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Is the Financial Storm Over?


Governments worldwide attempt to address the crisis.


The credit crisis may not be over yet, but we seem to be at an important juncture: Governments around the globe are attempting to address the root of the problem.

The most recent capital injections and federal guarantees have caused a sharp reduction in default risk, as evidenced by Bespoke's index of bank and broker default risk. Bespoke remarked, "Last week, default risk was factoring in a scary likelihood that the entire industry would actually collapse... So far this week, our index ... has declined by a whopping 67% and is at its lowest level since June 23rd!"

Although this is a good sign for both the credit and equity markets, one would also like to see a significant retracement in measures of lending confidence, such as the TED spread (i.e. the difference between what banks charge each other for 3-month loans (3-month dollar LIBOR) and what the Treasury pays (3-month Treasury Bills). This measure of risk aversion and illiquid repo conditions is still at elevated levels, notwithstanding yesterday's decline of 19 basis points.

Source: Plexus Asset Management (based on data from I-Net Bridge)

The major fall-out of the debt crisis is that the world is in recession, which will probably deepen as the path of destruction widens. Unemployment, budget deficits, the impact of the collapse of equity prices on personal wealth, and the effect thereof on spending over the next year or two, await us in the coming quarters.

Not only does the broader economy still face many challenges, but investors are particularly concerned about the earnings outlook and the implications for valuation levels.

I believe Bill King may very well be on the money:

"Once again we must reiterate that the current US deflationary environment has not been navigated since the early thirties and this time it really is different due to the hundreds of trillions of dollars in derivatives. So until stocks fall to grossly undervalued levels by verifiable balance sheet standards, one should remain extremely cautious.

"Those playing the 'E' in PE and other earnings metrics have been getting slaughtered because earnings historically are overestimated by analysts and in a deflationary environment they fall faster than most people can imagine. So you can toss earnings metrics overboard for awhile."

One could argue that stock prices are oversold, creating the potential for a further advance through year-end, especially if credit spreads tighten (i.e. normalize) further. However, stock market valuations are not at the same oversold level as prices, arguing that a secular low may not necessarily have been reached. The third quarter earnings season should provide part of the puzzle
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