Tuesday, January 6, 2009

Why did the market crash? And will it crash again?

This link contains some interesting thoughts
The reason this part of the story matters, at least from the perspective of the stock market, is that even after Lehman Brothers failed (provoking the crisis that Paulson and Bernanke were talking about) stocks initially held up pretty well. While they tumbled right after Lehman failed, the talk of a rescue plan seemed to reassure investors, to the point that the day before the first vote in the House was taken, the S. & P. 500 was only slightly below where it had been before Lehman went under, at around 1213. It was only after Congress failed to pass the bill that the market went into free-fall, tumbling twenty-five per cent in the next ten trading days.

Even after the bailout passed, the market didn't recover. The author argues this is because

Congress’ failure (thanks primarily to House Republicans) to pass the bill was a massive blow to investor confidence, because it told investors that Washington did not understand the magnitude of what was happening and wasn’t ready to do what was necessary to alleviate the crisis...

So, basically, we have a crisis of confidence, because investors have figured that government really isn't totally committed to fixing the problem. Now that the Fed has pretty much pulled out a bazooka and the Obama administration is preparing to drop the fiscal policy equivalent of an atom bomb, markets are recovering somewhat and credit spreads are starting to fall. Since confidence is starting to increase a bit, the market rallies.

However, there are a lot of other actors at play here. For instance, the banks, which are just sitting on money. Unless they start lending again, there ain't going to be a recovery, and rounds of bad sales will start to hammer the economy even harder. Things will get especially bad when consumers start seriously cutting back their consumption in response to falling house prices and job losses, which they already are.

So, if the problem is a crisis of confidence, bad news: The recent market rally is in for a surprise when they realize there simply isn't a recovery yet.

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