Growth stocks for pessimists

The percentage of U.S. mortgages in default climbed to an all-time high in the first quarter of 2007 -- and it's still rising. The percentage of mortgages in foreclosure also has increased. According to the Mortgage Bankers Association, in the second quarter of 2007, 0.65% of all loans on one- to four-unit residential properties entered foreclosure. That is a record in the 55-year history of the survey, breaking the record from the quarter before. A year ago, just 0.43% of loans entered foreclosure.

In fact, the problem is not just that the market is setting a record for the percentage of foreclosures and delinquencies. Thanks to the mortgage-lending and housing-price booms, there are a lot more mortgages to borrowers with shaky credit out there than there used to be. In the second quarter of 2002, according to the Mortgage Bankers Association, there were 1.2 million subprime mortgages outstanding, while in the second quarter of 2007, subprime mortgages outstanding numbered 5.9 million.

Central banks open the floodgates

Even as the number of mortgages and the number of portfolios holding mortgage-backed assets in trouble continues to climb, the current crisis has moved to Stage 2, "The Bailout."

On Aug. 9, the European Central Bank pumped $130 billion in liquidity into the European financial markets. The move followed hard on the heels of news that BNP Paribas (BNPQY, news, msgs) had frozen the assets of three funds worth $3 billion because of the funds' exposure to assets backed by subprime mortgages. On Aug. 10, the bank added $84 billion more in liquidity to the markets.

The same day, the U.S. Federal Reserve added $24 billion in liquidity to the markets. The next day, it added $38 billion more.

On Sept. 6, the Fed added $31 billion, following an overnight injection of $60 billion by the European Central Bank.

The war on inflation is over

In effect, the Federal Reserve, the European Central Bank and other central banks, such as the Bank of England, have become lenders of last resort -- at fire-sale prices. The European Central Bank offered its Aug. 9 loans at 4%, for example. Banks have been hoarding capital so that they can fix their own problems, and that has left borrowers seeking funds desperate for cash. The central banks have stepped into the gap by providing billions in loans to banks so that they can keep lending to battered investors in the asset-backed securities market.

This huge injection of liquidity into the financial markets puts an effective end to any real fight against inflation by the Federal Reserve and the European Central Bank, which sets us up for Stage 3 of the crisis, "The Shock."

Over the next few weeks, as investment companies and banks report their quarterly numbers, Wall Street will profess shock at the size of the losses and write-downs. I fully expect a "kitchen sink" quarter where the big players in these markets -- Bear Stearns (BSC, news, msgs), Goldman Sachs (GS, news, msgs), Barclays and JPMorgan Chase (JPM, news, msgs), among others -- write down everything they can in an effort to put the crisis behind them.

More trouble, and more optimism, to come

Will they really have written off all their losses? Not a chance. Unwinding all the vehicles involved and pricing every infrequently traded asset will take quarters yet. I expect that we'll see other shoes drop at all these financial companies every quarter for some time to come.

But the size of the losses announced for the third quarter will be enough to let Wall Street feel that the worst is over. Bet your last dollar that you'll start to see talking heads argue that this is the bottom and that it's time to buy.

That argument will have just enough evidence behind it, and the financial markets will have more than enough new liquidity in them to produce a solid fourth-quarter rally sometime after mid-October.

Good refuges for your money

If that comes to pass, just remember that the central banks have done nothing more than paper over the current crisis. The long-term problems that have made this a period of boom-panic-boom in the financial markets will remain in place.

With this all as backdrop, I want to add more exposure to gold to Jubak's Picks. (See the updates at the end of this column for a specific pick.) That's a way to profit from the upturn in inflation that all this added liquidity will bring.

And I want to add growth stocks to take advantage of the likelihood of a post-shock rally. I've put together a list of five names -- all stocks with good growth stories in a sector that offers some protection in case of an economic slowdown. The list consists of Ceradyne (CRDN, news, msgs), DaVita (DVA, news, msgs), Itron (ITRI, news, msgs), Jacobs Engineering Group (JEC, news, msgs) and Nvidia (NVDA, news, msgs). I'm adding DaVita to the portfolio with this column. I'll look to add other names from this group during what I expect to be a very volatile September and October.

Continued: Updates to Jubak's Picks

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