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The big question is whether a new global credit crisis is just starting, and whether it will end up worse than last time. I can't answer that question, and nobody can no matter how strongly they'd protest to the contrary. But nevertheless, as investors, we have to make choices and in order to do so, we have to make assumptions about likely or even just possible outcomes. So to answer the question, I'm framing the issue as follows: a credit crisis unfolds in three steps, and as you recognize these steps unfolding, it becomes easier to assume that a credit crisis is, in fact, starting.

Step number one is that it all starts with cumulative imbalances - excessive leverage, excessive risk taking, and so forth. Record budget deficits coupled with high (and possibly uncontrollable) levels of government spending are one example of excessive leverage and risk taking, and probably the salient example of the moment.

The next step toward a credit crisis comes in the form of oblivious government leadership. We saw this during the collapse of Lehman Brothers - the Fed really just didn't get it, and by the time they did, it was far too late. We saw this as Congress fumbled the first bail-out package in 2008. Plenty of investors could take the view that we are seeing this phase unfolding right now, as European leaders dither and fiddle as speculators assault sovereign bonds using credit default swaps and other instruments that many within the European leadership haven't even heard of. In my view, we've seen the Congress exhibit oblivious leadership throughout the debt ceiling debacle, as tea party members pushed the country toward the first U.S. government default in history, all the while saying that a "mini" default would somehow be okay, and maybe even a good thing. Not that the President got his arms around the threat early enough either. One hopes that the last couple of weeks in the global capital markets have provided the Congress with a bit of enlightenment on this point about threatening defaults, the lesson having cost investors across the Earth trillions of dollars in lost wealth. So far and counting. Yes, describing what we've seen out of Washington, as merely "oblivious" is almost inaccurate. I'd go so far as to say treasonous or criminal, but the point is, step number two toward a credit crisis seems well accomplished now.

The next and final step into a credit crisis is opportunistic rumor spreading by hedge funds. There must be enough truth to the rumors that investors are easily swayed into ever higher crescendos of panic, selling assets indiscriminately at any price without waiting around for the truth to unfold. Wednesday was a very good example of this third step, as gangs of traders fomented rumors of possible bank insolvencies in France, driving the lemmings over the cliff and reaping the rewards of already-laid short positions on French bank stocks. The rumor-followed-by-stampede phase will continue until there is no money left to be made shorting asset prices, and in my view, we've only now just started to see this step materialize in the news.

The three steps into a crisis will ultimately lead the markets toward a cliff, and as the third step nears completion, the end result comes as a sickening capitulation, with a seemingly endless fall in asset prices and no possible end to the carnage in sight. Once the dust settles after the fall, many companies have failed, global economies have been left retrenched or frozen, unemployment has skyrocketed ever higher, and riots rage in the cities of the world. In a true crisis, anything that can be beaten down is beaten down, and there are no safe harbors.

I cannot tell anyone whether we have seen the three steps yet, or whether we are likely to see the end result described above. The saving grace may be that investors can buy an index fund like SPDR S&P 500 Fund (SPY) with an earnings yield roughly 500% higher than the yield on a 10-year US Treasury (and if that's not jaw dropping cheap, I'd love to find out what is and where I could buy it). And for a certainty, people are still going to be buying Big Macs, industrial equipment, pharmaceuticals and light bulbs, all regardless of what Standard and Poor's has to say about the foibles of U.S. political drama and how this drama impacts the reality of U.S. creditworthiness. And regardless of fear mongering on the part of hedge fund managers and of the utter ineptitude on the part of politicians and appointed officials. At some point during a panic, rational thoughts like these begin to percolate, and then comes the greedy hope of catching a great investment bargain while the bargain is still there for the catching. The fear, of course, is that this point may be a long, long, long way down from here.


Disclosure: I am long SPY.

Disclosure: I am not an investment advisor, and no person should rely on any opinion or statement of fact contained in this article for any purpose, including, but not limited to, any investment decisions.

Source: How to React if a Credit Crisis Emerges in 2011