Does Credit Crunch Signal Deep Woes in Economy?

By JAMES B. STEWART. Is the recent credit crunch a "financial" crisis, likely to be short-lived, or is it a more profound "economic" crisis, likely to have longer-lasting, more serious consequences?This is now the great debate on Wall Street, Main Street and in global capitals as investors try to assess the recent credit paralysis and market turmoil. The answer is of pressing interest, since the first scenario makes the recent stock-market decline a compelling buying opportunity, while the other is cause for caution.Last week, as markets stabilized and credit began to flow, however haltingly, proponents of the more benign, short-term financial crisis seemed to gain the upper hand. In this view, the problem is largely psychological -- a panic-induced fear of risk -- rather than anything more fundamental.
Apt comparisons are the market crash of 1987, aggravated by the failure of program trading, and the collapse of Long-Term Capital Management in 1998, which prompted the Federal Reserve to cut interest rates. While those crises were painful for many investors, they had negligible impact on the broad economy and represented buying opportunities for stock investors. Market averages were significantly higher six months later in both instances.

History, however instructive, never repeats itself exactly. The current crisis can't be dismissed quite so easily. Apart from the credit panic, several more-fundamental forces are at work. First is the broad and sharp decline in real-estate prices. The result has been a plunge in construction, home sales and housing-related consumer spending, and an alarming rise in foreclosures. The recent credit crisis had a very real economic underpinning, which was the failure of borrowers to make their mortgage payments. The scope of the problem has been unfolding slowly, originating in subprime but moving up the ladder of creditworthiness and affluence.

A second, related fundamental development is the broad deleveraging now under way in everything from commodities to private equity-led buyouts. As long as credit was easily available and packaged into seemingly safe, triple-A rated packages of debt obligations, anything could be bought, leveraged, and sold off to a higher bidder. Now that lenders have rediscovered the notion of risk, those days are over.

Faced with these two fundamental threats to the economy, market historians might point to the savings-and-loan crisis of the late 1980s and early '90s, and the 1989 collapse of the junk-bond market after the failure of a proposed leveraged buyout of UAL. Both entailed some degree of financial panic, but also involved real economic issues. The S&L crisis unfolded over years, not days, and took a massive bailout from Congress. The collapse of the UAL deal led to a near halt in buyouts and mergers. There was a recession in 1990-91, albeit a relatively mild one. The S&P 500 peaked in July 1990 at 369 and reached a low for the year of 294 in October.

I could argue the similarities and differences between then and now at some length, but one thing I can say with confidence is that the present isn't exactly like anything in the past.

Let's assume that the housing/mortgage/debt crisis is bad, but not as bad as the S&L mess. The major market averages have already undergone 10% corrections, which suggest that further downside risk isn't all that great. Nonetheless, I remain wary of private-equity and hedge-fund stocks, investment banks and all but the largest and most diversified companies in the financial sector. I doubt the market has fully priced the likelihood of more bad news on the buyout front, just as it failed to anticipate the severity of the subprime defaults.

Yet I was very comfortable buying stocks recently, even if further declines are in store. While we're pondering history, it's worth considering that most bear markets don't begin with a "crisis" or a sudden plunge in stock prices. It would be so much easier for investors if they did, thereby announcing their arrival with fanfare.

More often they creep up with slow, agonizing declines punctuated by occasional "suckers' rallies." No crisis or sudden selloff marked the beginning of the 2000-2002 bear market. Yet the bear market of 1990 set the stage for the massive bull market of the rest of the decade. When I wrote that the S&P peaked at 369 in 1990, that wasn't a typo. Seventeen years later, it's at 1450. Looked at from the long term, even the S&L bailout and junk bond collapse of 1989-90 was a buying opportunity.