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By Eric Roseman

We're smack dab in the middle of the worst U.S. financial crisis in a generation. Investors are responding by dumping stocks and fleeing for the relative safety of Treasury bills, foreign currencies, and commodities. Stocks are now settled in bear market territory, defined as a loss greater than 20% from all-time highs.

Large-Caps Take a Large Fall

$SPX Chart

And the panic selling lately has gone global...

In fact, this is the worst bout of selling since 9/11. Global equities, as measured by the MSCI World Index, have now declined more than 20% from their October 2007 all-time highs. Meanwhile, the U.S. broader aggregates are down over 21%.

Just since late May, more than six trillion dollars worth of equity values has been erased worldwide.

Investors now sit on two opposite sides of the fence.

The optimists continue to allocate assets globally while maintaining high cash reserves. They continue to believe this crisis, like all previous economic disasters, will eventually bottom.

They repeat the mantra: "Stocks and bonds will recover." To prove their point, they show how previous market shocks were all great buying opportunities for long-term investors like the 2000 tech bust, 1998 Long Term Capital Management debacle, the 1997-1998 Asian crisis, the 1989 - 1990 S&L Crisis, and the October 1987 stock market crash.

But on the other side of this contentious fence, the bears believe we're at the cusp of a major financial unwinding. They're saying this market environment will eventually parallel the events of the Great Depression in the 1930s.

Both market forecasts will determine the ultimate value of investment portfolios for years to come. But the question is: Which side is right?

 

A Case for Financial Armageddon

Many bears agree 2007 marked the "beginning of the end" of the global financial system. The devil threatening the financial order is Wall Street's monster called "securitization."

The securitization beast developed into a monster after former Fed Chairman Greenspan's relentless push to bring interest rates down to 1% by 2003. He was trying to stave-off deflation following the mini-2001 economic recession.

Although Greenspan's monetary policy gamble worked, the policy combined with the Bush tax cuts to boost GDP growth also created a leveraged beast. The monster grew as Wall Street packaged and repackaged mortgage-backed securities tied to leverage.

Low rates always entice financial product innovation. When Greenspan made U.S. money available literally for "free" at 1% or less by 2003, the securitization monster went wild. In a low interest rate world, credit spreads for all types of fixed-income securities plunged to historically low levels by mid-2007.

Then the party ended.

Deep Economic Recession or Worse?

With housing values accelerating their decline across most U.S. markets, the entire gamut of mortgage-backed securities and other markets tied to leverage all began to unravel by August 2007.

The toxic spillover has spread to other segments of credit, including consumer loans, corporate loans, credit-card debt, mono-line insurers, auction rate securities, and other synthetic derivatives.

The result is a massive policy challenge for the United States. A whole year later, the banking system remains heavily stressed. Worse, surging food and energy prices have cornered the Bernanke Fed, the dollar, and U.S. asset markets.

How does the United States - the world's largest and still the most influential economy, control deflation in housing and bank credit combined with skyrocketing food and energy prices? You could say 2008 is a bizarre twist of 1930s deflation mixed into a deadly toxin of 1970s stagflation.

The economic challenges are truly formidable. Soon, the Federal government will have to pitch in and help (with a taxpayer's bailout) because the Federal Reserve is running out of options. The Fed has already exceeded its chartered mandate following Bear Stearns' (NYSE:BSC) rescue in March.

According to the bears, a deep economic recession in the United States will morph into a 21st century Great Depression. This will happen as mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE) eventually collapse, housing values continue to deteriorate and a greater number of banks fail.

Unemployment will soar, bread lines will re-emerge and the dollar will become worthless as America's largest trading partners dump Treasury's.

An Optimist's View

The optimists maintain that the modern financial system will not fail.

Since the advent of modern capitalism under the British Empire, global crises have unfortunately surfaced regularly as asset bubbles deflate or unwind. This crisis triggered by the housing bust, won't be any different.

Governments and corporations always respond under times of economic duress by throwing bundles of money at the problem until the crisis stabilizes and eventually, fades.

The consequence of this policy response, like most others, will ultimately lie in higher inflation. World governments will eventually have to print credit to arrest deflation in bank credit and plunging asset markets.

Gold and most other commodities should continue to perform well as this recovery scenario occurs. Eventually, distressed stocks will also make a strong comeback but will unlikely surpass their all-time highs for many years to come in a fractured global financial system.

Deflation Intense in Asset Values

There's no hiding the damage already inflicted to global portfolios this year and over the last 12 months.

Since July 2007, global markets have declined 20% or more. The majority of non-Treasury securities markets have also been pummeled and housing values across several industrialized countries continue their downward spiral. Global balance sheets, both personal and corporate, continue to hemorrhage in the worst attrition of values since the 2000 to 2002 bear market.

$CRB Chart

Unless your portfolio is over-weighted commodities and foreign currencies this year, you're under water. Even cash or T-bills alone won't save you. In fact, in real or inflation-adjusted terms, both trail official CPI (consumer price index) by approximately 200 basis points or 2%.

At some point, according to the stock market bulls, markets will form a bottom. At that point, a recovery will ensue as investors grab for the next bargains. Many market indicators already point to massive contrarian buying opportunities in late July.

Institutional and individual cash reserves now sit at their highest levels in six years, representing almost 25% of total U.S. stock market capitalization. That's an enormous amount of buying power.

Short-selling, or the level of institutions betting against further market declines is now in record territory on the NYSE and the NASDAQ. And the Investors Intelligence Bull/Bear Ratio now stands at 0.58 - the lowest reading in almost six years. In short, nobody is buying stocks.

Dividends, which barely existed 12 months ago, are now scattered across the landscape in the United States and Europe. In Japan, companies now distribute the highest after-tax profits to shareholders in history. That's impressive considering this country barely paid dividends to shareholders 10 years ago.

Plus, dividends, compared to bond yields and money-market rates, also look very attractive. The majority of non-financial companies continue to raise pay-out ratios - far outpacing the rate of inflation in most countries and superior to staid CDs or T-bills.

These and other market-based ratios do not suggest stocks are excessively valued in July 2008. What they do suggest is that the market is heavily oversold and might embark on a powerful liquidity-driven rally, probably as seasonal strength begins later this fall accompanied by U.S. Presidential elections in November. Historically, the best time to buy stocks for the long-term is from May to September.

My Advice to Guide You Through This Confusion

No matter which side of the fence you're sitting on - bull or bear, I still say your best strategy is probably a mixture of quality assets. Diversification is your best defense.

Don't abandon stocks at these levels. Stick to blue-chip global multinationals now trading at multi-year lows and paying attractive dividends. Investors can select their own blue-chip stocks or buy diversified exchange traded funds (ETFs) and global value equity funds. These securities have all plunged over the last 12 months and continue to provide optimal entry points for the dollar-cost-averaging investor.

Also, gold and gold stocks should play an important role, including other commodities as central banks eventually lose control of inflation.

Foreign currencies - mainly in Asia, should remain a primary focus for dollar-based investors over the next decade and should be accumulated. Corporate investment-grade debt continues to trade at attractive levels compared to Treasury bonds and also offer good values. Finally, don't forget to diversify your portfolio with a reverse-index fund to hedge your market exposure.

On the other hand, if you truly think we're approaching financial Armageddon, I strongly suggest hoarding gold coins and selling everything else. It won't be a pretty world if the bears win this fight.

Disclosure: None

 

Source: Is This Financial Armageddon or the Greatest Buying Opportunity Since 2002?