The market's worst is yet to come

By Bill Fleckenstein

This week's Contrarian Chronicles focuses on the multitrillion-dollar question on Wall Street: Has the worst been seen, or is the worst yet to be seen?

The majority of market participants find themselves in the former camp (which, regular readers know, is not where I stand). They believe that because a handful of folks have now said the word "recession," it's nearly over. As a result, they say all the bad news we see is a function of what we "already know." Thus it has been discounted and should be ignored.

Similarly, they take confidence in the fact that the stock market reached a low in January, created around the Société Générale banking panic, and retested that low as Bear Stearns (BSC, news, msgs) supposedly almost took apart the financial system (which led the Federal Reserve to create the latest alphabet soup of funding facilities).

The combination of recession, massive Fed easing and those two financial panics has encouraged the bulls to think that we now have seen all we need to see before we have a bull market. Therefore, we should buy stocks.

Problems can't last, can they?

That glib notion has arisen because of the policies pursued by the Fed and then-Chairman Alan Greenspan over the past two decades, which led to the current sad state of our bailout nation.

Bulls have been conditioned by that ride, in Pavlovian fashion, to believe that anytime there is an admission of recession or any kind of panic, it will resolve itself positively in relatively short order, if not almost instantly. (They forget that it took a little time, between 2001 and 2003, to resolve the stock bubble. But that's a minor point.)

That same class of animal also believed that as the credit bubble initially burst, in the form of the initial subprime FPDs (first payment defaults), it would be limited to subprime mortgages and thus be contained.

Everyone knows how the story went from there. I believe folks in that camp never understood that the housing bubble was the economy, which is why they are now quite sanguine.

Listening to the speakers at a recent conference hosted by Grant's Interest Rate Observer, I found that some thoughtful people remain in the it's-going-to-get-better camp because it hasn't yet gotten all that bad. Perhaps they are right, but I don't think so.

I think the better arguments are made by those who understood what the unwinding of the credit bubble meant, who understood that it wasn't just subprime, who understood that it wasn't contained -- and, armed with that knowledge, realized the ramifications of that bubble's unwinding are quite large.

Tear-downs in home prices

One such person is John Paulson, whose hedge fund made an enormous score, perhaps the biggest of all time, betting against subprime and the rest of the credit structure. His best guess, as articulated at the Grant's conference, is that when housing reaches a bottom, prices on average will be down 25% from the top, which is to say an additional 10% to 15% from where they have already fallen.

This is on average, mind you. Some locations will fare worse, others better.

If that happens, the ramifications throughout the financial system and economy will be sizable -- which, to repeat, is what I expect.

Continued: Bulls still in charge (for now)

 1 | 2 | next >