So, I’m going to go out on a limb here:

I think the financial market has just about hit bottom. The worst is over for the banks – although not for the rest of us.

Let’s start with some data:

Home Prices

For about 40 years (1960-2000), the ratio between imputed rents and actual rents (i.e. the premium people pay for owning vs. renting a home) has oscillated between 0.8 and 1.2. Between 2000 and 2006, the ratio rose to about 1.8 – meaning people paid, on average, 80% more to own vs. rent. This is a fundamental measure of the housing bubble. (Note that there are several measures of this, and the peak ranged between 78% and 86%, and in some markets it went much higher: Miami went to 120%.)

Today, this ratio has fallen to 1.2, so the premium is 20%, and is now within historic norms. There is probably more to go, but in general there should probably be a premium of 10% or so (most people prefer owning vs. renting assets, for non-economic reasons).

This means that we are at, or nearing, the end of home price deflation. Since home price deflation was the main driver of the financial meltdown, this is a very good sign.

Bond Market

The bond market is the most largest and, arguably, the most important part of the capital markets. It is 10x bigger than the equity markets, which get all the press. And there are signs that the bond market is reopening for business.

First, there is an increasing number of new issuances. February was the fifth-largest month in history for new US investment-grade corporate bonds, with $96 billion of issuances. This is double last February, and on top of a huge January, which had over $100 billion.

Additionally – and no coincidentally – spreads have continued to narrow. In fact, they’re back to where they were in 2001, which is a very good sign that the bond market is loosening.

And it’s not just corporate bonds. Municipal bond markets have started to re-open as well, at least to good credits. What I hear from muni bond guys is that there is more demand than supply for AAA credits, and anything that comes on the market is snatched up quickly at pretty reasonable spreads.

So, the bottom line is that money is again flowing into the bond market. And since that is the lifeblood of business, this is a very good sign.

Consumer Spending

Retail sales have leveled off after falling off a cliff. Over the past three months, real retail sales have been about $308 billion, and last month even saw an uptick in spending. This is down from a pre-meltdown peak of almost $350 billion in December 2007, or a drop of about 11.5% in one year. This was a staggering decline.

Consumers, watching the erosion of their home equity, quickly reacted and cut their spending. The message here is that they changed their spending behavior to save their homes; rather than give up their house, they cut discretionary spending. This cut the heart out of the retail business, leaving them with excess capacity that is still being worked through. So while we may will continue to see an increase in delinquencies as people (especially the unemployed) struggle with cash flow, the worst is probably over.

Stock Market

The stock market found a very significant support level at about 6500 for the Dow and 675 for the S&P. At these levels, the PE ratio (not to be confused with the profit to earnings ratio) is about 10 for the Dow and 14 for the S&P, based on estimated 12 months projected earnings. Given how low interest rates are today, these are not far from a fair value.

Now I still believe this week’s surge is only temporary; I would expect the market to fall again. But the support at 6500 is pretty key, and it will take another round of really bad news to drive it too far below this level (although touching 6000 would not surprise me). The market is likely to remain in the 6000-7000 range for the next year as the investors sort out the implications of the meltdown on the “real” economy.

So, it looks to me like we’re in the 9th inning for the financial sector. But that doesn’t mean the pain is over. You cannot turn off the credit market for 6 months and pretend that there is no impact on the real economy (the one that actually produces goods and services, vs. just allocating capital).

There is still a lot of unemployment to come. Capacity continues to get cut, and that means jobs are going to be shed. The pain will be concentrated in those markets where the excess capacity exists: the Midwest, the Northeast, California, and Florida. In those places, there will be a lot of disruption, and a net outflow of people as folks leave in search of work.

But there are over 2,000,000 job openings in the US, and those openings will get filled. As house prices stabilize, buyers will re-enter the market and those who need to sell and move will be able to. My guess is that this will happen throughout 2009, and maybe into 2010.

The big fly in the ointment is Washington. The first “Stimulus” was a joke. If we get the Porkzilla Budget as proposed, and Son of Stimulus, it will have really, really big negative impact. The need to finance the resulting deficits will hurt interest rates, as investors demand higher returns to purchase the tsunami of supply that is coming. In addition, the fear of inflation – driven by fiscal deficits and an increasing politicization of monetary policy – will start to spook bond buyers, and that will also push interest rates higher. Higher interest rates will create a panic in Washington, and there will be tremendous pressure put on the Fed to keep rates lower so as to sustain the recovery. That will lead to a rapid run-up in prices.

So, if I was a betting man, I’d bet with Rogoff. Get ready for inflation, which, given its timing in the business cycle will be stagflation, since unemployment will still be high.

The bottom line is this: the “crisis” that President Obama was “handed” was well on its way toward getting worked out. However, rather than continuing to focus on monetary policy, he has begun the most rapid fiscal expansion in history. This will extend the recession by 3-5 years longer than it needed to be, and the result will be a protracted period of stagflation.

By the time he’s done 2012, Obama will be wishing he was as popular as Jimmy Carter. His only way out at this point is if his budget and Stim2 fail. So, oddly, if he fails he may survive. But with the “help” of Pelosi and Reid, “failure is not an option.” After all, we’re trying to save the world here.

So, if the President gets his way, it will take a decade to undo the damage. And the ultimate irony is that the people who will suffer the most through this period are the very people who put him in office: the poor, the young, and the clueless.

Perhaps that’s not irony. Perhaps it’s justice. But it’s still sad.

For all of us.

L3