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What's Next For the Credit Crisis? Part 2


The path to Treasuries.


Editor's Note: This is the second of a two-part series. Click here for Part 1.

There are a few other reasons I believe tech would lead another leg down in stocks, namely that the short interest in the largest companies in the NASDAQ 100 are at very low levels, which would suggest a dearth of buyers, should a down move develop. Further, insiders are selling in droves and valuations are hardly inspiring. Mutual fund cash as a percentage of assets remains at very low levels (as it has since 2000) and the best potential outcome for the stock market would be persistent sector rotation as opposed to broad market strength. More likely I expect large net redemptions from mutual fund investors that need to get cash from somewhere as they have exhausted all other avenues for liquidity. Consumers have already tapped home equity extraction and credit card advances, which in turn could lead towards a self-fulfilling prophecy of lower equity prices that lead to more redemptions, and so on.

And let us not forget the hedge fund industry, where returns have been better than long-only investing, but nothing to write home about as a group, which could also prompt redemptions in that space as well. Considering the leverage that many funds employ (present company excluded as my firm utilizes limited leverage), it has the potential to set off quite a dramatic sell-off. This scenario seems more likely to me these days as the markets seem more random (everything from equity futures to bonds to commodities) on a daily basis in terms of unexpected volatility.

Other industries that I find susceptible to a move lower include transportation, commodities, materials, and manufacturing concerns. The concept of a "black hole," which I mentioned in my last piece (and a concept that I borrowed from a good friend of mine) seems to want to play out.

Black holes basically absorb anything in their path, and now that banks and brokers have been absorbed, other industries are being sucked in. Let's not forget about retailers in general. I know that some companies have benefited from the economic weakness, like discounting giant Wal-Mart (WMT), but they are not immune to a general economic slowdown any more than Costco (COST) is (I recognize that Costco is a well-run organization but is hardly the bargain at nearly 30 times trailing earnings). I realize that they are expanding into China and other developing nations, but those nations are not immune to the U.S.' macroeconomic issues. Rather, they rely on our consumption and deficits to recycle our dollars into our assets.

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Speaking of foreign investors, Sovereign Wealth Funds were early buyers of brokers and banks seeking fresh capital to cover their mortgage backed securities write-downs, but they have seen their purchases fall by 25 to 50%, and they were notably absent from Lehman Brothers' (LEH) capital raise done last week. Speaking of Lehman, it's temporarily managed to stay out of the hands of a suitor (rumored buyers have been everyone from Goldman Sachs (GS) to BNP Paribas), but that will prove temporary in my opinion.

Let's face it: It took David Einhorn, a savvy hedge fund manager, to undress Lehman's inability to price its own assets, and the obvious lack of ability for top management to assess its own portfolio and all in a span of days when the COO and CFO were unceremoniously dumped.

The thing that bothers me is that I don't think Lehman is alone. In fact, I think it's the poster child of the financial system.

I don't believe that most investment banks and other financials have any clue how to value many of their assets.

Pile 25 to 40 times leverage on top of his mess and, I have to admit, it gives me the shivers.

I find it interesting that so many companies, from General Electric (GE) to Merrill Lynch (MER), to KeyCorp (KEY) and National City (NCC) and Lehman have such lack of risk controls that they act surprised when the values of their securities suddenly drop and they have to write down assets. We need to be on the lookout for more of this activity as the assets held from everyone from hedge funds to mutual funds to financial institutions are about to face Phase 2 of the credit crisis, when loan performance continues to worsen as the stretched consumer pulls back from purchasing all but necessities and corporations find their inventories rising, which in turn leads to less manufacturing and finally higher unemployment. This will go on and on until the painful de-leveraging process is completed. This train of thought should help explain our cautious, and sometimes downbeat, view of equities and credit risk.

There has been considerable jaw boning by the European Central Bank and the Federal Reserve about inflation of late. The jaw boning has been so severe that Treasury notes have sold off violently, so violently that I suspect some large market players like macro hedge funds were taken off guard. The markets have taken on an almost surreal, random intra-day feeling on some days, frustrating many, present company included, which has led me to trade smaller and play closer to the vest until the market takes on a more rhythmic feeling.

When yields of 2-year Treasury notes can move 40-50 basis points in a day or two with nominal yields in the 2.5% range, it is easy to see how prudence will likely be rewarded. As rates have risen into the 3% range in 2-year notes and closing in on 3.75% in 5-year notes, I've taken a strategic long position as I feel that fears of Fed tightening will prove unfounded; in fact, I'm leaning heavily towards the deflation camp over the coming year or two as debt destruction leads to deflation.

It seems that we're facing an "inflationary recession" head on, which is not the best of propositions when one considers the debt that has piled up in nearly every part of the system, both in the U.S. and other parts of the world. Higher rates in an over-leveraged system are a self-fulfilling prophecy, in my view. And while I believe that the financial sector, as a whole, has been hit hard, credit issues from other parts of the economy, both domestic and abroad, are yet to be heard from and I believe that Treasuries will once again be in favor after this bout of weakness.

Don't forget, "Buy when you can, not when you have to." I find flight to Treasuries all but inevitable in coming months. Recall that Chairman Bernanke is known for being one of the most educated regarding the period of the Great Depression, when the Fed made the mistake of raising rates, which led to a more prolonged period of economic duress.

In summation, it is my opinion that we need to continue to respect the credit crisis and its potential impact on other parts of the economy. Frankly, I can't come up with a sector that isn't either "damaged goods," overvalued, or in many cases, both. As a result, we continue our cautious view in general, but will begin to focus on groups of equities and debt that will likely come under attack as the credit crisis makes its way through our markets and economies worldwide. We cannot forget a few valuable investment management commandments:

  • The key to making money is not losing money.
  • Buy from the fearful, sell to the greedy.
  • Keep volatility of return low and avoid large draw downs.
  • Buy when you can, not when you have to.
  • Do not burn through "emotional capital."
  • When in doubt, play small until the trend becomes obvious.
  • Better to lose opportunity than capital.

As we head into what may arguably be a tough couple of years, the seasoned investor with risk controls will likely come out on top. Those that have lived through credit crises before will emerge the likely winners. At Atlantic Advisors and in the Harbor Pilot Fund, we're looking forward to the challenges ahead and hope to come out on top with both our investors' capital intact and hopefully some solid gains. That would then allow us to take risk when others are not in position to do so.

While I know I have sounded a bit like a broken record these past seven or eight years, warning about high equity valuations, the monstrous buildup in debt not to mention the leverage in the financial system, I suppose I would rather sound like a broken record than go broke. Or as Paul Thorn aptly sings, "I'd rather be a hammer than a nail."

No positions in stocks mentioned.

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