Thursday, April 10, 2008

A Moment of Clarity

“…it is now clear that the current turmoil is more than simply a liquidity event, reflecting the deep-seated balance sheet fragilities and weak capital bases, which means its effects are likely to be broader, deeper, and more protracted.”

IMF Global Financial Stability Report
April 2008

This has been a truly remarkable week, one that alcoholics refer to as a “moment of clarity”.

On the foreign policy front, US Senators and other congressional members awoke this week from their multi-year stupor and managed to pin the clarity tail on the Iraq donkey when they finally and pointedly asked the right question – what constitutes success? Combined with the now clear evidence, courtesy of the testimony of Gen. Patraeus and Ambassador Crocker, that in 2006 the Bush Administration, just prior to the midterm elections, “misled” (“misspoke’?, pick your euphemism for lying) the US public with statements regarding the state of affairs in Iraq, perhaps a more clear-headed discussion re Iraq can now ensue.

As vital as this matter is, it is the clarity that emerged on the financial and economic front that I wish to focus on.

This week witnessed the publication of a must read document for every investor – the IMF’s “Global Financial Stability Report”. Having just picked up my printed copy of the 208 page tome, I have begun to wade into the report and can see from the very first pages that this report will pin the clarity tail on the credit crisis donkey in a way that no other report or commentary has done thus far. Here is a sample of what I have read thus far:

• The report provides a clear recognition of not just the scale ($945 billion loss estimate) but the scope of the credit crisis, specifically it’s not just a subprime problem.
• The report identifies perhaps the most critical aspect of the crisis, namely deleveraging.
“Macroeconomic feedback effects” are a high concern, specifically the likely consequences that deleveraging and the reduced credit lending capabilities of financial institutions will have on further economic activity. (This point has been noted on this blog and in recent reports published by my firm.)
“Private sector incentives and compensation structures” will need to be addressed. This is a clear reference to the agent/principal problem that animal spirits unleash. Normally, a market problem only but not when bailouts and politics come into the mix.

Investment Strategy Implications

Any investor thinking that the credit crisis has passed is operating in a state of denial.

The ramifications of a new financial order cannot be over emphasized. The feedback effects on the real economy and its likely self-reinforcing aspects portend a double dip in the US economy in 2009. The respite equity investors are experiencing this spring might run even into the summer. However, Joe Battipaglia may be right (Beyond the Sound Bite interview last week) when he predicts that S&P 500 operating earnings will fall to and through the top down 2008 number of $80. When combined with the risk of rising inflation, the valuation target for equities could match the longer-term predictions of many technical analysts for a much lower market next year and into 2010, suggesting that what has been experienced thus far is a dress rehearsal.

All investors must and will come to their own moment of clarity on this issue. It’s just a matter of time.

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