Saturday, June 20, 2009

The Forty Percent Problem

In 2007, approximately 40% of the earnings of the S&P 500 were attributable to the financial services sector. It is difficult at this point to estimate with any assurance the extent to which those financial services sector earnings were inflated by fraud, aggressive accounting practices, overleverage and a cyclical spike in levels of transactional activity, but all of those factors contributed. And it's difficult to say the extent to which appropriate regulatory reform and consumer protections initiatives will undermine the core earnings power of the predatory franchises on which so much hope for sector recovery in pinned.

If you remove that 40% of the earnings from the price earnings ratio of the S&P 500, and you look at the 40% decline in the price level of the S&P 500 since 2007, one nicely offsets the other. That is food for thought.

There are other factors at work, of course. Earnings in 2007 outside the financial services sector were at a cylical high, and can be expected to deteriorate sharply in a recession (just as recovery from recession-depressed levels to some idealized norm can be expected). No one really knows what the price/earnings ratio of a stock, much less of a market index 'should' be--though much ink has been spilled on the subject.

It's sufficient to say that the market has discounted the collapse of the financial services sector, though the sequence of events through which that occurs has yet to unfold. And the ramifications of that haven't yet been fully felt--nor, perhaps, fully discounted by Mr. Market.

My own guess is that unemployment will continue to rise, the magnitude of commercial real estate problems will be revealed with ghastly consequences for any number of traditional bank lenders, house prices will, in the aggregate, continue to decline until residential real estate has roughly half the value prevailing at the peak in 2006 or so, credit card delinquencies will rise, and so on. And an already crippled financial services sector will founder. Someone along the way, it will lose its place at the table.

It will be interesting to see what the new world looks like. I suspect that the transition issues and difficult adjustments of the formerly middle class, the elderly, upside down homeowners, the structurally unemployed, etc., will dominate the discussion, and strategies for restoring the global edge of the American financial services sector, if any, will have a distinctly archaic ring. My gut feeling is that the developed world is in for a prolonged period of painful adjustment, and deteriorating public sentiment will be fueled by reports of relatively progress in those parts of the developing world that have sufficiently large domestic demand that their economic growth in not dependent on the American consumer. I'm not predicting blood in the streets, or even bread riots. Just an opaque and heavy economically glum environment that sours the social mood, and contrasts with the innocent happiness of the furriner on holiday, using the cheap dollar to rub it in.

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