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Markets: Inflection Point?
New York: February 04, 2008
By John R. Stephenson

Talk about scary times! Markets are a mess, as the fallout from the reckless property lending in the US ripples through the world's stock markets. No longer is investing a risk-free mundane exercise. Volatility is the order of the day for global stock exchanges. With a possible US recession on the minds of investors, wave after wave of selling has hit stock markets, as investors fret, while their portfolios plummet. With the markets pitching and yawing back and forth, central bankers have stepped in to calm the markets, by slashing interest rates.

But, is it enough? Should investors be stepping back in, or, as some would argue, is the other shoe about to drop? With both financials and gold rallying of late, the investment outlook is murky.

Across the globe, more than $5 trillion in equity value has disappeared from public companies during the first three weeks of January alone. Markets are spooked and it appears, that so too, are central bankers.

By slashing interest rates by 125 basis points (1.25%) in less than two weeks, the US Federal Reserve has revealed that they too, are scared about the market. But is that cause for reassurance or more worry? For our money, it is a troubling sign.

While the stock market sell-off has been dramatic, for the most, it has been orderly. By slashing interest rates quickly, the Fed may have signaled weakness, rather than strength, to the market. If the Fed acted fearfully rather than strategically, then short-term movements in the stock market are driving decision-making rather than long-term forecasting and analysis. Perhaps, the emperor really has no clothes.

For now, it seems to have worked. But the big question for investors remains — is it time to jump back in?

No. The housing debacle that led to a banking crisis, is now leading to a credit crisis. Corporate lending and consumer credit are still shaky, while monoline insurers (companies that insure municipal bonds and subprime loans) are fighting for their survival! Though they are not giants, monolines have guaranteed a whopping $2.4 trillion in debt. If the monoline insurers fail, the $80 billion in bank write-offs witnessed so far, will seem like penny change. In an interconnected world, someone else's problem can quickly become your own. With trillions of dollars of exposure to bonds of all types, a bankruptcy or a downgrade of the monoline insurers (MBIA, Ambac etc.) could lead to a rout, rather than a rally, for Wall Street.

If a monoline insurer is downgraded, or worse, goes bust, the debt that it has insured must be downgraded too. That's a huge problem for banks and other financial institutions that have been trying to dodge the bullet of the subprime housing crisis.

Pension funds, investment banks and hedge funds around the globe have gorged themselves on a diet of too much debt of questionable quality. If the monoline insurers fail, this becomes another crisis that awaits the US and global financial system.

By packaging up these shaky loans on real estate, securitizing them and selling them around the globe to yield-hungry institutions, America has exported near-worthless paper assets in exchange for hard goods from abroad. This situation can't last. Pretty soon, foreigners will demand payment for appliances and BMW's in something other than paper assets from US financial institutions that look increasingly scarred.

But the problem is bigger than that — the credibility of the whole American financial system is at stake! If banks and financial institutions can blow billions on mortgages to people with no assets and no jobs, then they can blow billions more on other misadventures.

With a negative personal savings rate, America has little choice but to address the systemic problems that ails it — an all-pervasive culture of debt! Only by encouraging savings and investment, rather than consumption, will America be able to ride out the current economic storm and reduce its dependence on the third world for emergency cash infusions.

Junk bonds and commercial real estate come to mind as likely suspects for the next round of write-downs at money center banks. During the mania of the last seven years, banks extended billions to private equity firms so that they could take sleepy, cash-rich industrial companies private. In doing so, they have created another bubble, that before all is said and done, will need to be pricked.

With growth at home slowing and interest rate spreads for corporate bonds widening, are all the indebted industrial behemoths held by private equity companies likely to make it? Probably not and that will be another wave of bad news for the investment banks that helped to create the bubble mentality that is afflicting us all.

If homeowners are losing their homes, then it's unlikely they will be visiting the shopping mall as often. That's more bad news yet to come for financial institutions that lent heavily to commercial real estate developers to finance a wave of office tower and commercial real estate speculation. If the consumer isn't consuming, then there really isn't much of a need for yet another shopping mall or office tower. Yikes!

Junk bonds and the hundreds of millions in shaky Commercial Motgage-Backed Securities ("MBS") are the next wave of disasters waiting to confront the US banking sector. To be sure, the $29 billion bailout of Citigroup, Merrill Lynch and others by mainly Middle Eastern sovereign wealth funds has been a blessing, but what are the long-term implications of being dependent on the same part of the world for our energy and financial stability?

In every crisis, the first reaction is always one of disbelief. How could this possibly happen? How could venerable institutions such as Citigroup or Merrill Lynch be so stupid? Surely, the pain is behind us. Maybe, but don't count on it.

Bank CEO's have no choice but to reassure investors that the problems they face are "contained." The alternative, a run on the bank, is far too dire to contemplate.

There is more bad news to come. Investors, who don't panic, are patient and willing to wait, will be amply rewarded. Warren Buffett, who is arguably the greatest investor alive, took a look at buying some of the monoline insurers and passed. It will get worse before it gets better.

Things will eventually bottom and a great bull market in commodity producing companies will continue. Gold and other precious metals will look attractive and even a few select financial companies will be attractive.

Your signal for when it's safe to go back in the water is when gold has settled back down, the monoline insurance crisis has subsided and when the bank index (BKX) has outperformed the S&P 500 index for at least a couple of months. Until then, cash is king and patience is a virtue.

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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