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Markets: Flat Line?
New York: September 15, 2008
By John R. Stephenson

Another weekend, another last minute bailout by the US Federal Reserve and the Treasury. So far, Henry Paulson and Ben Bernanke have been remarkably skilled in staving off a financial crisis in the US. Their weekend emergency interventions have kept the US financial system from flat lining, but with the emergency room starting to get a little crowded, can they continue to stave off yet another crisis?

Who knows! So far the body count is starting to stack up, with the next two patients to enter the emergency room being Lehman Brothers and Washington Mutual. But while Ben and Hank's actions have been admirable thus far, they may be fresh out of miracles. After all, there is only so much anyone can do.

While it remains to be seen what will happen with the latest batch of walking wounded, what is crystal clear, is that the financial crisis engulfing the globe is so broad and so deep, that only the most acute patients can receive emergency care. Will central bank interventions be enough to save the US financial system from flat lining is the million-dollar question.

Figure 1: Lehman Brothers — In Search of Care!



Probably. But what is now clear, is that this crisis will take some time to find a resolution. By slashing interest rates early and intervening to save the most critically wounded financial institutions from a total collapse, Hank and Ben may have been able to avert a disaster. At least, that's the hope.

But the ultimate solution to what ails the US financial system, is for the banks to raise the necessary capital themselves, rather than depending on emergency interventions by the Fed. For that to occur, the stock charts of these banks will need to start showing some improvement and fast.

But that is starting to look like a tall order, since most of the stock charts of US financial institutions look positively anemic. And that's a problem. So far, the only sovereign wealth funds and the Fed have been riding to the rescue. Institutional and retail money is on strike and waiting for the situation to improve.

As each new behemoth fails, the likelihood of yet another government bailout decreases. After all, how many more institutions can the US taxpayer afford to bail out? With retail and institutional money on the sidelines, the other actor has been the sovereign wealth funds. But can sovereign wealth funds be expected to lend a helping hand?

Not likely. For starters, many of these guys were told six months ago that the worst was over and that the market would rebound , or something like that. Once burnt, twice shy.

So for a recovery to occur, the banks will need to find a way to recapitalize on their own. But given their sorry shape, that may be a little way away. That means a recovery in the stock market is going to take some time.

So far, the commodity stocks have been taking it on the chin. In part, this is because many leveraged investors got caught flat-footed when the Fed orchestrated a weekend bailout of Bear Stearns, as well as Fannie and Freddie. After each of these interventions, banking stocks rallied and commodities plunged — at least temporarily. For many hedge funds and other players, a winning trade had been to go long (buy) the commodities and sell (sell short) the financials. The weekend interventions ended all that. Faced with massive losses, many of these players have been unwinding their positions as fast as they can, sending commodities lower and financials higher.

But it is also darkest before the dawn. While it will take some time for a full recovery to occur in both the commodity stocks as well as the financials, a recovery will occur. The commodity stocks differ in one important way from the financials — they are extremely healthy. Their balance sheets are in great shape and their business models are extremely solid.

While it will likely take a pick-up in the global economy to see the valuation of the banks and the commodity producers improve, the valuations of the commodity producers look extremely attractive at these levels. Oil stocks are discounting $65 oil, while copper producers are discounting $2 copper. For savvy investors, this is manna from heaven.

The great fortunes that have been made in the stock market have been made when the stocks were inordinately cheap. Savvy investors, such as Warren Buffet, made the bulk of their fortunes investing in the stock market when the valuations were a paltry six times earnings and rode the wave of improving sentiment upward. While the financials are likely to improve, picking the winners among the nearly dead is a difficult task. But why take the risk, when instead of buying shares in a bank you can pick away at the shares of some of the great commodity producing stocks, which right now are discounting a worst-case outlook. They don't have any of the problems of the financial companies and they are dirt cheap, rather than taking a punt on a banking stock that might be ready to flat line.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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