Europe vs. the World - Can the E.U. survive this debacle?

As we have been facing this complete freefall in the market (can someone say capitulation?), I think we need to evaluate where to put our hard-earned dollars when it comes to the equities market. As I've stated before, I believe that we are facing deflation, in spite of all the unsuccessful US actions to increase the money supply, and try and shore up the lending system. With lending at a standstill, and deleveraging already underway with the banks, I often wonder where to put my money. But a more pressing issue to the world should be, how will the E.U. deal with this?

The reason why this question is so pertinent is that the European Union has one central bank for those countries that use the Euro (so U.K. is excluded among a group of the E.U. countries). That assists the Euro-zone in creating a central interest rate, and a central monetary policy. The big problem within the E.U. is that each country has its own Treasury function, and each country still has its own government with its own budgetary system. Because of this, countries in the Eurozone will decide to take different actions to shore their economies, thereby affecting all countries in Europe. This can create a worse problem than in the rest of the countries around the world. When a country doesn't control its own monetary policy, but controls the treasury function, it can only hinder coordinated attempts to stabilize an economy. I will be interested to see how Europe copes with the current meltdown, and I even feel there is a remote possiblity that the Euro could be rejected in some countries and even the total rejection of the European Economic Community by others.

What was Congress thinking? Markets collapse in the wake of "No" Vote.

I'm not going to mince words. The U.S. Congress showed its true lack of leadership, and its total ineptitude in the face of the worst economic crisis in the last 80 years. Congress is holding the world hostage, in the face of an election. This may be the first time in a few years that I have felt that George W. Bush, who has nothing to gain from pushing the $700B package, appeared to be acting in the best interests of the United States (and the world for that matter), while the U.S. Congress was doing just the opposite. In order to get re-elected, these people are willing to vote down an economic plan to unfreeze the credit markets (not "bailout" the financial system, as everyone is stating) by purchasing already discounted debt-backed securities, providing much-needed liquidity to the banking system, so that they can lend to each other, and more importantly open credit markets up for businesses and people. I'm surpised the markets didn't fall further. You only have to look at the terrible deal Caterpillar had late last week to see how bad it has gotten.

A company of the caliber and creditworthiness of CAT having to pay huge premiums in the credit market makes me question whether many companies will even be able to borrow to finance short term cash requirements, like employee salaries and working capital requirements. This means obvious things to me: companies are going to hoard cash, reduce their payrolls by cutting staff, and reducing capital spending over the next year. This ultimately will result in pushing us further into a deflationary market, worldwide. A credit crisis as intertwined as this means no country is immune to its issues. Deflation is the worst disease to strike an economy. It results in a downward spiral - this toilet will flush like it's broken, and we don't have a plumber to fix it. As deflation occurs and Wall Street suffers, people on Main Street will lose their jobs, lose their homes, lose everything - I'm not trying to be an alarmist, but the market needs intervention, because it won't resolve itself until most banks in the U.S. fails (the small regionals - remember, over 1,000 failed in the 1980s and 1990s in a less serious crisis). We only have to look at the Japanese markets to see that this can be a long drawn issue. Eighty years of inflationary growth presents a potentially long-term deflationary issue for the markets.

So what does one do in this market? The only thing I can see myself doing (and I'm not an expert nor am I recommending you follow my advice) is reducing risk and buying the companies that I feel are best of breed. I will not be selling in this market: as much as I hate the actions of the US government, I still feel that things can change in an instant, and I know that I am not smarter than the market. Not only will I maintain my asset allocation while facing this uncertain and tough market, I will actually add to my portfolio in stocks with little or no debt, but only in cases where their competitors have moderate to vast amounts of debt. Stalk these companies - they are being punished in the down market, and they may earn less money in the future. However, these companies will have pricing power, and they will have long term competitive advantages. As their competitors fail or downsize, they will be able gain market share for many years to come. And if they haven't raised money in the equity markets (as a substitute to the credit markets) over the last 3-5 years, even better. These companies are growing organically, and won't need capital while others suffer looking for it, and getting punished in a risk-averse market. In my retirement accounts, where I hold no individual stocks, I will simply continue my pre-authorized purchases, and re-allocate at the end of October.

U.S. Actions on the Markets

This was an unprecedented week in the markets (but isn't every week unprecedented?), with the US financial landscape forever changed with the bankruptcy of Lehman Brothers, the acquisition of Merrill Lynch by Bank of America and the US taxpayers' bailout of AIG, the world's largest insurer by assets. Only one word can be used to describe this: wow!

