Euro Crisis: If We’re Heading Towards a 1930s-Style Depression, Why Is the Stock Market So Bullish?

We seem to be heading towards an economic downturn equivalent to the Great Depression of the 1930s. This isn’t a secret. The synthesis below is derived from: Lawrence SummersNouriel Roubini, Simon JohnsonNiall FergusonPaul Krugman to name just a few. This crisis is not happening quickly. It’s more of a slow-motion train wreck — Greece’s crisis started in 2009. But that leaves a puzzle — why is the American stock market not reacting to obvious warning signs?

Greece and Spain already have unemployment rates exceeding 20 percent. If that isn’t a depression — what is?

Greece is in very deep trouble. Spain (the Euro’s fourth largest economy) just needed a $125 billion bank bailout. The weaker economies (Portugal, Ireland, Italy, Greece, Spain) face severe credit crunches as local banks lose deposits (withdrawn because of credit concerns and fear of forced devaluations following a Euro exit).

Serious discussion is already taking place about the demise of the Euro, or even worse the break-up of the European common market — in which case unemployment rates across Europe will exceed 20 percent. National incomes will decline sharply, resulting in large-scale corporate insolvencies, with the crisis spilling over into the U.S. and Asia.

Arguably, the Germans have a sufficiently healthy economy to avert the crisis. But they are reluctant to act — without clear structural changes in the European Union/member states to prevent future problems. Amidst a crisis, it’s difficult to make structural changes quickly. The Germans (with some legitimacy) fear that a bailout lacking agreement on structural changes will result in some combination of a larger financial disaster later, and/or the German economy permanently subsidizing some of the weaker economies.

Europe’s economies provide little reason for optimism.

The U.S. faces a recession next year if the Budget Control Act takes effect, which is likely if Obama wins and partisan gridlock continues. House Speaker Boehner already announced that if Obama’s re-elected, the GOP will treat us to another debt ceiling confrontation. If Romney wins, the Democrats (having learnt their lesson from the Republicans) would be as disruptive as possible. If the U.S. faces a major economic crisis triggered by the Euro’s collapse, bipartisan consensus on how to resolve it is unlikely.

China’s growth model may be reaching its limit. If the rest of the world’s problem is too much ideology, China’s is arguably the absence of any ideology except kleptocracy. China lacks a functioning legal system. Its officials are disciplined by shadowy communist party entities, rather than accountable to a transparent legal system. Nominally ruling in the name of the proletarian vanguard, China is governed by princelings and kleptocrats, with friction escalating among the kleptocrats.

Internationally, another regional war appears increasingly likely in the Middle East. The U.S. and/or Israel might have a military confrontation with Iran, over Iran’s nuclear ambitions. The Syrian situation has the potential to become a regional conflict (Syria, Iran and Russia fighting Syrian dissidents supported by some coalition of Saudi Arabia, the U.S., Turkey and other countries). A Middle Eastern war would lead to significant oil price increases, and trigger a global recession (at a minimum).

Compared to the financial crisis of 2008, governments everywhere are far more constrained by weaker balance sheets, loss of public trust and crisis fatigue.

I’m not saying everything listed above will go wrong (though if that happens, it would be a “global perfect storm”). However, even 1-2 of these plausible misfortunes would make 2013 a really bad year, and the world will have other challenges we cannot foresee (e.g., another nuclear accident, major earthquakes, etc.).

Depressed yet?

So why is the stock market trading as though all’s well? The S&P 500 closed on June 15th at 1343. Based upon stock price divided by earnings (P/E ratio), the market now trades at about 21 times the prior 10 years’ average earnings. The long-term 10 year P/E ratio is about 16, so today’s premium over that long-term average is difficult to explain, considering the risks listed above. At the top of the bubble in October 2007, the S&P was at 1565. Currently, we’re only about 15 percent below that peak, and (again) the market isn’t reflecting the referenced risks.

Is it a case of short-term delusions, leading to later major stock market debacles? If so — is it time to go short?

Or does the market know something we don’t? Are the risks outlined above really not so bad? Is the market assuming losses will be paid by the government, so let’s party like it’s 2006? Or could it be that all investments at this stage have poor prospects — so there’s no place to hide?

Stay tuned: 2013 will be an interesting year!

This post originally appeared at The Huffington Post and is posted with permission.

6 Responses to “Euro Crisis: If We’re Heading Towards a 1930s-Style Depression, Why Is the Stock Market So Bullish?”

MariaJune 21st, 2012 at 12:33 pm

Investors assume we now are ruled by 'too big to fail'; things have gotten so bad the government will have to save us, except that we have no big 'bazookas' left. Realizing that the Fed actually did not have any plans to ease things a bit, the panic set in today, to be abated by new short term measures.

contrariansmindJune 25th, 2012 at 11:52 pm

The shareholders of the market are no longer retail but institutional or government backed. Their holding period is indefinite hence no need to sell into the market. This has created a very small supply of shares available at any one time allowing for the appearance of a well maintained and balanced market.

anton kleinschmidtJune 26th, 2012 at 1:47 am

Could it be that equities are now seen by savvy investors as the only investment where value will be retained when the wheels inevitably come off. I am referring to intrinsic value in solid companies rather than value as reflected by price from time to time in volatile markets.

Most Read | Featured | Popular

Blogger Spotlight

Otaviano Canuto

Otaviano Canuto is Senior Advisor on BRICS Economies in the Development Economics Department, World Bank, a new position established by President Kim to bring a fresh research focus to this increasingly critical area. He also has an extensive academic background, serving as Professor of Economics at the University of Sao Paulo and University of Campinas (UNICAMP) in Brazil.

Economics Blog Aggregator

Our favorite economics blogs aggregated.