Wait out a weird stock market

By Jim Jubak

I'd feel a whole lot better about 2008 if the stock market in 2007 wasn't quite so perky.

The steady stream of negative news about the debt markets adds up to the possibility of a full-fledged crisis in the financial markets, yet, as of Wednesday, the Dow Jones Industrial Average ($INDU, news, msgs) was down just 7% from its all-time closing high of 14,165, set on Oct. 9.

Something's out of whack here.

The stock market seems to be looking past the current crisis in the debt markets, the possibility of a recession in 2008 and a lot of other bad news. Current prices are reasonable only if the debt markets and the economy will hit a bottom by mid-2008 and be on the road to a second-half recovery.

Could be. At this point, the optimists think it won't get too bad. Their view:

• The economic downturn will stop short of a recession, and the crisis in the banking system won't take down a major bank, set off financial panic or produce a global credit crunch.

• The bottom will be sometime in the middle of 2008. By that time, investors will be able to see the end of write-downs from major banks and signs that housing prices are starting to stabilize.

• Stocks will hang on for the first half of 2008, as repeated interest-rate cuts from the Federal Reserve prop up the market, and stage a strong rally in the second half of the year, as investors anticipate a return of higher economic growth.

Pessimists don't buy it:

• They put the odds of a recession in 2008 at 50% or more.

• They don't think the Federal Reserve can bail out the financial markets without triggering runaway inflation.

• They don't buy the argument that growth in the rest of the world will be strong enough to keep the global economy chugging, even as U.S. consumers go into retreat.

• They think at least one big-name financial institution will announce it's broke and that we won't see the end of damage to the entire sector's balance sheets until 2009 or later.

• They think housing prices will sink for all of 2008 and 2009.

• And they think stocks will be down for all of 2008.

All of that leaves the risk for 2008 definitely on the downside, so investors should hope for the best and plan for the worst.

A stunning rise and fall

The collapse of the debt markets in 2007 was stunning in its speed and extent. Let's look at just one of these markets, that for commercial paper backed by such assets as mortgages, car loans and credit card receivables. What had been one of the fastest-growing financial markets in the world collapsed even faster than it had expanded.

The volume of asset-backed commercial paper had soared to a peak of nearly $1.2 trillion by the beginning of August. That was a huge increase -- $357 billion, or 43% -- in the size of this part of the capital markets.

By Dec. 12, according to the Federal Reserve, the market for asset-backed commercial paper had shrunk to $791 billion, a drop of 34%. In a little more than four months, almost $400 billion in capital had vanished from this market.

Those who are pessimistic about 2008 use that data to make three points:

• The contraction in the asset-backed commercial-paper market isn't over. Nothing the world's central banks have done has brought buyers back to this market, which is so critical to companies that need working capital but have less-than-sterling credit ratings.

• The collapse of this particular market is just one of many collapses. For example, assets held by structured investment vehicles, or SIVs, have collapsed from a peak of $400 billion in July to just $150 billion in December. Banks set up SIVs to make money by borrowing at lower short-term commercial-paper interest rates and buying higher-yielding long-term debt.

• Many of the steps that have kept the financial markets from collapse are just Band-Aids that actually increase the odds that what started as big but limited losses in the mortgage sector will turn into a disaster for the entire financial system.

For example, while the Federal Reserve and the European Central Bank are getting the headlines, it's the little-known Federal Home Loan Bank system -- a group of 12 private banks funded by thousands of financial institutions, set up in 1932 during the Depression -- that has kept the mortgage market from imploding.

Continued: Banking on a guarantee

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