Why the banks won't bounce right back

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In the last three months, I've come to the conclusion that the credit crunch is one of those rare events that is significant enough to change our long-term outlook and investment strategy. Here's why.

Banks used to give loans only to people they believed would pay them back. This was the business model of every bank -- until the securitized loan business invented a new school of go-go banking.

It's that business which has broken down.

For banks, the securitized loan business model offered two big advantages. Since the loans were packaged and sold to investors, the quantity of loans a bank could make was not limited by its capital. And the bank was off the hook if a loan wasn't repaid.

The profits generated from securitizing loans made a big contribution to earnings growth in the financial sector. And therein lies the problem for stocks. The shutdown of the securitized loan industry is going to take a big chunk out of the earnings of Washington Mutual (WM, news, msgs), Citibank (C, news, msgs), Merrill Lynch (MER, news, msgs), Bear Stearns (BSC, news, msgs) and other names that were the leaders in securitizing loans.

No financial rally in sight

Investors might be able to look past the big subprime mortgage write-offs if they believed the banks' problems were behind them, because in the end, market prices reflect future earnings. But without a source of earnings to replace the profits that used to come from securitizing loans, it will be difficult for the financial sector to sustain a rally.

So although the financials have taken a beating, I am not at all tempted to bottom-fish the sector because I don't see how earnings can recover. Further interest-rate cuts will not restore the securitized loan industry, so if earnings are to recover, they are going to have to come from something else that I don't see right now.

Lower interest rates, however, have already started to impact the rest of the market by driving the dollar to new lows and the price of oil (and other commodities) to new highs. This is likely to continue, because the Fed seems determined to lower rates as much as is needed to address the problems in the financial sector.

The economy will bounce

Reducing interest rates is the most potent tool the government has to stimulate the economy. By reducing interest rates so much so fast, the Fed has put more stimulus into the economy than we've seen in many years. The problem is that it often takes nine to 12 months before the impact on the economy is noticeable.

Since interest rates started to come down about six months ago, I expect the economic statistics will get worse and the market will be weak until sometime in the third or fourth quarter of this year. But once the effect of all the interest-rate cuts works its way into the economy, we may see the best economic growth we've had in years.

The market is currently pricing in a long, drawn-out recession. If we start to see an improving economy later this year, many stocks outside of the financial sector could come roaring back.

At the end of last year, I changed the lineup up of the m100, the group of proven investors who advise us at Marketocracy.com, to remove members whose track records told me they were skilled in making money only in the financial sector. This change is the single biggest reason why my mutual fund -- Marketocracy Masters 100 (MOFQX) -- although down, is ahead of the market so far this year.

Over the last seven years, many of the current m100's most profitable positions were purchased when the market was engulfed in fear as it is now. The ability to pick the right stocks when everyone else is afraid is the skill that I think is most important to have on my team right now. If you agree, send a message to me at kenkam.mofqx@marketocracy.com to let me know.