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What's Next For the Credit Crisis? Part 1


Tech not as safe as some think.

"I climbed in the ring with Robert Duran and the punches began to rain down.
He hit me with a dozen hard upper cuts and my corner threw in the towel.
I asked him why he had to knock me out and he summed up real well.
'I'd rather be a hammer than a nail."

- Hammer and Nail (Paul Thorn Band)

This article comes fresh off a trip from visiting my son in Chapel Hill, North Carolina, where we had the good fortune to take in a live show of The Paul Thorn Band, one of my favorites. Paul is an ex-prize fighter that once lost in a title bout against Roberto "Hands of Stone" Duran. For those of you not familiar with Paul Thorn, he is a native of Tupelo, Mississippi and his lyrics are wonderfully folksy and sometimes downright hilarious. His style is a splendid mix of blues, rock, and a bit of country.

While listening to a Paul Thorn CD on the way home today, I thought of this song that he calls his 'theme song'. And it reminded me of how I feel about today's investment environment: I'd rather be a hammer than a nail.

Now that this investment environment is here, we must ask ourselves if a) Is it fully discounted? and b) What other sectors of the stock market and economy will be hit next?

There are a couple of basic trading disciplines that I live by. First, "what the market knows isn't worth knowing." What I mean is that by the time I see thoughts I wrote about several years prior make their way to the cover of my local newspaper, I know that most people are now aware of the problem and likely positioned for it.

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Second, I was a taught at a young age (the hard way) that no matter how intriguing an investment opportunity appears the balance of risk and reward must be squarely in my favor; most seasoned traders and investors like to have risk/reward somewhere between 2:1 to 3:1 in their favor before establishing a position, long or short.

Lastly, we must "plan for the worst and hope for the best," a difficult position for most anyone with even a moderate sized ego to take. The markets seem to find a way to sniff out crowded positions and crush the crowd at extremes, otherwise known as the "Pain Trade." Having been on the wrong side of the Pain Trade enough times, I try to avoid the crowd as often as is practical.

With this in mind, I think that the easy money has been made on the short side of financial stocks. By no means does this mean that they cannot decline further, it just means that the balance of risk and reward just isn't there, as a group, to be short. There are most certainly isolated instances that offer excellent risk/reward characteristics, notably weakly positioned broker/dealers and regional banks that have not yet 'fessed up to the real value of the esoteric securities that remain on their balance sheets, but this is more of a "rifle shot" approach as opposed to the broad "shotgun approach" that has worked so well since the crisis began in earnest last summer.

I would note that the fundamentals of the housing industry are nowhere close to turning and, in fact, are worsening. Recent reports show foreclosures soaring 50% year-over-year which will certainly force more write-downs, and eventually-write-offs, both at housing companies and banks. Other reports estimate that nearly 2/3 of all sub-prime and Alt-A loans originated in 2004 - 2007 will be in a "negative equity position," which makes refinancing all but impossible for many years to come.

Does this make us suddenly bullish on the equity market as a whole as a result of our more neutral attitude towards financials? Not in the least. In fact, this is where I believe the next stage of the crisis really takes hold, in sectors that one might think are not correlated to banks and brokers.

I've read recently that technology stocks are a "safe haven" in the equity market. The rationale, I'm told, is that you should buy Microsoft (MSFT), Cisco (CSCO) or Apple (AAPL) because "at least you can understand their balance sheets." I can't disagree that Apple's balance sheet is much easier to understand than the labyrinth of leading investment banks and regional banks. However, if this is an investor's sole reason for buying a stock, I would be wary of letting them manage my money.

If this is what the market has become, the best of the worst, then we had better start worrying as this is behavior of an equity bear market that is about to get "into gear" to the downside.

Think about who buys iPods, PCs and routers for a moment. On the corporate side, many of the largest buyers are those in the financial industry, the very ones that are being forced to raise capital just to stave off bankruptcy or the many smaller institutions that I fully expect to be merged into larger organizations in coming months and years. From the consumer side of the ledger, most consumers are stretched beyond their means. We also know that the majority of homes purchased with Alt-A and sub-prime mortgages now have negative equity. Not to mention the nearly $100 it costs to fill up a tank of gas.

Consumers are now officially tapped out and this helps explain why nearly 20% of all Americans have borrowed against their retirement accounts, a clear sign of financial stress.

Consumers have become so programmed that their assets will rise in price since the stock market bull market began in 1982 and the real estate bubble that began in 2003 they are used to borrowing against these assets. Now that debt has piled up, savings are depleted, and inflation in the "things that we need," like gas and food, have exploded up into their own bubble you might say that the "Perfect Storm" has now formed for the median wage earner. Anecdotally, I sense that spending habits are changing for the upper class as well. As producers face higher price inputs, they then try to pass the costs along to consumers.

Retail sales numbers may have risen this past week, but most of it was as a result of more money spent on gasoline and higher prices paid per item purchased. This is not a harbinger for future growth; rather, it is a recipe for a deep and prolonged recession, which explains our caution.

So if you believe that technology companies are immune to the mess that began with banks and brokers, you may wish to re-consider. Earlier on, I mentioned that I need the balance of risk and reward to be squarely in my favor, and I now believe that the next sector that could be the new downside leadership if the market decides to have another leg down is technology. It is as close to being a safe haven as I am to being as good a golfer as Tiger Woods.

Click here for Part 2.

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No positions in stocks mentioned.

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