Wednesday, February 11, 2009

How Long Until the Stock Market Fully Rebounds?

Even if the economy recovers quickly, I am skeptical that stock prices would soon return to what they were in 2007. During the housing boom, so many resources were devoted to housing that it was hard for new companies in other sectors to find the funding they needed to get off the ground or significantly expand their operations. This put incumbent companies at an advantage in the marketplace, and made them more valuable to stockowners. With the housing bubble now burst, a situation like this will not happen again soon.

Stock prices, such as those measured by the Dow Jones industrial average, represent the market’s valuation of ownership of established corporations. One factor contributing to the reduction in stock prices during 2008 was that markets became concerned that the earnings of those corporations were going to be reduced for a while as the economy endures a potentially severe recession. As fourth quarter earnings reports are released, those concerns now seem warranted.

Even if the economy had not been in a recession, or the recession proved to end quickly, the earnings of established corporations were going to suffer – thanks to the legacy of the housing boom and bust.

One stock market legacy of the housing boom and bust is that a number of established corporations – especially those in the banking industry – own mortgages, typically bundled up into securities. Now that it is apparent that the housing sector is overbuilt, the residential properties that back those mortgages are not worth much. With homeowners defaulting on their mortgages left and right, and their homes worth very little when they do default, the earnings banks had hoped to obtain through those mortgages will not materialize.

Even stock prices in the non-financial non-residential sectors (that is, the stock prices of businesses that do own few, if any, mortgages) were elevated by the housing boom because of all of the capital used by the housing sector. Last week I showed how the non-residential investment had suffered during the housing boom. The housing boom was a time when established non-residential businesses had a measure of protection against new entry into their industries and expansion by their competitors, because some of the resources needed for that expansion had been diverted to housing.



The housing boom is over, and it seems that the United States economy can go a long time without building houses at the rate it did in 2002-2006. This measure of protection for established businesses is now gone. When the economy recovers, investment in new and expanding companies will keep a lid on the earnings – and thereby stock prices – of established, incumbent corporations.

1 comment:

Rick said...

So...this means...what?
Invest in small caps? Absolutely! Small Caps typically outperform in tough times (go back to 2001/2002 and take a look), as people seek new ideas and outlets.

Stocks, in general, will take time to recover. But we are plumbing the lows now. Remember, in 1932 and in 1974 we hit all time "lows". Tracking a straight line from those will take you to 7,300 on the Dow. Both times, within 8 years, we were back on track and the market was moving up again.

Good times will come. They may surprise you how quickly they will come, too.