The Next Several Years

House Price Declines

House prices will fall, regardless of government intervention, as long as market forces are such that valuations remain too high. House prices will descend rapidly while there is a material source of foreclosures. Structurally this will persist through at least 2012. It is highly likely that prices will fall beyond this date, at minimum in real terms, given the totality of the issues affecting the housing market.

It appears that the government may act directly to head off foreclosures by providing low cost mortgages to distressed owners for some period of time speculated to be five years. Such a program would be disastrous. Prices will not stop falling due to an absence of foreclosures. They will descend less steeply but the length of the descent will increase.

If federal intervention delays foreclosures, housing will not recover as the market is not allowed to clear. Inevitable foreclosures will be pushed out by several years and potential buyers will refuse to accept the prospect of a housing bottom until the government sleight of hand is reversed. Furthermore, as prices drift lower and unemployment climbs more foreclosures will occur. The government will be pressured to perpetually bail out homeowners.

We risk socializing the ownership and lending function with respect to troubled homes and creating a Japanese type scenario where house prices can not recover because the market isn’t allowed to clear and subsidized housing represents a consistent overhang on the market.

It is highly unlikely that housing will be a good investment over the next five years.

Economic Pain Has Yet to Really Be Felt

The fourth quarter of 2008 and a disappointing Christmas season will likely be the events that trigger both real economic damage and a capitalization by many employers. Disappointing retail sales will trigger widespread layoffs in the first quarter, and a steady and growing number of bankruptcies throughout the year. Unemployment will increase dramatically during 2009.

The Stock Market

There is unlikely to be a persistent stock market recovery for the next 18 months. The forces that have yet to significantly impact the economy are powerful and interrelated. High leverage, contracting credit, falling money supply, increasing unemployment, declining consumer spending and asset deflation will damage the economy and inevitably impact the stock market.

The Dow is present above 9,100. Many professional sources are predicting that we have seen the bottom of the stock market slide. The market may easily rise from its present level but there is no reason to believe that such a rally would be sustainable. It is difficult to imagine that the stock market won’t set new lows for this bear market in 2009.

Contracting Economic Activity

Non-government economic activity will contract for the entirety of 2009 and likely through 2010.

Deflation

Depressions tend to be defined by sustained periods of declining economic output, contracting credit, rising unemployment and falling asset prices. This environment is already persistent and there is little reason to believe that any of these requirements is likely to reverse itself in a sustained fashion in the near future.

Some will argue that depressions require broad based price deflation. Price levels are subject to manipulation. The federal government can insure that prices across the entire economy do not deflate simply by printing money. Mr. Bernanke can drop dollars from his helicopter in such numbers that the prices of goods and services will rise nominally. But the real price of assets will fall irrespective.

This is similar to government distortions effecting how we define a recession. Purists define recessions based on historical data showing declining GDP. In the second quarter of 2008 we had positive GDP. But that was the direct result of stimulus checks which artificially distorted that data. If thing government doesn’t want to meet the definition of a recession it can mail stimulus checks out every quarter.

Housing prices are falling because assets are overvalued and potential buyers expect prices to continue to fall. No amount of government interference, stimulus, liquidity injections or printing of money will change this situation.

Over the Next Two Years

· Unemployment is likely to rise through 2010
· Hundreds of small banks will fail
· Hundreds of hedge funds will fail
· Hundreds of highly-levered, private-equity, portfolio companies will run into trouble
· Credit default swaps will trigger crises globally
· Commodities prices will continue to fall or be weak driven by the global economic slowdown
· Any incremental efforts to prop up housing prices may slow the rate of descent, but will fail to stabilize prices and ultimately lengthen the decline