Why The World Will Avoid Armageddon

The risks are grave. But for the eurozone, the probability is high that the turmoil will be contained mostly to the financial markets themselves. The average citizen will get more help from lower oil prices than he or she may be hurt by a possible further tightening of credit standards from a bank at home.

For Europe, the determined efforts by the U.S. authorities to tackle the financial crisis, and the additional liquidity injections by key global central banks, are good news. Details of the U.S. Treasury proposal to buy at discounted prices distressed mortgage-backed securities off the balance sheets of U.S. financial institutions still need to be worked out. But seasoned observers remember that, from 1989 to 1995, the Resolution Trust Corporation charged with working out the debris from the S&L crisis helped to stabilize financial markets and contain the spillover into the real economy in the U.S. and the world.

It's Still True: Buy Low, Sell High
Barton Biggs, the famed Wall Street strategist, believes that the end of the chaos is in sight, and stocks will bounce back sooner and faster than expected.

Equity markets of the world have been and still are gripped in an epic financial panic right out of the late 18th and early 19th century. History teaches that crisis spells opportunity for long-term equity investors. In fact, the panics of a hundred years ago savagely massacred speculators, were short, and didn't do permanent damage to the economy. Today I believe markets are in the frightening and ugly process of putting in a major bottom, and that the gloom about credit, equities and the global economy is in the process of cresting. My hunch is that shortly a 10 to 15 percent rally will emerge from the wreckage. It's too soon to say if a new bull market will follow.

The financial world still has a number of serious problems. However, time and money will eventually heal them. Other economies, most notably Sweden in the recent past, have effectively dealt with issues of comparable magnitude. Of course what terrifies investors currently is the precedent of Japan, which, when faced with somewhat comparable difficulties in the 1990s, blundered into a long period of economic stagnation and massive wealth destruction. I believe the U.S. is not repeating those errors, and certainly this time the Federal Reserve and the Treasury are on the case.

That said, in all probability the world economy is slipping towards 2 percent real GDP growth, which is technically a recession. Purchasing Manager Indexes, the best leading indicator, have turned down everywhere. House prices in the U.S. and around the Anglo-Saxon world have fallen and are still falling. Some famous banks have gone bankrupt. The credit markets are in horrendous disarray. However none of this is a secret and, in fact, is front-page news every day. Remember always that stock markets are discounting mechanisms that peer into the future.

Here's the bull case for equities. Markets have already had declines consistent with a serious bear market. The U.S. is down 25 percent from its 2007 peak, Asia and Europe about 35 percent, and some of the previously hot markets such as India and China are pushing 50 percent. Even the developed markets are far below their highs of 2000, and adjusted for inflation are down 40 to 50 percent. Absolute valuations are very cheap. The U.S. is at 12.5 times forward earnings, Europe at 9.1, the U.K., and the emerging markets at 9. Moreover relative to interest rates (what is called forward yield gap analysis), valuations are at record extremes.

Meanwhile, investor sentiment is deeply depressed. Our sentiment measures are at oversold levels consistent with previous bear market bottoms. Hedge funds, according to prime broker surveys, have never had so much cash and have a net long of around 22 percent of their equity—again, a record low. They have materially reduced their leverage, and most are having a lousy year.

As for the global economy, everyone now knows that activity is declining as ordinary people's incomes are diminished by higher oil and food prices and rising inflation. Increasing unemployment and the wealth effect from the fall in stock and house prices is sapping confidence and the propensity to spend.