A Thought Experiment

Wednesday, September 05, 2007 | 11:30 AM

Jack McHugh engages us in this delightful thought experiment:

>

"Let's try a little thought experiment to examine just how well stock prices reflect what's happened this year. 

Imagine it is January 1, 2007, and you have just been given the following information about what would unfold during the first 8 months of the year:

-- Oil prices would rally back to over $75/bbl;
-- The dollar would drop against every major currency;
-- Corporate earnings would benefit from the greenback's slide and continue to post double digit gains;
-- The housing industry, instead of bottoming, would continue to slide all year;
-- Home prices would actually be down in many major cities;
-- Over 90 mortgage lenders would cease operating and the survivors would be on life support;
-- The origination of subprime mortgages would all but cease;
-- All but prime, conforming mortgage loans would be either hard to get or very pricey;
-- Private equity deals would soar in the first half, but come to a halt after July 1;
-- Some prominent LBO deals would have to be "eaten" by commercial and investment banks;
-- The leveraged loan market would see stress;
-- High yield bond spreads would widen markedly;
-- Commercial paper would come into question and ABCP conduits would be in jeopardy;
-- T-Bill yields would plummet into the 2% area before rebounding to fed funds minus 85 bps;
-- LIBOR would actually rise from +10 bps to fed funds to +45 bps to fed funds;
-- Loans for all second tier credits would either be very costly or unavailable;
-- Prominent hedge funds would either blow up, face losses, or have investors seek redemptions;
-- Volatility, as measured by the VIX, would triple from 12 to 37, before settling in the mid 20's;

Given the above information, where would you expect the major stock averages to be in relation to their closes on December 31, 2006?  Ah, you need more information about how the authorities responded, right?  Well...

-- The fed funds rate would still be at 5.25%, but the discount rate would be down 50 bps

-- Regulators would be seeking ways to allow delinquent borrowers to remain in their homes

Now, given this admittedly limited information about market moving events and governmental responses to them, where would stock prices be?  Down 10%, 20%, perhaps? 

The answers are:

* The Dow is up just about 8% for the year
* The S&P is up just about 6% for the year
* The NASDAQ is up just shy of 10% for the year

If you are surprised, you are probably not alone.

As to whether stock prices have fully factored in the withdrawal of credit described above, it may depend upon whether or not the promises made by Chairman Bernanke and President Bush ever come to fruition (and how quickly). 

Judging just by the price action to date, however, it seems Mr. Market has decided there is little or no chance that either the markets or the economy experience anything but peace and tranquility for the rest of the year. 

Then again, the old gentleman didn't see all the housing troubles coming in the first place. How can we be sure he so clearly sees the proper solution(s) will be applied in the future?"

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Great stuff. Thanks, Jack.

Wednesday, September 05, 2007 | 11:30 AM | Permalink | Comments (45) | TrackBack (0)
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Mr. Market has been, for some time now, asleep at the wheel.

Posted by: Mike M | Sep 5, 2007 11:38:08 AM

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