Negative Trend Continues in the 3rd Quarter of 2008
By Akber Zaidi
Yorba Linda, CA 

 

The third quarter of 2008 continued the negative trend of this year.  The S&P was down 8.9% for the quarter and is now down 19.4% for the year. World markets are doing even worse with developed countries down 28.3% and emerging markets down over 31.9% year to date.  The credit crisis has continued unabated and threatens our entire financial system. 

Historic events are happening in the financial markets that have not taken place since the Great Depression.  Thirty day Treasury Bill rates went negative for the first time since 1931 in a run for safety from all other assets.  Bank failures are on the rise and thirteen US banks have failed so far this year including the largest bank failure in US history, Washington Mutual with over $300 billion in assets. An additional 100 to 200 bank failures are expected over the next 12-24 months.

We have entered a phase of bank runs nationwide with failures, nationalization, forced liquidation and mergers.  Many of the names that were icons not too long ago no longer exist or have been taken over by the government including Fannie Mae and Freddie Mac, Wachovia the fourth largest deposit bank, Lehman Brothers with a 150 year history, AIG the world’s largest insurer, and Merrill Lynch the world’s largest retail brokerage.  We suggest avoiding the banks and brokers as an investment until we get a bottom in housing prices.

Housing prices continued to decline last quarter. The Office of Federal Housing Enterprise Oversight index showed that average home prices slipped in every region of the country for the first time. The financial system's uncertainty is likely to hinder a housing-market recovery. Buyers now face tighter lending restrictions and often must make bigger down payments.  Our research indicates that real estate will not bottom until mid-2009 or 2010. 

The Fed’s recent attempts at quick fixes have not worked and current events are reinforcing that this is much more than a normal cyclical correction. As the Fed and the Treasury continue to intervene in the market, they continue to lose ground and credibility, caught between a sharp recession and strong inflationary pressures. In an effort to bail out the financial sector, they have no choice but to inject hundreds of billions in liquidity into a contracting market place. This will contribute to the creation of a stagflation period with slow growth and higher inflation that will eventually devalue the dollar.  We believe gold will ultimately become the new store of value and should be bought on any significant declines. 

There is a bigger issue looming and that is the $55 trillion of bond insurance purchased by financial institutions.  These Credit Default Swaps are supposed to insure bonds against default.  This in itself is not a bad idea as it allows financial institutions as well as pension funds, cities, counties and states to purchase bonds and not fear their default. But because this market is not regulated, it allows any one to purchase these Credit Default Swaps without owning the bond.  A simple real world example would be that if I thought you were a bad driver and would crash your car, I would go to an insurance company and get collision insurance on your car.  When your car crashes I would collect on it.  Thus, instead of being used as a hedging instrument to protect the purchase of a particular bond, Credit Default Swaps began to be used as betting instruments on bonds that one did not even own.  So what started out as a vehicle for hedging risk ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, Credit Default Swaps became the world's largest casino. 

The issue now is: if the economy goes into a deep recession and corporations start to fail and default on their bonds how many insurers will honor their Credit Default Swaps and pay on the defaulting bond.  If a significant number of insurers fail, banks and pension funds will be left leaving holding worthless bonds. The bank or pension fund will have to write off the bond and take a hit to profits and their own capital bases. Thus, failures will lead to cascading failures. We continue to believe investors should underweight equities as an asset class and shorten the maturity of bond holdings. 

What can we do?  We are in a recession with falling corporate profits, a collapsing housing market and the largest bailout in our history.  Traditionally the fourth quarter is good for equities and we recommend investors lighten up their stock holdings on any run up into yearend.  We believe gold should be bought on drops in price and a significant portion of investors’ portfolios should be held in cash.   


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Editor: Akhtar M. Faruqui
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