear problems about borrowers, but from the problems of lenders themselves. What does that mean?

As I have stated before, the banking system has no desire to function until it has gone through a period of natural selection, which eliminates the weakest players, and leaves those that remain to deal among themselves without worrying about counterparty risk. The central banks are fighting this trend, but they cannot win because they’re dealing with sophisticated actors who know only too well how bad the balance sheets of hundreds of medium and large institutions around the world are. No level of interest will induce them to lend as long as they’re unsure about recovering the principal. The one and only solution to this problem is a string of bankruptcies, and until we have seen hundreds of banks in the US, and tens of banks in Europe and elsewhere fail, the crisis will continue. Short of buying all the bad mortgage, consumer, corporate debt in the system, nothing that the governments do will solve this crisis.

And why does it have to be that way?

Because it’s too late by now. The problem has spread to every single part of the global economy, and has reached monstrous proportions. Central banks, as financial actors, have only a very indirect impact on the countless credit channels that have now been blocked. For instance, while the libor serves as a benchmark for many purposes, the rate itself is only useful for uncollaterised interbank lending on a period of between 0-30 days. It has an ignorable effect on risk premiums in capital markets, and, in the present circumstances, no effect at all on banks’lending plans. To put it in another way, overnight libor was at 2.97 on Monday, today it is at 4,52. The difference is similar to the rate cut of today by central banks. In other words, in an environment of extreme volatility even in overnight rates, central bank target rates lose most of their significance.

Indeed, the Fed, and to a lesser extent many other central banks, have a lot of difficulty maintaining their overnight target rate through their market operations.

Of course, while it’s not very useful, reducing rates is what central banks can do, and their attempts should be supported, even applauded. But expecting that these actions can end this crisis is not a logical and realistic assumption.

So when will the crisis end? It will end when Asians finance the bailout of the US financial system, or, if that doesn’t happen, it will end when unemployment reaches double digits, S&P reaches 500, and thousands of firms become bankrupt. My own expectation for S&P 500 is 500 for 2009.


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