Sell stocks while the selling's good
The euphoria over the Dow's 400-point day isn't going to last. But smart investors can avoid the worst of any train wreck ahead by unloading most stocks and nongovernment bonds soon.
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.
Two recent victims of this practice have shocked the world of high finance: Peloton Partners, run by two former Goldman Sachs (GS, news, msgs) partners in London and celebrated as fixed-income fund of the year for earning over 86% in 2007, and Carlyle Capital, a spinoff of one of the world's most powerful private-equity firms, Carlyle Group.
Peloton couldn't meet margin calls from its prime brokers, including Goldman Sachs, and was shut down Feb. 28. Carlyle Capital, which had leveraged $680 million in real capital by 32 times into a $21.8 billion fund, has failed to meet repeated margin calls and is on life support as partners look for quarters and dimes under the seats of their Bentleys.
It's a little hard to believe that brokerages would force their best clients into ruin, but that is the emblem of the current panic. Think of it as a form of extreme economic Darwinism, as brokerages decide that it's better to cut their customers' throats than to face the executioner themselves.
Remarked one veteran bond market strategist: "Regulators have set up all these rules about margin to give the little guys in the stock market the impression that investing is on the up and up, but there's nothing like that in bonds. That's just the way it is -- welcome to my world. A broker will give you 32-to-1 leverage today, but the trade goes 3% against you, they'll cut you off at the knees."
The strategist, who asked that I not use his name, said equity investors need to understand two points about what's happening in the land of credit:
One is that the extreme level of borrowing that pushed the market to new highs last year (via leveraged buyouts, corporate share buybacks and the momentum style of trading) is gone. "You only get one chance like that in a generation," the strategist said, laughing. "That money ain't comin' back."
The other is that debt panics can last a lot longer than anyone expects because there are only a couple of exits in a crowded room. The strategist notes that dozens of billion-dollar funds had identical trades, and they're all trying to get out of the same securities at the same time in a market with no bids. Unlike stocks, which represent the earnings streams of companies that file quarterly reports, asset-backed bonds and the collateralized debt obligations into which they're packaged are opaque, hard-to-value instruments originally sold person to person in private placements where no illusions of transparency or disclosure are even attempted. "The lack of transparency is why credit panics are never a one-day or one-week deal," the strategist said. "They last until everyone is out of the room. It could take months. Could take a year."
In this context you can think of the Fed's move Tuesday to accept $200 billion in AAA-rated securities from banks and brokers in exchange for Treasurys as little more than a modest money-laundering scheme. Although it is accepting mortgage-backed securities for the first time, the Fed isn't taking any of the really bad stuff that's gotten investors into trouble, and its bond whitewashing service will last only a month. It buys time more than anything else.
Switching metaphors, the world financial markets right now are like high-stakes poker games in Las Vegas, and the casino's largest players are on the ropes. Recognizing that they are in trouble, and not wanting the game to end early, the house has decided to act like the world's biggest pawnshop. The players have already pawned their gold Rolexes. Now the Fed is accepting their wives' wedding rings -- but no houses, cars or boats. Maybe after the next hand.
Sell stocks while the selling's good - MSN Money