Issue 22 • April 29, 2009

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How to Measure the ‘Second Derivative’ of Financial Meltdown

This bear market has introduced investors to a new indicator to tuck away in their market analysis toolbox — the so-called “second derivative” (see also “green shoots”).

I must confess that even after more than 20-years experience in this business, I hadn’t heard of the “second derivative” indicator before, but desperate times create the need for desperate new indicators.

Investors, and especially the financial media, have been preoccupied with this new indicator for the past several weeks. Basically, the second derivative is said to measure the rate of change — of the rate of change — of an economic indicator.

In other words, an indicator may be going from bad to worse, but if the most recent data point didn’t plunge as fast as the previous one ... then it’s considered to be somewhat “less-worse.“

Plunging less worse than previously is considered an improvement in the second derivative, and it’s seen by some as more evidence of “green shoots” sprouting, and potential economic recovery ahead.

So, Are These Green Shoots or Weeds in Housing’s Backyard?

Take, for example, Monday’s release of the latest S&P Case-Shiller home price data. To be sure, home prices nationwide are still declining according to the latest reading, but February’s 18.6% year-over-year decline in the 20-City Index compares somewhat more “favorably” with the 19% drop the month before ... a clear-cut improvement in the second derivative.¹

Wow! Home prices ONLY plunged 18.6% from a year earlier! But, before you rush out to buy a bargain-priced McMansion, you should also know that the index has fallen each and every month since January 2007 — that’s 26 straight monthly declines in home prices across the U.S.²

And, from the peak in 2006, home values have now plunged over 30% nationwide — the most severe contraction in home values ever recorded.³

Moving from a Steep Cliff to a Slippery Slope

This and other “positive” (or should I say “less negative”) news lately has generated lots of optimism. But is this optimism justified, or is it merely the sign of a desperate man grabbing on to a thin reed of hope? You be the judge.

Even the Federal Reserve said recently that the level of economic activity remains very weak, but “slightly less weak” than previously reported. However, this only means that the economy has gone from plunging over a steep cliff ... to merely sliding down a slippery slope.

For some, this may be cause for optimism, but it’s hardly a bullish trend in the making. For a sustained improvement in the economy, we’ll need to see hard evidence of a recovery in real-time business and employment indicators — and above all in housing and the financial sectors.

Speaking of the financial sector, the second derivative here still looks like it’s falling fast. In spite of profit reports that were cooked-up to look much better than meets the eye, as I reported in last week’s Weiss Advice, officials warned that banks and financial firms are only about one quarter of the way through this crisis ... and may still face up to $3 TRILLION in additional losses!⁴

IMF Sees No “Green Shoots,” Just More Red Ink for Banks

Although investors may be hoping for the best — a quick recovery for banks — the International Monetary Fund (IMF) is saying you had better prepare for the worst instead, because the worst is still to come.

As housing and banking continue to hammer the broad economy, the IMF now sees the global financial sector suffering over $4 trillion in total losses as a result of the deepening crisis.⁵

So far, the banking sector has ONLY written down about $1 trillion in losses ... so there’s still a long, tough road ahead ... regardless of the positive “spin” you may hear from the upcoming bank stress-test results.⁶

Still, this isn’t a totally bleak picture for U.S. banks either. After all, the IMF says that European and Japanese banks will take some of this hit. U.S. firms ONLY face losses of $2.7 trillion on loans and securities — almost TWICE what the IMF forecast just six months ago.⁷

So this is one rate-of-change that’s about to get a lot worse before getting any better!

In the end, the IMF’s forecast may prove too gloomy ... then again, it could be too rosy as well. The bottom line is that even the most pessimistic forecasts from some economists and analysts since this crisis began have proven far too optimistic.

Anyone remember Ben Bernanke saying the financial crisis would be contained to sub-prime and not spill over to the broader economy?

Listen, I’m just as hopeful as every American that the economy will turn around sooner rather than later, but it doesn’t hurt to prepare your portfolio for more tough times ahead, just in case.

The worst that could happen is you miss some potential gains if markets stabilize quickly. On the other hand, if the second-derivatives stop improving, and there’s more downside ahead, that rate of change could be very ugly for your portfolio.

One thing’s for sure: this is no time to engage in wishful thinking.

Good investing,

Mike Burnick