Sell stocks while the selling's good

By Jon Markman

Central banks and corporate leaders are locked in the battle of their lives this month as they join in efforts to head off the worst credit crisis in at least four decades, pulling every monetary and fiscal trick in the book -- and inventing some mutant new ones.

Yet veteran observers are swiftly coming to the conclusion that attempts to regain world financial stability could be doomed due to a stunning crash of commercial-debt financing and lack of trusted leadership, and they now believe private investors should take advantage of any rallies to purge their portfolios of most stocks and nongovernment bonds.

Yes, you heard me: On a rebound toward the 1,350-to-1,400 level of the S&P 500 Index ($INX), consider exiting shares of all but the strongest, most creditworthy companies. This bear market is likely not ending soon, the recent 400-point jump in the Dow Jones industrials ($INDU) notwithstanding.

If that sounds like a harsh judgment, or too late, it's because equity investors have been mostly shielded from the wreck that has befallen credit investors. But the firewall that has long existed between the two sides of the global financing system is burning, and it won't be long before the spreading credit panic works its full destructive power on stocks. The typical bear market of the past century has slashed stocks' value by about 30% from peak to trough, so at a current reading of minus 16% we're probably only halfway done. And analysts say the last half of a bear market is more intense, as hope gives way to terror.

Out of time

Although it seems like the debt crisis has been with us for a long time, true panic has been kept at bay because the size of the potential losses has been underestimated at the same time that the redemptive power of government entities like the Federal Reserve has been overestimated.

It's only in the past couple of weeks that investors have been able to determine the potential scope of damage to companies outside banks and brokerages, and those estimates frighten even jaded players.

One leading hedge fund reported in an internal memo this week that "the threat of a death spiral hangs over us" and added, "There is insufficient time for those with the wrong positions to reposition and there is even insufficient time for those with reasonable positions to just get out of the way."

The main problem: Over the past six years, banks and brokerages have lent staggering amounts of money on margin to hedge funds on extremely thin bases of real capital and then allowed them to use that money to speculate on the direction of interest rates, currencies and commodity prices. Now, faced with the erosion of their capital bases from losses in U.S. mortgages, brokers are yanking funds' credit lines on short notice, seizing all collateral and selling it quickly at steep discounts into a market with no bidders.

This is where the rubber meets the road. Much of the seized collateral consists of illiquid asset-backed securities carried on books at prices assigned by computer models, not the market. As soon as they are actually priced by the markets in these fire sales, any similar securities held by other funds are then automatically re-priced to that new lower level -- slashing their value as collateral. In this way, funds that might otherwise be innocent bystanders are dragged into a lethal vortex, as collateral is being downgraded and new margin calls are generated at breathtaking speed. Indeed, the acceleration of this downward spiral in the value of collateral has caught everyone by surprise, precipitating the latest phase of the panic.

Continued: Darwinian dilemmas

 1 | 2 | next >