The Future is Now
A rally may be inevitable, but don't forget the pain.
The finance-based dike has sprung a lot of leaks. It remains to be seen how many fingers are left to plug the holes.
We can discuss the moral hazard of privatizing gains and socializing losses until we're blue in the face. Much like the Iraq war, the debate whether we should be there in the first place is now moot. Pulling out at this point, in either instance, would have profound consequences for the world at large.
The government had little choice but to backstop the debt of Fannie Mae (FNM) and Freddie Mac (FRE). I don't like eating the bar tab either but given the $5 trillion of underlying mortgages, they're the textbook definition of "too big to fail."
Lost in the shuffle to rescue Government Sponsored Agencies, IndyMac Bancorp (IMB) was absorbed by the Federal Deposit Insurance Company (FDIC). That seismic shift shocked an already shaky financial foundation desperately looking for signs of stability.
Given 25% of the financial universe disappeared in the 1989-1991 recession and only 10% thus far vanished during our current crisis, there's no denying that real risks remain for many banks. The question for the sector-and by extension the broader market-is how that weeding out process manifests.
In other words, can the contagion be contained?
Looking Back and Looking Forward
The DNA of the current marketplace is a historical anomaly. Policy makers never let us digest the overcapacity from the technology bubble and cumulative imbalances have steadily built under the seemingly calm surface. There is indeed a difference between legitimate economic growth and debt-induced demand and that dichotomy has come home to roost.
During the same period, financial engineering recreated and repackaged risk that effectively passed the buck. Our economy, once rooted in manufacturing, shifted from service-based to finance-based, dependent on the velocity of money and the prices of financial assets. Fannie and Freddie generated that velocity and their inability to execute exacerbated the current conundrum.
When the private sector could no longer shoulder the load, the government stepped in to assume the obligations. They unleashed a litany of conduits, auction facilities, working groups and lending windows with hopes of muting the deleveraging process. On Monday, Hank Paulson took the final step of socialization when he proposed a plan to buy the equity of Fannie and Freddie.
The Wall on the Street
While cracks in the financial foundation are now front-page news, the writing has been on the wall since last summer.
You remember that period-the Dow Jones Industrial Average was at record levels, the banks were 60% higher and despite obvious signs, we were hard-pressed to find a single bear on the corner of Wall and Broad.
Fast-forward one year. Fears of a complete market seizure are running rampant. Well-known market pundits are proclaiming that real estate will never recover. Oversold indicators, including those used by savvy seers such as Jeff Saut of Raymond James and Lowry's, were recently at decade, if not all-time, lows.
Toss in the capitulation of the analyst community-eighteen of twenty-two analysts have "holds" or "sells" on Wachovia Bank (WB), fifteen of sixteen have a similar stance on Washington Mutual (WM) and twenty out of twenty-one are negative on Keycorp (KEY)-and, barring the doomsday scenario, the stage is set for a sharp, mean-reverting rally.
I've never been accused of being Pollyanna. In fact, given my oft-stated big picture blues, I'll admit feeling a bit odd swimming against the ursine tide. Some perspective is in order, however-the BKX could double from here and still be entrenched in a negative pattern of lower highs.
I've traded through my fair share of disasters-Long-Term Capital, Thai Baht and Russian Ruble currency contagions, the dot.com debacle, September 11th, the real estate implosion-and I understand that the sharpest sell-offs occur during an oversold condition when the fewest possible participants are properly positioned.
While my big picture bent since 2006 has been that we're in for a prolonged period of socioeconomic malaise-one that could potentially last five years-we must draw the distinction between trading and investing. Indeed, synching time horizon and risk profile is perhaps the most important element of effective money management.
The obvious key to the tape is the financials, which continue to correlate with the S&P. If they can find a bid, the tape will fry the fur of the late-to-the-party bears. If, however, they continue to slide-or, for that matter, hold current levels-downside risk remains to S&P 1050.
I operate with two buckets of capital, an active account and an all-cash nest egg that's stashed away for a rainy day. Into the teeth of yesterday's steep slide, I aggressively scaled upside exposure into my trading account. While I rotated some of that risk into the lift as a function of discipline, I carried some of it home.
I have concerns about our long-term financial fate but as a trader, the destination we arrive at pales in comparison to the path that we take to get there. It's a delicate dance between the elephants but one that is ripe with incremental return for those that operate with discipline over conviction.
I will simply ask that when the inevitable rally arrives, you remember how it felt when we were perched on the precipice of pain.
For when choruses of "all clear!" arrive, it will likely be time to batten the hatches anew.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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