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Markets: Slippery Slope?
New York: December 10, 2007
By John R. Stephenson

What a difference a week makes. The market seems to be shrugging off the subprime woes and is instead focusing on lower interest rates to come. The US dollar has been rallying and gold, as well as gold stocks, have been tumbling. Perhaps the worst is behind us. Maybe good times will be the order of the day and the market will continue higher with all that unpleasantness in the rear view mirror. Perhaps.

But that's unlikely. That's because the outlook for the economy and the financial sector in particular, is simply unknowable and that's a bad thing. The news for the stock market keeps getting worse by the day and while the bounce of late is positive, it may be setting-up investors for a much bigger fall in the future.

Moody's Investor Service has warned that there are wide-ranging downgrades of corporate credit coming. The likely impact? There will be corporate write-offs of debt obligations on the order of hundreds of billions of dollars. Defaults on automobile loans are at decade highs. Mortgage arrears are at record levels in the U.S., as is the default rate on student loans. Clearly, what we are witnessing is the unwinding of the excesses of the past decade of loose monetary policy. Where it will end is anyone's guess.

One reason why it is so difficult to predict the bottom for the stock market is that the American credit-related problems are opaque. In the past, if a bank made a mortgage contract with someone and they defaulted on their mortgage, the extent of the loss would be known. Today, that simply isn't the case.

Recently, mortgages were made to people with little, if any, credit and then these mortgages were pooled and syndicated. Sophisticated buyers who bought these packaged securities sought to hedge their risk by buying insurance. The provider of that insurance often bought insurance from another financial institution to hedge the risk of providing the insurance in the first place. What ensued was a tangled web of contracts between major hedge funds and large financial institutions. The problem however was that many of the assumptions underlying these transactions turned out to be wrong.

So now the global financial players find themselves in a strange brew. They are in the middle of a tangled web of obligations, contracts and debt and no one knows who holds what and how much it's worth. Sure, much of it has been written-off, but will more of it be tumbling out of the closet in the future? No one knows for sure and that's where the problem lies.

The next shoe to drop on the US economy is in the form of rising default rates on junk bonds, another creature formed by the promiscuous use of debt over the last decade. Junk bonds are corporate debt obligations that do not carry an investment grade rating. During the last few years, the levels of debt have been ratcheted up on corporations of all kinds as private equity players have taken these companies private in an attempt to "restructure" them. But the real reason for these going private transactions was that private equity players had ample inducement in the form of cheap debt to stalk their prey.

With the economy slowing and the balance sheets of many companies hemorrhaging on debt, investors will start demanding massive premiums for funding these debt-laden behemoths. That will send the junk bond market tumbling down.

Once the world figures out that both the public and private debt markets in the United States are full of risk, they will panic, sell their stocks and go home and sulk. And that's a bad thing for stock investors. But markets will get cheaper and that's when you, the savvy investor, step back in.

Look for a major pullback in the stock market over the next quarter or two. That's when pessimism will reach a high as global investors begin to give up on the U.S. because it is deemed to be a risky place in which to invest. But that's when to step back in because that's when the bargain hunting will be at its peak.

Gold and gold stocks will profit as the dollar weakens with all the uncertainty that is out there. When gold pulls back, that's not the time to panic, but rather the time to step back in and buy some more gold ETF's and gold producers, as the likely outcome over the next twelve months is a weaker rather than a stronger US dollar.

Figure 1: Potash Corporation of Saskatchewan is a Fertilizer Stock on Fire!


Agricultural stocks are the other great commodity investment that investors should be making since they are linked to one of the big investment themes we have been witnessing — food inflation globally. The world's supply of wheat has sunk to an all-time low of just six weeks. Companies that provide the fertilizer and help the farmer farm are all logical areas in which to invest. And while the price earnings ratios (p/e ratio) are starting to look a little stretched for some of these companies, they are precious indeed. If biotech companies, which have developed unique drugs to combat disease, can trade at multiples of 90 or more, then surely an agri-business that feeds the world, has enormous barriers to entry and suffers from a scarcity premium, should be able to trade at lofty multiples as well.

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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