Has the Fed redeemed itself?

By Jon Markman

Two weeks ago, the world financial system hung by a thread as a battle raged among corporate leaders, government officials, portfolio managers and independent traders to control its destiny. Half wanted to pull it down and spill the globe into economic Armageddon for personal profit, while the other half fought to stave them off.

It will be months before we understand exactly how the good guys won; for now, we know only that the Federal Reserve Board staged a stunning coup d'etat in Washington last week, fulfilling its goal of stability at any cost.

Backed by allies in the Treasury Department, the bank regulator brazenly tossed aside decades of precedent and law to wrest control of the brokerage industry from its usual overseers at the Securities and Exchange Commission and forced the reckless directors of Bear Stearns (BSC, news, msgs) into a shotgun marriage with JPMorgan Chase (JPM, news, msgs) that appears to have prevented disaster.

Before Fed chief Ben Bernanke and the head of the New York Federal Reserve Bank, Tim Geithner, displayed such unexpected cunning and speed, the world equity and debt markets were on the verge of collapse. In a climate lacking leadership and trust and characterized by a total lack of transparency, a crash was possible. And that's why I wrote a column suggesting that readers sell all but their strongest stocks on any bounce to the 1,350 to 1,400 level of the S&P 500 Index ($INX).

Times -- and my mind -- change

Now here we are that level, and I am happy to rescind my blanket sell recommendation, as the worst of the threat has likely passed. Don't get me wrong: The credit crisis isn't over, massive mortgage losses still imperil bank earnings, recession will still wreak havoc on corporate results, and the bear market could well continue at a lackluster pace for many more months.

But the Federal Reserve's outside-the-box decision to prevent the market from forcing Bear Stearns and its network of satanically intertwined risks into bankruptcy has likely prevented total ruin. And now that Fed and JPMorgan have studied the books of The Street's most irresponsible company, they know where the worst risks are buried and how to neutralize them.

In other words, we aren't out of the woods by any means, but with risks much better understood today, the worst actors sidelined and transparency opening up, we can get back to the usual business of the markets, which is allocating capital at a measured pace to deserving entities for legitimate business purposes.

So what are the prospects now? Maybe not so bad now that the anguish of extreme volatility is receding and we can settle more into the mode of being buffeted by strong breezes rather than being knocked down by hurricanes.

Indeed, we could be coming into one of the most ideal periods for long-term investors, for stocks virtually always start to levitate off lows when a recession is halfway complete, as institutional investors begin to look through the pain and fog of consumer-spending weakness and corporate-earnings shortfalls to a time when inventories will be cleared out, banks will be lending, enterprises will be buying equipment, transportation companies will be shipping orders and consumers will regain their taste for malls, hotels and restaurants.

Although this feat of imagination sounds simple, this is one of the hardest tricks in the book to get right because it requires investors to get the timing of three things right: You need to figure out when an economic contraction started before it has been officially labeled a "recession," figure out when it's likely to end and then pick the midpoint.

It's like a quarterback throwing to a spot downfield rather than directly to a receiver. When it works, you look like a genius; when it doesn't, you can lose your career.

All's well that ends . . . when?

Though difficult, there is never any shortage of investors willing to try their hand at this game, and that accounts in large part for the past two weeks' rally in the shares of transportation and retail companies, known as "early cyclicals" in the trade, whose fundamentals look abysmal today and are expected to be lousy for at least the next three to six months.

The big bet is that a recession started in the fourth quarter of last year and will end in the second quarter of this year. That would put us currently astride the gloomiest days of recession, when news should be the worst. The idea is predicated on the guess that we'll see rip-roaring third and fourth quarters once tax-rebate checks kick in and are complemented by a new spree of cash-out home-equity refinancing as interest rates fall to rock-bottom levels. And it depends on the notion that a suddenly innovative Federal Reserve will mitigate the global credit crisis by agreeing to take troubled U.S. banks' and brokerages' mortgage and derivatives risks onto its publicly financed balance sheet.

Continued: Looking at the potential

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