Saturday 26 January 2008

Why US market needs a crash now

US stocks look very weak. This is hardly a surprise considering the impact of the credit crunch and the prospect of a US recession. However, the fall looks hardly enough, considering the circumstances.

There are two schools of thought in the market at present: One sees a good old-fashioned correction; a small US recession that will pull back on the economic throttle and produce a little bit of pruning on an out of balance US economy that is due for a reality check. The other is a vision of a financial train wreck on a scale not seen by the current generations.

The second leg of the credit crunch is about to kick off with the bond guarantors in the process of precipitating hundreds of billions of bond write-downs.

So-called 'monoline' insurers have seen their stock prices collapse, and everyone can see that many of the bonds made AAA by their promises are now junk.

Coupled with phase one of the credit crunch, this puts the bond market out by about half a trillion dollars. That's half a trillion up in smoke. However, this is only about 1.5 per cent of the New York Stock Exchange's value, so by comparison this is a small amount.

Yet things aren't that simple. Market processes are driven by leverage and feedback. Monolines guarantee over 3 trillion dollars' worth of bonds, with only 1 per cent to back up their promises. This failure of promises backed up by this $35 billion of cash is evaporating $250 billion from the value of the bonds in question. This is how financial avalanches are set off.

Against this background, will a $150 billion stimulus package do the trick? Treasury Secretary Henry Paulson has come out saying that he continues to have confidence in the underlying strength of the global economy. However the Fed's large interest rate cut (from 4.25 per cent to 3.5 per cent) on the back of Monday's equity meltdown is more a shot of adrenaline than the shot in the arm President Bush prescribed. It does, however, to paraphrase Paulson, suggest that the central bank is quick to respond to market conditions.

In terms of the $150 billion jump-start package, to have an effect it will have to get into the system in places that matter to the disrupted financial chain of events. Clearly, if it ended up in the monolines' capital accounts, it would wind back the damage done to bonds, but that won't happen. If it ends up in people's savings accounts, that wouldn't be much help, while splurging it on more cheap goods from China is hardly likely to do anything at all.

The US and European markets now carry the chart pattern of the first initial bear market phase since the crash of 2000. The bear still looks in its infancy but has all the hallmarks of a big one. Nothing looks set to change the upcoming narrative of recession.

For the investor there are two ways to go. The random walkers would say to stay put, cost-average as usual and expect to forget the impact of the bear a year or two after it blows over. By 2020, when you are a bit older, it will all look like a scratch. The other way to go is just to get out.

2008, 2009 and 2010 are going to be harsh for investors. Here are some scenarios and possible strategies.

Protracted period of volatility: Sell the spikes, buy the dips. Buy good companies that get crushed. Do not hold speculative companies.

Small, short bear: What, me worry? Keep buying, but at a slower pace. Focus on defensive stocks. Dollar-cost average. Pick up bargains along the way.

Crash: Run away. Go to cash. Sit on your hands. Wait until it is over and there is a medium-term confirmation that the bottom has been reached before getting back in. Clearly anyone with the stomach to short will have an easy ride. Yesterday's stars will crash, good companies will fall and only special situations will prosper.

In many ways, the best thing that could happen now would be a quick crash. A lot of professionals are praying for a so called 'puke' because that would set a bottom for a recovery and signal that the worst is over. A short, sharp shock would be good for everyone. Recovery is better than sickening.

Is this 'the puke,' right now? It certainly feels like it, but until we have a period of relative calm or a massive drop, it's too early to tell. If it does happen, it will be in the next few weeks, and if it doesn't, then a grinding bear for an extended period is likely.

The old saying goes that when America catches a cold the world gets pneumonia. The optimists say this is no longer the case. America has a bad case of flu, and we should hope the optimists are correct, or else in due course the world economy will be on a ventilator.

-Clem Chambers, Forbes.com