Relieved, panicked or maybe you have just become numb.  The one thing you are sure of is that nothing feels stable right now and you desparately want stability.  This is the first of a series of posts that will look at the after affects of the credit crisis, where the markets are going and how you should be reacting.

As I have stated before, the center of this crisis was the destruction of trust in the credit system.   The world’s governments are now taking the problem seriously and I am confident that it is now just a matter of time for them to get the credit markets working properly again (that is not to say there won’t be bumps and bruises along the way).

The Damage

Like when electric power is disrupted, restoration will not be the end of the story.  The credit crisis will have damaged some companies and it will take time to repair or replace them.  It will also affect people directly as they see their credit lines reduced or eliminated.  For example, GMAC, GM’s main financing arm, has had to tighten is lending to only those with FICO scores of over 700 eliminating 25% of car buyers.  In addition, many home equity lines of credit have been closed and credit card limits are likely to be reduced.  All together these changes will make the recession longer and deeper than average.  Current bearish estimates have the recession running to the end of next year.  I suspect it will be 2010 before the recession ends (or for it to at least feel that way).


But some perspective is in order.  Comparisons to the great depresson are overblown.  GDP is not dropping like a rock.  From 1929 to 1933 nominal US GDP went from $103.6 billion dollars to $56.4 billion dollars.  Almost a 50% drop.  No one is predicting anything near that for the US economy.  Other than the financials, most companies are in good shape and will experience the normal pain associated with a substantial recession.  Most experts expect a GDP decline in the single digit percentage amounts.  Looking at the following graph of US Real GDP going back to 1790 you can see that GDP growth other than the great depression has been amazingly consistent.

Unemployment during the great depression ran 25%.  In the early eighties unemployment went over 10%.  Upper estimates for maximum unemployment in the current recession run around 8%.  I could see it going as high as 9%.

So while I expect the recession to be a bit deeper and longer than average, I don’t expect it to have economic consequences on the average family anywhere near what the depression did.  Like in all recessions, if you are one of the unlucky ones to lose your job, it will feel horrendous, but for the majority, it will mostly be a period of delayed gratification as people wait to buy that new car, furniture, or big screen tv.  And it will be a time of anxiety as the news continues to blast you with the latest economic problems.

The Market

Given the above, what do I expect the markets to do?  That is actually a much tougher question.  And the reason it is much tougher is because it is much more dependent on investor psychology than on the economic facts.

Our brains have hardwired biases towards buying high and selling low as we get swept up in euphoria and panic.  Investors were most euphoric in 2000 when they were willing to pay over $43 for a dollar in earnings (using Schiller’s price/ 10 year earnings average method).  During the depression, the forties and the early eighties investors payed less than $10 for a dollar of earnings.

We are currently around $15 per dollar of earnings which is slightly below the historical average of $16.  If people become as pessimistic as they were in those past difficult times the market could drop another 40%.  However, I don’t think the recession will be long enough to bring people to that level of despair (at least during this recession).  So I would put the bottom in this recession no more than 20% below current values.  And of course, if people regain their bearings sooner we could have already hit bottom.