Financial Contagion and the Negative Feedback Loop

Alternative media sources contain some of the best information for investors. Such is the case with the podcast service, “Bloomberg on the Economy” with Tom Keane. In a recent podcast, which is available via iTunes, Mr. Keane’s guest was economist Nouriel Roubini.

The program format allows for the deeper exploration of a topic, which in the very capable hands of Mr. Keane enables a listener to learn about a guest’s views that go beyond the sound bite.

In the interview, Mr. Roubini describes the chain reaction that is at the heart of much of fears of the financial contagion swirling about the investment markets. Coupled with the potential negative feedback loop to the real economy, the dangers of the credit crisis are better understood.

The case made by Mr. Roubini flows as follows.

Mr. Roubini describes the current financial system as a subprime financial system, lacking transparency and one in which a contagion could readily spread from the subprime mortgage market to other areas of the credit market.

The flow looks something like this:

From

• Subprime to
• Near Prime to
• Prime to
• Consumer Credit to
• Auto Loans to
• Credit Cards to
• Student Loans to
• Commercial Real Estate to
• Leveraged Loans to
• LBOs to
• Corporate Bonds

Note: The last item listed (corporate bonds) dovetails tightly with the credit default swaps (CDS) of corporate bonds and the concern expressed by PIMCO’s Bill Gross, as noted last week on this blog (“Here Comes the Global Depression”, Jan. 22, 2008). Additionally, Mr. Roubini notes that the CDS market is a $45 trillion financial Frankenstein, which did not exist a mere ten years ago.

Investment Strategy Implications

Current valuation levels support higher stock prices. This is true if one believes, as I do, that earnings for 2008 will not collapse by 20% plus. However, the situation is still very fluid and risks of contagion and the negative feedback loop exist and are very real.

The positive equity market assumptions made on this blog and in my reports are twofold:

• Earnings for 2008 will be better than the bear case expects thanks to the global growth story and stimulative actions (fiscal and monetary) taken by government bodies
• Financial contagion outlined by Mr. Roubini will not unfold to greatly significant degrees thereby mitigating the negative feedback loop between the real and financial economies

The risks to these points rests in their interrelated nature, one that is mutual reinforcing. Moreover, it must be noted that even if my two points do hold, the danger point has not completely passed for equities as the special aspects of 2008 (electoral campaigns in the US and the China Olympics) give way to 2009, a year without such positive factors at work.

At that point, a second wave of earnings declines could stretch a 10% decline in earnings for this year (a much more realistic expectation) into another 10% decline, or more, in 2009. This, however, is not the consensus view and, therefore, should be noted but not stressed at this time.

Bottom line: good valuation levels, a more resilient global economy, an oversold stock market, and high degrees of investor pessimism should be strong enough underpinnings for an equity market that is almost priced for a financial contagion disaster.