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Last week, it's true, I raised the possibility that aggressive, coordinated, rapid action by the Federal Reserve, the Bush administration and Congress could lead to a massive bailout of distressed property owners before the 2008 election -- a monetary "surge" to match the troop surge in Iraq this year. Yet neither the industry nor the administration have proved themselves capable of smart, aggressive action on any topic, much less the most complicated financial mess of all time -- so a sudden revival of financials' fortunes seems as remote as peace in Baghdad.
As government officials and bank officers have dragged their feet -- deploying misplaced faith in the Fed as their main weapon -- the investment world has become divided into two camps:
- Optimists think the "real" global industrial economy is so robust, driven by insatiable Asian demand, that it cannot be driven off track by some dinky problem with subprime mortgages in California and Florida. They think every sell-off is a buying opportunity and that all ailments can be fixed by prudent, measured liquidity injections by an accommodating Fed. This point of view accounts for rallies like the one on Sept. 11.
- Pessimists think that the financial "plumbing" that underlies the global economy has become hopelessly clogged and is much too complicated to fix merely by trying to flood it with more money. They believe that a dysfunctional financial system will lead inevitably to cracks in the optimists' idealized "real" economy, preventing businesses from being financed. They point to evidence the trillion-dollar market for a type of corporate short-term debt known as commercial paper has frozen, as investors who would normally buy it without question are afraid that it is fatally tainted with hidden pockets of broken mortgage loans. They further point out that the Fed cannot rescue the market, as the trouble with bad paper extends to Europe and Asia, where central banks are actually still raising rates.
How will these divergent views be reconciled? I think that slowly but surely, the optimists and pessimists will merge into a consensus dominated by skepticism and anger. My guess is that financial stocks will suffer through the end of the year unless the Fed applies shock treatment to the financial system by slashing the federal funds rates by 50 basis points or more next week and joining hands with their European counterparts to do the same.
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Without coordinated action, the dollar will be crushed, foreign investors will come to U.S. markets simply to borrow cheaply and invest elsewhere in higher-yielding currencies, U.S. economic growth will remain stagnant, more layoffs will ensue, and we'll see a spike in inflation to boot. The best position to own will be the ProShares UltraShort Financials (SKF, news, msgs) exchange-traded fund, which supplies twice the inverse action of the Dow Jones Financials Index.
In short, the only real way out of this mess is the hardest. Financial executives need to bare their souls and balance sheets, let bad loans default and permit companies and individuals that took inappropriate risks to go under. Only after the true value of assets are laid open for all to see will the financial institutions reach fair value and we can move on.
Fine print
You've probably heard that September is historically not a very good month for stocks. But just to throw some more fuel on the fire, it turns out that in the eighth years of decades (those ending with 7) they're especially bad.Logical Information Machines asked its database: How has the Dow performed in September and October in years that end with the digit seven? The answer: According to the 11 previous occurrences, the Dow has shown a strong bearish edge that peaks on Oct. 31. The Dow has declined from the first week of the month forward by 38 trading days in 10 of the 11 cases since the late 1800s by an average of 12.1%. The one rally provided a gain of 3.8%.
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The overall return of the 11 cases is minus 10.6%, which, if it were to transpire now, would result in a Dow of 11,723 by the end of next month. The 1987 crash is included in the results, of course, but there are also several other years, especially early in the Dow's history, when there were double-digit declines. History is not destiny, however, so hopefully this fate will be avoided in 2007.
At the time of publication, Jon Markman did not own or control any securities mentioned in this article.
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