"How Far Can U.S. Equity Prices Fall Under Asset and Debt Deflation"

Equity prices have been falling since March 2000. How far can they fall before they reach bottom? The current bear market differs from the mid-1970s plunge in equity prices in terms of the causes and, consequently, the factors that should be monitored to test its progress. In the 1970s, the bear market was caused by soaring inflation resulting from a surge in the price of oil. It eroded households' real disposable income and corporate profits. That was a supply-led business cycle. Now, the bear market is caused by asset and debt deflation triggered by the burst of the "new economy" bubble. This working paper argues that on current economic fundamentals, the Standard & Poor's (S&P) index is fairly valued at 871, but the fair value may fall if the economy has a double-dip recession that triggers a property market crash. We suggest that the U.S. economy is heading for such a recession, as the poor prospects of the corporate sector are affecting the real disposable income of the personal sector. The forces that drive the economy back to recession are related to imbalances in the corporate and personal sectors that have started infecting the balance sheet of the commercial banks. The final stage of the asset-and-debt-deflation process involves a spiral between banks and the nonbank private sector (personal and corporate). Banks cut lending to the nonbank private sector, creating a credit crunch that worsens the economic health of the latter, which is reflected subsequently as a further deterioration of banks' balance sheets.