Surviving the Financial Tsunami

The Better Part of Valor

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If you have any money in the market, you probably have just one question on your mind right now: "What should I do?"

Monday was the worst day in the markets since the Sept. 11 attacks of 2001, after the news about the liquidation of Lehman Brothers and the emergency buyout of Merrill Lynch by Bank of America over the weekend.

For bankers, Sundays just aren't what they used to be.

To complete the trifecta of terror, AIG, the largest insurance company in the country, announced that it was on the ropes and desperately trying to raise enough cash to stay afloat. They needed a fix immediately, and by Tuesday night they had it: another $85 billion bailout by the Fed.

We've been anticipating this meltdown for most of the year, as regular readers of this column know. The bodies that were buried under a thick mud of cleverly sliced and diced loan-backed securities were bound to float up to the surface in the next 100-year flood.

And that's what we have here. Some have called it a financial tsunami, others a hurricane. Alan Greenspan called the global financial crisis it a "once-in-a-century type of event."

Choose your metaphor, but the result is the same: widespread devastation.

Even gold and commodities, the safe havens that investors typically turn to in times like these, are being sold off.

The markets just aren't working the way one would expect them to. For example...

Oil and Gasoline

The recent hurricanes have reduced Gulf oil supply by 20 million barrels, and a quarter of the U.S. refinery capacity is offline. Gasoline stockpiles are at their lowest levels since 2000, and headed for record lows.

Normally that would mean higher prices for oil and gasoline.

But these are not normal times.

Instead, as the financial markets melted down, oil had its steepest two-day slide since 2004. Oil has been in freefall since its July peak at $147, touching $91 on Tuesday and closing at $93, a level it has not seen since February. And all the important technical indicators are pointing to further selling.

Gasoline has only experienced a slight uptick from around $3.70 to $3.80 a gallon since the hurricanes began, after experiencing its own freefall from the July peak around $4.11.

This tells me that the selling has been indiscriminate and probably overdone, because I estimate that the trendline price would be closer to $120 a barrel now. On the other hand, as the financial meltdown eventually translates into a global slowdown, even the fundamentals may be impacted as demand cools. It may be time to rethink our outlook for oil demand.  

Gold

Gold plunged from a high of $981 on July 15 to $782 on Tuesday, after going as low as $741 on 9/11.

The action in silver is basically the same.

Interestingly, the chart for gold is nearly identical to that for oil.

What this tells us is that broader market conditions, like the valuation of the dollar, lowered global growth expectations, and the ebb and flow of big money from hedge funds and institutions, are dictating prices much more than the fundamentals.

Sea Sickness and Storm Surges

Still reeling from a 4% loss on Monday, the major averages see-sawed for most of Tuesday before charging up to a more than 1% gain on the day. This was even as AIG went down the Street hat-in-hand, and Goldman Sachs reported a 70% slump in profits for the third quarter.

Why?

Because this time, the Fed opted to defend the dollar, rather than cutting rates. I think that was the right call, since taking the other path courts hyperinflation. What we really have here is a liquidity of credit problem, which can't really be resolved by lower rates, and that problem seems to be getting addressed. The Fed pumped $120 billion into US banks between September 15 and 16, expanded its lending to investment banks for the first time, and agreed to accept more types of assets as collateral.

Those moves have assuaged the markets somewhat for now, but we are still in an extremely precarious position.

It will likely take months to unwind the estimated $700 billion in trades in which that Lehman was involved. But before all that is done, we will have not only a continuing fallout in the financial sector, but a financial storm surge (if you will) that swamps related parties, like insurance companies.

The sectors of the economy that depend heavily on getting credit will be whacked next, like automakers and construction companies. And it certainly isn't going to help the mortgage market to recover.

Plus there is a whole raft of banks in danger of going under. Addressing that issue will necessitate recapitalizing the FDIC, because it only has $50 billion in its accounts—not enough to cover a new run on the banks.

For now, there are still two major investment banks left standing—Goldman Sachs and Morgan Stanley—but experts like Nouriel Roubini, an economics professor at New York University, expect them to be gone in a matter of months, as they succumb to the same flawed business model that did in Bear Stearns and Lehman.

We could be looking at a major reorganization of the banking industry, pairing investment banks with commercial banks that are more tightly regulated and which have actual deposits. It could take a good long while to put this mess straight and win the confidence of investors again.

Meanwhile, the US economy remains, as Roubini put it, reliant "on the kindness of strangers" to keep buying Treasuries and keep our leaky boat afloat. Virtually all of our half-trillion annual deficit is borrowed from foreign banks, principally in Japan and China.

Including the AIG loan, the Fed just added $205 billion more to the country's debt load in the last two days. And it's not over yet. Not even hardly.

When In Doubt, Sit It Out

The stock market hasn't been this messed up since the Great Depression. Look around: Every sector, including the traditional safe haven of gold and commodities, is being sold off as hedge funds and banks scramble to raise cash.

There is nowhere to run, and nowhere to hide. The selling is indiscriminate.

In times like these, cash is king. Cash and bonds are the only true safe havens right now, and until all the scared money has scuttled off to hide under a rock, your investments are at risk.

If you've been holding onto your positions in energy and commodities, as we have recommended, rest assured that we feel your pain, and have had our fair share as well.

We still believe that a recovery in the sectors is somewhere up ahead, but with the bottom falling out of the markets the way it has been, it's getting increasingly difficult to say when. This could go on a whole lot longer than anybody would like.

So if you want to protect your capital and take it off the table, we can't blame you. I have lightened up on my holdings considerably until the dust settles a little. That's what the smart money seems to be doing. It certainly isn't rushing in to scoop up bargains.

As Falstaff said after feigning death in King Henry the Fourth, Part One, "The better part of valour is discretion; in the which better part, I have saved my life."

This is no time to be a hero. It's a war zone out there, and the better part of valor is to keep your head down and your powder dry, and live to fight another day.

Until next time,

Chris


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