Three Scenarios for the Economy (and the Stock Market)

Which way are the economy and stock market going to go? Up? -- or down. And, how far? Since the future is unknowable, rather than planning for a single future, strategic planners find it useful to develop multiple scenarios. Typically, one develops 3-5 scenarios covering a wide range of possible futures. In this post, I outline (literally) three scenarios that I think are representative of the range of possible outcomes of the current financial/economic crisis. They range from “Business as Usual,” the best-case scenario, to “Snowball,” the worst-case scenario. The “descriptions” help me to visualize a future environment so that I can conceptualize plans suitable for that scenario.

I apologize for the lack of prose, but the outline form may be clearer. Equally importantly, I don’t have time to make it "flowery." Note that these are preliminary descriptions and I may update them periodically.

Business As Usual Scenario

It’s always helpful to have a “status quo” scenario; this is also my best-case scenario. In essence it says this economic “crisis” will turn out to be
just another one of our normal, periodic recessions. That is, we will have a recession that is the same “ballpark” in magnitude and duration as those of last 30 years or so.

We learn from, and avoid, policy errors made during the Great Depression and the collapse of the Japanese housing and stock markets.
...Avoid runs on banks and their equivalents
...Bernanke’s in-depth knowledge of the Great Depression pays off
We learn from past successes
...Swedish success in dealing with their banking crisis in early 1990s.
The unprecedented global cooperative intervention continues and is successful
We minimize job losses and their impact on spending.
...Create new jobs in infrastructure, alternative energy, education, etc.
...Unemployment insurance, possibly extended, cushions the blow
We are able to quickly
...Restore confidence to lend
...Restore consumer confidence to spend
...Reduce foreclosures to normal levels and stabilize the housing market
The stock market recovers in about same length of time as after dot-bomb era.

Headwinds Scenario

This scenario assumes it will not be business as usual; on the other hand, the crisis will not snowball out of control. The economy is severely injured and the stock market faces “headwinds” for an extended period.

Stock market earnings -- Decreased income
Reduced levels of consumer spending (~70% of GDP)
...Slow wage growth -- minus increased savings, paying off credit card debt, re-paying the equity taken out of homes, etc. (Jan '11 note: including continuing impact of global wage competition.)
...Negative wealth-effect caused by reduction in value of homes & stocks
...Higher taxes and/or lower government benefits
...Less confidence
Reduced corporate spending & investment because of low consumer sales
Reduced state & local government spending because of reduced tax revenue

Stock market earnings --Increased expenses
Higher cost of credit (and equity)
Higher taxes and new regulations
Stronger unions
Higher medical costs, under-funded pension plans

Low Stock market P/E (price/earnings) ratio
High risk premium
Supply/demand: Reduced demand caused by de-leveraging by hedge funds and investors, and lack of confidence
Rising interest rates (though not immediately)
...At minimum, removal of the interest rate tail-wind

Snowball Scenario

This is the worst-case scenario. As the name suggests, it assumes that we are unable to short-circuit most or all of the following self-reinforcing cycles.

Job losses->fear->reduced spending->job losses
Job losses->foreclosures->lower home prices (& bankruptcies)->reduced spending->job losses
Job losses->lower state and local tax revenues->reduced services and job losses
Lower home prices->hopelessly negative home equity->bankruptcies/turn in keys->lower home prices
Stock market losses->reduced spending->job losses
Lower stock market->selling (and lack of buying)->lower stock market
Unwilling to lend->companies fail (= loss of jobs & loss of sales for their suppliers)->less willing to lend (credit less available, and only at high rates)
Hedge funds redemptions/de-leveraging->equity sales->lower prices->more hedge fund redemptions (note: they’re highly leveraged)
Lack of confidence->poor economy & stock market->lack of confidence
Deflation->fear of buying/wait for better price->deflation
Protectionism/nationalism->protectionism/nationalism
Every man (company, and country) for himself/ lack of cooperation->retaliation

Conclusion

So, where is the market going from here? No one knows for sure. However, it is helpful to be aware of the possibilities, and to develop plans that take those possibilities into account. Typically, the plans should be tilted toward the most likely outcome, but permit one to survive even in the event of the worst outcome. At this point, I think the “Business as Usual” scenario is the least likely of the three; the “Headwinds” scenario is the most likely. “Snowball” is somewhere in between.

