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I thought I would begin this week's commentary with a quote from Alan Greenspan, taken from his address to the Council on Foreign Relations on November 19, 2002 regarding the risks associated with use of derivatives:

More fundamentally, we should recognize that if we choose to enjoy the advantages of a system of leveraged financial intermediaries, the burden of managing risk in the financial system will not lie with the private sector alone. Leveraging always carries with it the remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked.

At the end of 2006, the Bank of International Settlements reported that there was $415 trillion worth of open interests in derivatives instruments. The Black-Scholes Model, the architectural framework used to construct many of these instruments, once haled as one of the most ingenious financial equations of the century, has recently come under fire by such authorities as Nasim Taleb for lulling the vast majority of financial intermediaries into a false sense of security. Their argument is that within the bounds of reasonable market activity Black-Scholes is adequate, but in irrational and extreme cases the Model breaks down. An excellent summary of the argument is made in this month’s Condé Nast Portfolio in the article “Inside Wall Street’s Black Hole.”

If the very foundation that financial intermediaries’ rely on to calculate risk is flawed, this would mean that the intricate web of cross referenced financial instruments meant to insure against catastrophic failure may be nothing more than a complex and tangled f knot of wires delicately resting on one another. Each time one wire snaps, it creates a “cascading sequence” of events roiling institutions and threatening to collapse the entire financial system. The manifestation of this can be seen if we look back over the last eight months and follow the trail of disaster from subprime to market neutral hedge funds, to prime, to corporate to auction markets, and the list goes on.

Both the Federal Reserve and the Administration have offered their solutions, specifically, a lower Fed Funds and Discount rate, open market activity and a stimulus package, yet with each move they make a counter move is made by the credit markets erasing their gains. Vulnerability may be at an all-time high with most of the governments bullets used up and conditions signaling danger ahead. Swap spreads, a measure of the difference between buying government debt and making a loan to a bank, are spiking to levels not seen since July. Another measure of risk, the Markit CDX Investment Grade Index, which tracks the cost of insurance in against investment grade corporate defaults, is up over 300% since June. Whether we are on the tipping point of capitulation in the credit markets or the verge of the next wave of the collapse remains to be seen.

The Administration has continued to deny that they will create a bailout package for homeowners. The New York Times reported last week that 8.8 million homeowners, or 10.3% of all homeowners, are now underwater. With the household debt ratio near an all-time high of 14.3%, this means that consumers are now overleveraged to an underlying asset that can’t support the value. With velocity of home values still pointing down, this situation will get substantially worse before it gets better. The Administration may soon be forced into a bailout scenario as it was in 1933 under President Roosevelt when he created Home Owners’ Loan Corp., which refinanced around 1 million mortgages. The most recent government bailout was in 1989 when the Resolution Trust Corp. was set up to take over more than 700 failed savings and loans at an ultimate taxpayer cost of about $132 billion. Any government sponsored bailout would likely top that number.

Against this backdrop, one could either look at the equity markets as incredibly resilient or obtuse, given the panic that has engulfed the credit markets. The stock market’s resilience may be as simple as, there isn’t much in alternatives. Based on an interest yield versus earning yield analysis, stocks still look better than bonds, and that doesn’t even take into consideration the overwhelming additional risk factors in bonds right now. Real estate doesn’t offer much of an alternative until we at least see a leveling off of the supply-demand curve for homes. Commodities seem to be the lone bright spot among asset classes where fundamental still point to appreciation.

So if you are going to have to be in US equities where should you be? It seems the overwhelming response from Wall Street is Large Cap Growth. Unfortunately, many analysts seem to pick last year’s best performing market cap and style to be this year’s, hoping the trend will extend into the current year. Picking last years winners has usually proven itself to be an unsuccessful approach to investing. As some readers might recall from my January 7th market commentary (The Markets Have Spoken: They Say 'Bear') discussing sector allocations, I suggested Small Cap Value might be a place to put money in 2008. Let’s take a look and see Small Cap Value is fairing. Year to date, the Russell 1000 Growth Index is down 8.57% versus the Russell 2000 Value Index being down 6.26%. It might be even more surprising to know that in recessionary periods, Small Cap Value tends offer the best intermediate term performance over the last century.

Source: A Spike in Market Turbulence May Point to Capitulation