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Can Stocks Push Higher?


History suggests caution, as risk remains high.

The debate rages on as to whether the market is on the road to recovery or gearing up for more pain. I'll be the first to admit I don't know for sure where the markets are heading, but I believe we still have some work to do before we mark the bottom in stocks. While the slug-fest continues to play out, let's try to make heads or tails of the situation.

To follow up on my piece from Friday, here are a few thoughts on the current state of the financial world.

Financials: Value or Trap Door?

Financials are the classic value trap. Can they rally further? Sure. Is there some value among some names? At some point. Is strength an opportunity to sell? Probably.

Bear Stearns (BSC) will not be the only casualty of this credit cycle. Wait for the real panic, make like a vulture and grab an easier meal among the decomposing carcasses. Overpaying for banks has been a bad strategy historically for acquisition-minded firms; it's also a bad strategy for investors. Further writedowns, continuing credit concerns, and a recession likely provide the opportunity to be patient.

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Sub-prime Superfund Cleanup

The price discovery process in collateralized debt obligations (CDOs) and other toxic debt is still in the early innings. Bear Stearns, with all the pain and staggering financial losses, only clarified one thing - such debt is worth somewhere slightly above zero. That's great and all, but it's kinda like saying the house you bought for half a million dollars is now worth somewhere between $275,000 - $500,000. What can you actually do with that information? Not much.

The next phase of the subprime cleanup will uncover the true magnitude and extent of the hazardous waste out there. It will reach across global markets in the process. Get Federal Reserve Chairman Ben Bernanke a hazmat suit, put a good portion of the debt markets on the Superfund site list and let's get some more taxpayer money flowing for the cleanup.

onds, Junk Bonds

The credit markets are still in a state of chaos. Money markets are dysfunctional. We have historical volatility in short-term T-bills and Fed Funds. From the chart below, we can see that high yield spreads are still +800 over Treasuries. The message of the bond market remains one of extreme caution regardless of what stocks are saying.

Bonds don't trade based on technical oscillators. As opposed to stocks, which bounce solely on short-term lopsided sentiment and psychology measures, providing financing for companies isn't as arbitrary. Stated another way, the real economy is more connected to economic and financial reality during a fierce credit meltdown than in times of relative calm. Not insignificantly, debt levels are also at breaking point levels.

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Source: Bear Stearns

Housing Prices: Bottom anytime soon?

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Source: Bear Stearns

Housing prices have obviously been demolished. That's not news to anybody. The question is how much of the excess is left to work off? Keep in mind the bottom in housing stocks won't necessarily correspond to the bottom in housing.

The Fed's Balancing Act

Despite its best efforts to balance slow growth and higher prices, inflation will continue to remain a headwind that threatens the already struggling consumer.

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The Fed will still need to find a way to resuscitate a consumer that is already on life support. That may be a difficult task with the aforementioned suffocating levels of debt and rising unemployment.

Looking at the charts below, the employment picture is clearly deteriorating. Unemployment trends higher during recessionary periods as we know. As Bear Stearns research points out, "This magnitude of a rise in the unemployment rate has never occurred in the post-war period without the economy being in recession."

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Source: Bear Stearns

Is the credit crunch the jab that set us up for a consumer recession type knockout punch? Time will tell, and we may want to have some smelling salts on hand just in case.

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No positions in stocks mentioned.

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