The previously posted Worst Case Scenario can be thought of as “quantifying” the “Snowball” scenario. In that post, I calculated a worst-case value for the DJIA (Dow Jones Industrials Average) based on valuations seen during previous extreme bear markets such as the crash associated with the Great Depression. Note, however, that there can be degrees of “snowballing.” The more the factors above continue to snowball, the closer we are likely to approach those extremely depressed levels. With minimal snowballing, the Snowball scenario morphs into "just" Headwinds.

This is intended to be a preliminary, and high level, look at the possibilities. I welcome comments on important factors that you think I have omitted or misrepresented.

Recommended Articles:

Stock Market Earnings Growth History, Average Returns, and a Worst Case Scenario
Worst-Case Scenarios Based on 100 Years of Dow Price/Earnings History
The 1929-1932 Stock Market Crash Revisited
Will the U.S. Bank Re-Capitalization Work? Lessons from Japan: A fascinating, and somewhat disconcerting, 40 minute video presentation by Professor Anil Kashyap of the University of Chicago Booth School of Business. Explores similarities between the U.S. in 2008 and the Japanese experience in the 1990s -- and lessons to be learned from their experience. There are two links after you get to the site: one to the video; a second to a PDF file with the associated 20 pages of slides (which may be viewed while listening to the presentation, or separately).
Dow 5,000 Redux: Bond guru Bill Gross' assessment of the investment outlook as of December 2008. He discusses many of the factors mentioned in this post, but more eloquently.
8 really, really scary predictions (their words, not mine) from Fortune magazine's 2009 forecast issue. Prognosticators incluse NYU economics professor Nouriel Roubini, aka Dr. Doom, Bill Gross, Robert Shiller, and others.
Jeremy Grantham's January, 2009 Quarterly Letter: The second section compares the current financial crisis to both the Japanese experience in the 1990s and the Great Depression.

2009-10: The Emerging Picture (Selected Articles)

California risks "insolvency" amid budget woes: Reuters, Jan 15
Buy American Once Again: Gary Becker's February, 2009 article on the re-emergence of protectionism.
Brighter Days Ahead: Barton Bigg's March 2009 Newsweek article.
On the Urgency of Restructuring Bank and Mortgage Debt, and of Abandoning Toxic Asset Purchases: John Hussman's March 30 newsletter.
The Last Hurrah and Seven Lean Years: Jeremy Grantham's 1Q09 newsletter. Assigns probabilities to various outcomes. (Note: requires subscription, but it's free.)
Europe's Reckoning ... and why it menaces recovery: Robert Samuelson's Newsweek article about sovereign debt issues.
The Dismal State of Long-Term State and Local Government Finance From the Becker-Posner Blog 12/19/2010

2011
A G-Zero World: The New Economic Club Will Produce Conflict, Not Cooperation. By Ian Bremmer and Nouriel Roubini in Foreign Affairs.
S&P Lowers Outlook for U.S., Sending Stocks Down Keeps U.S. debt rating at AAA, but lowers outlook from stable to negative. From the New York Times 4/18/11
Just Four Global Events Will Determine Investors' Fates: A very interesting global scenario analysis from the Institutional Investor website.
Roubini Warns of Global Recession Risk: Aug 11 Wall Street Journal video interview.
The Way Forward: Thought-provoking analysis of the post-bubble/bust economy and proposals, by Roubini & others.

2012
CBO report warns of U.S. falling off 'fiscal cliff' if the budget deal Congress agreed to last summer is allowed to take effect in 2013.  From USA Today.
Note: Additional articles with varying viewpoints will be added as I discover them.

Last modified 6/30/2012
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