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You’ve gone on record, at the end of last year, as predicting a 50% correction in the markets.  What are the key economic and market factors behind your forecast?

U.S. stocks are too far above their trend lines, a fact that the "new economy" ideology made us forget by pretending to give us a "free lunch." The new economy has been discredited recently by the sub-prime crisis and other problems.  The bubble burst and stocks will return to their trend line. The Dow is still way ahead of my proprietary investment value calculation. And, from 1932-1992, the difference was never more than 50% either way. So the overvaluation has been a post-Persian Gulf War, "1990s" phenomenon.  This is illustrated in the following table of the actual value of the Dow versus my calculation of investment value:

* Bill Gross' estimate.

Stocks got ahead of their long term trend line from 1982 to 1999, and now need to “catch up” by “catching down.”  Stocks could go nowhere over next 9-10 years, but this is less likely.  More likely is a major dip that creates a bottom like we last saw at the depth of the Depression in 1932 or in 1974.

I foresee three scenarios, each with a distinct probability:

60% - stocks make a major dip to catch down to earnings
30% - sideways movement for the next 10 years
10% - meaningful up movement

If there is a big dip, then there can be a big upside, but don’t mistake a 10% dip for a big dip.

My forecasts apply only to the US market.  China, India, Brazil and other small countries with different economic cycles and stock market behaviors are different, both in direction and magnitude. 

European markets will behave like the US markets, but with greater volatility.  I believe we are in a recession and the economic slowdown will be felt in Europe.

Now that we are at the start of the second quarter, how do you feel about that prediction?  Is there anything in the first quarter market results that surprised you?

One thing I did not get, and could not get, was the timing of the market correction.  I thought it would be more of a Q1 2009 event after the Presidential election. If anything, the secular trend is weaker than I thought. So we are well on our way to a major decline punctuated, however, by 1930s type rallies by those who refuse to believe how bad things will get.

I thought we could escape a major correction because of the election year, which tends to be kinder to the markets.  The weakness in the market says there will be a change in leadership (i.e., the Democrats will win the Presidency).  The nasty correction we have seen is a down payment on the larger 50% correction.   Look for ups and downs because it is an election year.  We will see a rally when the Democrats nominate their candidate.  After the election things will head south.

Where are we now with respect to the sub-prime crisis?  Is the worst behind us?

The sub-prime problems are just beginning. It took a decade to create,
which is to say it will take about that long to resolve. What's interesting is the fact that the courts are getting involved to force lenders to jump through hoops before they dispossess home owners.  Trial lawyers in this field of litigation are in for a bonanza.

The Fed is doing the right things with Bear Stearns and this will lessen the damage but not fix the situation.  The problem is already baked into the cake.  Who will suffer?  Banks, brokers, hedge funds who were trading CDOs, homeowners and borrowers, or taxpayers – the question is who will pay the price.

The largest number of ARMs adjusted in the first quarter of 2008 and we haven’t seen the fallout from these yet.  This will be felt over the rest of 2008, and will cause more finger pointing regarding who was deceived on the terms of the loans.  Hedge funds will say the originators gave them implicit guarantees, and that will be adjudicated in the courts.  This is more good news if you are a trial lawyer.

Most advisors believe (or would certainly like to believe) the sub-prime crisis is not much different from previous crises the market has successfully weathered.  What is you view – is this time different?

The sub-prime crisis is worse than most because it was artificially and deliberately created for bankers to earn fees. Lenders created a bunch of shaky products for sale to consumers on one end, and for resale to so-called investors on the other end.  In this regard, the sub-prime is different from a one-time problem such as a tsunami or even the 1970s oil crisis.

In 1920 we over-farmed and created a dust bowl.  Now we have over-farmed the housing market to squeeze as much as we could out of that sector of the financial system.

Another important aspect of the sub-prime crisis is the moral hazard issue.  The Fed has protected hedge funds, banks, and others from the consequences of overleveraging.  If we had more failures earlier on, we would have had fewer and smaller failures later on, like Bear Stearns. 

In previous bailout situations, like LTCM, rates were kept artificially low.  There was a stable relationship between Treasury and inter-bank lending rates, but that has broken down.  Spreads are much higher, which means lowering Treasury rates doesn’t do a lot of good.

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