Dow – Next Stop 7,200!

The Dow collapse is gaining momentum. The next stop is 7,200. And if that level is broken, almost anything is possible!

The government is throwing everything at the credit and mortgage markets. It has taken over Fannie Mae and Freddic Mac and has pledged to take hundreds of billions of dollars in crummy assets from the nation’s major financial firms.

Outcome – the rate of the 30-year fixed mortgage, which is America’s bread and butter loan are not going down – they are going up. The average 30-year rate jumped to more than 6.4% and just shy of the August high of 6.58%, the highest in more than a year. This is because bond investors are dumping the heck out of bonds as they learned that the budget deficit soared to US$454.8 billion in fiscal 2008 – more than double the US$161.5 billion deficit in 2007 and the highest in history of the country.

Thus far, the carnage on Wall Street is linked to forced liquidations by hedge funds that had taken on far too much risk. Over the past decade, the greatest excesses were in housing and finance. Volatility in financial markets this week appears to have been sparked by the growing realization among investors that a global recession is imminent. It has overshadowing the good news on the declining LIBOR rate.

The recession that we may be facing is likely to be along the lines of the 1973/75 downturn. That recession was relatively long and deep. Real GDP from peak to trough and the downturn lasted for 18 months. By contrast, the past two recessions were relatively short and real GDP declined at most 1.3 percent and the downturn lasting for nine months each.

My view is that in this round of recession, the weakest period for the economy is likely to be the fourth quarter of this year and the early part of 2009. The unemployment rate will likely rise through the next year and peak at around 7-8% in early 2010. In this environment, consumer spending will be particularly weak and it would not be surprise to see declines for multiple quarters, marking the first declines in consumption since 1990-91. The National Association of Realtors (NAR) noted that 35 to 40 percent of sales were foreclosure-linked. Distressed sales are pushing activity higher.

In short, the leaks are now turning into a gusher. For a recessionary economy like US, Dow is still trading at a relatively high valuation with PE in excess of 20x. This compared to an average PE of 10x for Asian markets.