Credit Crisis Conclusion
Credit Market Crisis - Final Thoughts & Looking Forward
So, how does this crisis end? We spent the last three chapters harping on the ills that resulted from the oversupply of money and the inevitable ensuing greed. We also discussed bloated bank balance sheets and their inability to support the markets at this time of need. But, believe it or not, after three very negative paragraphs my outlook may not be so bad. As Franklin Roosevelt once said “there is nothing to fear but fear itself”. That statement portrays our situation. If the markets and risk takers in this economy can keep a level head, I believe we can emerge from this crisis in the next 3-6 months without a severe recession. If banks continue to fear lending and investing, this market could be held hostage for a while and this crisis could continue for a long time.
Real estate may see prices drop significantly for one, two or even more years but guess what, Wall Street knows that. When the markets price securities, they put much more weight on the future than the past. For example a company may have great earnings going back 20 years. Any hint of future problems will lead investors to shun the company and re-price their debt and equity much lower. Right now the markets are doing just this. They are factoring in some dire housing scenarios which in turn has led to many mortgage related companies being priced at or even below book value. I believe these dire foreclosure and default scenarios are possible. The good news is that stocks and bonds have largely factored that in. If the situation in housing is bad but not as bad as the 20-30% house price declines being talked about, many of these companies are cheap and many write offs already announced may be overstating actual losses.
Currently fear has gripped the market and the major players are on the sidelines regrouping. Balance sheets are dear to banks and brokers. Year-end and the closing of books is exaggerating the situation. Banks, brokers and investors of all sorts publish their holdings, assess risk and most importantly determine profits and losses for bonus purposes. Many institutions are willing to sit on their hands at this point in the year to either hold on to whatever slight gains they may have or to prevent any further losses. These big players are shunning risk on their balance sheet in exchange for top rated securities such as Treasuries in order to paint a good picture for their shareholders. The market is essentially crippled and will be so for the remainder of the year.
When looking to 2008, and the macro economic environment for the next few years my biggest concern revolves around the Federal Reserve. They are in a pickle to say the least. The banking sector has significantly tightened lending standards to all sectors of the economy as they reel from losses of profits and capital. To counteract this, the Fed has eased monetary policy via the Fed Funds and Discount rates. Results from these actions are a tug of war. Will the Fed lower rates enough to counteract the banks aversion to lending? If not, the other problem for the Fed is their fear of further dollar declines and the dreaded I word, INFLATION. The dollar is already trading at 20+ year lows versus most major currencies and gold is sitting near an all time high as investors are realizing that the Fed will continue to lower rates despite a falling currency and rising inflation risks. Simply put, lower rates create less incentive for foreign investors to own dollar based securities which in turn lessens the value of the dollar versus other currencies. This also has the effect of igniting inflationary pressures as the cost of foreign goods becomes more expensive in dollar terms.
The big question is how the tug of war, mentioned earlier, resolves itself. Will the banking sector ease lending standards enough so the Fed does not have to lower rates much more or will the banks and other financial institutions continue to retain a very conservative posture thus causing the Fed to stay very active? My guess is a little of both will happen. Banks will open up and ease lending standards somewhat as they realize that housing will probably not drag the whole economy into a severe recession. The Fed will fight lower rates but in the end they will bring Fed Funds below 4%. As a result the economy will more than likely tread water. The cheaper dollar will promote investment in the US and American exports will increase on the cheap dollar. In addition global growth will help counteract some of the financial hardships of the housing sector. I find it hard to imagine the Dow trading much above 14,000 or below 12,000. With languishing stock prices and low interest rates, how does one invest for this scenario?
Commodities such as gold and oil are good bets for the next few years. The combination of lessened supply and increased demand coupled with a sinking dollar poses well for many commodities. Crude may have retreated from $98 a barrel and gold from $845 an ounce but both over time have more room to increase especially on dollar weakness. Stocks will bounce higher and lower but those that can effectively range-trade should do well. Volatility will begin to decrease as we approach 2008, which should make range trading a little easier on the stomach. Higher yielding stocks such as utilities and certain, non-mortgage, REITS are also good bets for the New Year.
As we approach 2009 we should keep in mind that stocks do very well going into presidential elections. The optimism that candidates create can have a very powerful effect on consumers and their spending habits. We may see stocks break their upper ranges in late 2008. If this occurs and the housing recession shows signs of bottoming, the stock markets may have a higher road for 2009 and beyond. The continued global economic boom coupled with an improving US economic situation and lower interest rates is a potentially very profitable combination.
The risk to my forecast is the complete shutdown of the financial system. If lower Fed rates do not spark banks to ease lending standards we could see a deeper recession. These will not only negatively effect equities but also damage commodities. Because this possibility exists I would maintain a larger than normal cash position. Cash may not have great returns but they are positive and some times not being negative is good enough.