After a brutally volatile year in financial markets, U.S. stocks are now back to levels from the start of the year. Wall Street's dreary performance in 2007 will inevitably lead to a lot of soul searching among investors, and a lot of questions remain unanswered. Now that the bears have enjoyed Thanksgiving, will the bulls come back with a vengeance and celebrate Christmas? To answer this, we need to ask another question: Will the credit crisis spill over into the broader economy and crush the consumer?
Investors seem to think that the sky will soon cave in on U.S. retailers, and markets seem to be pricing in a worst-case scenario despite solid consumption data. Then came black Black Friday, a day of deep discounts that kicks off the holiday shopping season, and bulls breathed a sigh of relief. It looks like the U.S. consumer is doing OK, for now – Research group ShopperTrak RCT said sales rose 8.3% to $10.3 billion on Black Friday, the day following Thanksgiving, compared with a year ago. Of course, the bears would say that Black Friday sales were great, not because U.S. consumers wanted discounts, but because they had to buy on discount.
It is important to understand why U.S. consumption has remained strong despite the dramatic deterioration we are seeing in the housing market. As I mention on The Panelist, one possible reason for this is America's extremely uneven distribution of income, as a result of which the poor consume only about one quarter as much per head as the middle class. At the end of the day, it will be the poor people of America that pay the price for Wall Street's excesses. The Wall Street fat cats couldn't care less about the two million or so households at risk of losing their homes in the aftermath of the subprime mess. According to some estimates, even an extremely drastic one-third decline in their low levels of consumption would shave off only 0.3% of total U.S. consumption, and only 0.2% off total GDP.
How will the credit crunch nightmare end? Congress should pass legislation that will require more transparency in the way banks manage their risk exposures. But this will never happen – banks thrive on the lack of transparency. Banks want to keep their shenanigans off their balance sheets, and politicians depend too much on Wall Street to stay in power. Instead, Congress is passing unproductive legislation that only make matters worse for our working class heroes.
A recent Wall Street Journal editorial stated:
The U.S. House earlier this month passed a bill that would reduce home ownership. That's not the stated intention of the "Mortgage Reform and Anti-Predatory Lending Act of 2007," but it is the probable result. Chief sponsor Barney Frank boasts that his bill will avoid a recurrence of the subprime lending meltdown. That it might do, but only by exposing mortgage banks to so many new financial penalties and lawsuits that they will refuse to lend to many low- and moderate-income home buyers.
In summary, I believe that America's extremely uneven distribution of wealth will lead to poor Americans taking a disproportionate knock from the subprime fallout. The working class heroes will be crushed, but overall consumption will remain solid. I believe that stock markets are priced in for a worst-case scenario, creating a buying opportunity when markets realize it's not all doom and gloom out there. As long as the spillover from the credit markets remain contained to the poor population, we could see a bull-run on Wall Street in the weeks leading up to Christmas.
Merry Christmas, Wall Street. And a happy new year to two million working class heroes who will lose their homes.