With the markets in turmoil, and financials falling precipitously Thursday morning, word spread of a government-sponsored plan to thaw the frozen credit markets with an RTC like entity (RTC was formed and funded by the government in the 1980s to buy assets of banks and sell them in the markets. It ultimately made the US taxpayer a tidy little profit). This was an incredibly bullish move for the markets, and investors were right to cheer this move as it will only benefit the world credit markets, and prevent the world from falling into a severe depression, and destroying tremendous value in the markets. This plan was announced later Thursday evening in a bipartisan news conference.

While I cheer the moves of the Treasury Secretary Paulson, along with Bernanke and US Congressional leaders, I think that the SEC has overstepped their bounds. The SEC thought it would be wise to ban all short selling on 799 financial stocks (including many that I own). By banning short-selling, essentially we have prevented one of the most efficient corrective measures in the marketplace - we as investors can sell shares of stocks we believe are overvalued to bring them down to fair value. The SEC has blatantly allowed short selling on all stocks at all times, even as they fall (selling on "downticks" - when a stock's price is falling on the exchange), and now, instead of reimplementing the "uptick" rule (that was first implemented after the Crash of '29), they eliminate the practice altogether? This socialistic move will not prevent the declines in the marketplace for financial stocks, and really is a targetted move against hedge funds - it's funny how politics gets in the way of free market capitalism. The US (and UK, I may add) took a giant leap backwards with the full ban of short-selling on financial stocks, and this will not ultimately stop the declines in the marketplace.

A final note: what was happening to financial stocks was not unhealthy. It is important to note that banks were lending callously and without regard to risk when they sold mortgages to unworthy customers. The investors in these banks should be punished for reckless abandonment of risk-reward modelling. While the world governments need to protect everyone from complete collapse of the financial system (by saving those "too big to fail" like AIG), they should not stop the markets from running effectively. There is always collateral damage in the marketplace - let the system cleanse itself, even if it involves a little hemorrhaging. We will see in the weeks following October 2nd whether the short selling ban really "saved the death spiral".

The Financial Market Turmoil - a Thesis

I've been a short-term bear of the market for some time, but I will never EVER get out of the market because of this. I may invest in ETF's that short the market (as I have since Bear Stearns collapsed) with SDS, HXD (on the TSX) and FXP (shorting China), but I always want to maintain my positions in the market, as you never know when the market will return to the good old bull days (of course, as a value investor, I'm a long-term bull). That said, I believe we are in the late innings of the financial crisis, but we are only in the first few in the US and global recession.

This credit crunch has been a lot deeper than most people really thought. The subprime mortgage mess was perpetuated by 1% interest rates in 2002-2003, and resulted in millions of US households investing into an already heated real estate market. Because housing prices were flying high, banks were giving away mortgages like they were candy: with little income and little downpayments, people were buying houses way over their budget. The banks packaged these loans and sold them to other banks (mortgage backed securities - or MBS). Banks also buy insurance against borrowings amongst each other when they either swap securities or lend cash (credit default securities). All of these securities are under pressure these days. Liquidity is drying up, as individuals shift monies out of financials and into the safety of treasury bills (taking the money out of the banking system, and banks are now trying to deleverage themselves. This is problematic for the world market.

Since banks are deleveraging themselves, they are essentially trying to sell assets (or even denying mortgages/loan renewals) and thereby getting liabilities off their books - by repossessing assets, or by allowing other companies to lend the funds to the companies that they have denied. Banks are also failing to lend new projects, including formerly lucrative gold or oil projects. As banks reduce their liabilities, investors have less money to invest with, and consumers have less money to borrow so that they can consume. Essentially this lowers demand for everything, including commodities. Therefore, we see commodities falling, companies lowering earnings and revenue estimates, as everyone tries to pay down their debts.

The cycle then brings down world markets as demand dries up for foreign products by US consumers. As the biggest consumer of foreign goods, this will destroy growth stories for the BRIC countries further than they already are, and Europe will continue to weaken. The world markets will continue to decline, until the US banks lend again, and the US consumer spends again. Disinflationary or deflationary pressures will bring prices down as the price of consumer goods decline (since unemployment will increase, and commodities will continue to fall), and no consumer wants to buy something today, when it will be cheaper tomorrow. Therefore, prices will continue to fall, similar to what is happening in Japan for years.

Once again, this is just a theory. Your comments are welcome.

I have long positions in FXP, SDS and HXD.