Stock Investments: Don't be Trapped by Bear Market Rallies

By Tobin Smith, Editor, ChangeWave Investing

Say hello to the Federal Reserve, ladies and gentlemen. After Sunday's unexpected 25-basis-point cut, the Fed continued the trend with a 75-point cut on Tuesday. So how did this affect stock investments?

If you've been paying attention, you're likely thanking the Fed for the bear market rallies that followed. These rallies give us all another chance to lighten up on stock investments and build cash in anticipation for the true end of the bear market.

Don't shoot the messenger, but I have to tell you the worst of the subprime mortgage mess hasn't even begun. There will be more pain before it's all said and done.

So what is the best question to ask after this federal interest rate cut?

A) Do the worst offenders in the subprime market have a liquidity problem?

Or ...

B) Do the financial institutions heavy with subprime debt -- Washington Mutual (WM), National City Corporation (NCC), etc. -- have a solvency problem?

The correct question to ask is B, and we should expect to see lower housing prices and more liquidation, just like Bear Stearns (BSC), before the "all clear" signal is sounded.

Before the curtain falls, you can expect to see more investment banks rolled out on gurneys in an attempt to rectify the gigantic level of bad judgment behind this whole debacle

Now let's not get too bearish here -- we're making progress. Personally, I can't wait to take advantage of some of the great opportunities that lie ahead.

As a matter of fact, at ChangeWave Investing, we're already taking advantage of some opportunities that are just too good to pass up -- particularly in the Freddie Mac and Fannie Mae guaranteed mortgage paper owned by mortgage real estate investment trusts (REITs). That paper is discounted 50% below its actual value.

We're buyers now, and in six to 12 months, I think we'll see 50% to 100% gains, plus we get to collect great dividends along the way.

Come Back to Reality

The denial stage is over. It's time to re-enter reality.

Do you remember when the financial market turmoil was labeled a "temporary liquidity problem" in August? We do. When the B&P Paribas and Bear Stearns hedge funds detonated, they were viewed as isolated incidences.

Fast forward seven months--this "temporary" problem has seen $200 billion (likely will be $500 billion before the end) in bad loans write-offs and the politicians are still in denial. We need to step back and acknowledge that the current situation is not a liquidity issue, and hasn't been one for a long time.

The problem is the genuine uncertainty about the underlying value of the assets, and that's a solvency problem. This problem is intensified by the fact that many of the entities that own these bad assets are financial companies with 20- to 30-to-1 leverage.

There are still dozens of these special purpose entities out there sitting on a platform of paper that's supported by leverage -- and no one has any idea what they're actually worth.
If this were a simple liquidity problem, then the action that's been taken by the Federal Reserve and other Central Banks ($1.5 trillion worth) would have solved things -- but it hasn't. Instead, the Fed's actions have resulted in bear market rallies, followed by pullbacks.

If you still think we're dealing with a liquidity problem, consider the following:

1) The cost of buying credit is higher today than it was seven months ago.

2) Mortgage rates are higher today than they were seven months ago, even with all of the liquidity that has been pumped in by the Fed.

3) Corporate bank debt is now paying a higher rate than what they can hope to get lending the money out, which is unheard of.

We are now experiencing the classic example of what George Akerlof described in "The Market for 'Lemons.'" He basically said that, without better information, it is perfectly rational for the buyer of an asset to assume that the assets offered for sale are lemons, i.e., the bad stuff.
This is why we're currently seeing the flight to quality in the way of Treasuries and other things that people can value, while the rest of the stuff is floating out in la-la land.

Well, at ChangeWave Investing, we are turning lemons into lemonade, so to speak, by taking advantage of some of these situations. But until the financial institutions and politicians come out of denial and we get to the hard business of separating the dead loans from the live ones -- and, unfortunately, moving about 1 million unqualified homeowners back into the apartments they can really afford -- we have more pain to go.

However, we don't need all of the pain out of the markets to get the "all clear" signal for stock investments -- we just need to get about halfway there.

Don't kid yourself, the Bear Stearns takeover is not the last chapter in this story. We are at the end of the beginning.

P.S. The Fed is stepping up to the plate, but it can't fix the solvency issues that need to be worked out before we can start to see a turnaround. But, just because we're in a bear market, that doesn't mean your portfolio should go into hibernation. Try ChangeWave Investing risk-free for 90 days and learn how we're surviving and thriving in this tough market.

by Kim Stup |  03/21/08