In a pretty good article from Motley Fools’ Ray Gibbons about how the economy will get worse, there is some solid advice on stocks. The general thesis of that article is about the terrible state of the housing market. But things might very well get worse.

Although the article erroneously credits Goldman Sachs (Schiller, a well known economist argued this years before Goldman), the thesis that the correction in the housing market is far from over is a pretty solid one.

Schiller (and Goldman, ok) argued that houses are some 30% overvalued and have corrected a little over 8% only. There is, therefore, much more to come, and that spells gloom and doom. I could think of an argument to make this scenario worse still, when asset markets correct, they do not usually correct to the mean, but overshoot, implying the correction might exceed 30%.

We will be leaving that argument aside for a moment, as a 30% correction would be worse enough, look at the ramifications that mere 8% correction:

• Credit markets froze over
• The FED and other central banks had to resort to quite extraordinary measures to keep the financial system from meltdown, like orchestrating a rescue for an investment bank, and getting into mortgages, sort off.
• The Dollar has plunged, giving a boost to commodity prices
• People are abandoning their houses voluntarily (in case the mortgage exceeds the value of their home)

The article doesn’t mention it, but there is also something of a vicious cycle going on. The two premisis that made people buy into the ‘owner society’ via seemingly attractive mortgages that didn’t ask too many nasty questions about creditworthyness, are now turning in reverse:

• the idea that house prices can only go up
• the easy supply of mortgages

Credit markets have become autistic, and the idea that house prices could only go up was, well, just an idea. This hasn’t nearly played out yet, and although the FED has, after some initial dithering (and discounting the fact that it has denied the housing bubble for years and contributed to it), has acted decisively

Whether monetary policy works via the normal transmission mechanisms during abnormal times remains to be seen, we think. Banks have two sources of liquidity (which they need as reserves to increase lending), other banks, and the central bank.

Banks don’t trust one another because risk has been put in a blender and distributed as confetti to all of them, making a proper assessment near impossible. That leaves the central bank, and boy, they have worked the liquidity card ad nauseam, shoveling enormous quantities down the throats of banks like mothers shovel Brussels sprouts down their children’s throats.

But does it work? Ultimately, that depend on the banking system, and they do not seem in the mood to expand credit anytime soon. Requirements for getting bank credit have, how shall we put it, strengthened. Go to a bank and try for yourself.

Bond and other commercial paper are not in a more generous mood either. So, all this super expansive monetary policy might not lead to much anytime soon. A great economist of the past likened it to pushing at one end of a rope.

As an avid reader of these pages, one might have noticed the occasional “we like this stock, but don’t trust the markets” type of uttering. Now you know why. The market may look cheap, and indeed we see quite a few cheap stocks, but if the crisis deepens, it won’t be cheap no more..

We will discuss the stock philosophy and a couple of suggestions in another entry.