Let’s assume for a moment that the bail out bill passes in a form that is relatively close to the original proposal. Now what?
I’ve been watching the drama very closely (my wife would say too closely) for clues as to what will be in store for the economy, credit markets, and stocks once all of the dust settles. Let me start by saying that I believe there is an incredible disconnect between the stock and credit markets at the moment. If we believe the experts, the crisis that began with the collapse of Lehman Brothers (LEH) and quickly spread to insurance giant, American International Group, Inc. (AIG), the United States financial system was closer to the brink than we have ever seen (see also, “AIG Armageddon.”)
With consequences that may be worse than what transpired during the Great Depression, it is understandable why the Treasury, in concert with the Federal Reserve, moved to save the system. Prior to the proposed bail out the credit markets were in complete chaos. Investors were rapidly liquidating money market funds, not willing to risk principal in that supposedly safe market. In its place, they purchased Treasury securities, so much so that they drove the yield into negative territory.
Think about that for a minute. Investors were essentially willing to pay money in order to guarantee principal repayment. Confidence was shattered nearly bringing the market to a grinding halt. Why is that important? Simple: The inability of credit markets to function properly, especially with respect to short term lending would have resonated throughout the entire economy (see also, “Fire Sale for Financials on Wall Street“).
Companies would have struggled to pay vendors and possibly worse, payroll. We may have seen riots on the streets followed by complete anarchy (not a good scenario given that most National Guard units are fighting in Iraq, but I digress… ). In response the stock market basically shrugged. Yes, stocks moved lower with the crisis growing by the minute and volume of shares traded increased, but for the most part the response was fairly controlled. On a percentage basis the damage was minimal. Not the kind of response one would expect for an economy that is on the verge of depression.
I’m a Rational Investor for a reason and panic is not in my vocabulary, but seriously folks, there will be … > a bill coming due for this mess in the form of slower or negative growth. If stock prices are a discounting of future profits and those profits drop, stock prices must adjust lower. It is that simple and as of yet, stock prices have not adjusted in the least to the reality of the future. I think it is a safe bet that they will after the hyperbole passes.
Even if the bail out is approved, nobody and I mean nobody, can tell you what the result will be. With the entire Nation focused on the crisis, it is only natural to expect people to batten down the hatches no matter what happens (see also, “Users Manual for a Bear Market“). At a minimum the bill for the buyout is estimated to total in excess of $2,000 for each taxpayer in the country. Such amount, if accurate, essentially wipes out the tax rebates that we all received earlier this year and that were so essential to avoiding a recession earlier this spring. So in response to the mess, the stock market rallied to the tune of erasing prior losses from earlier in the week. After Monday and Tuesday losses we are at about break even since the crisis began.
What crisis? Are you kidding me?
Even if you assume credit markets are acting irrationally meeting in the middle would require a 10% drop or more in stock prices for the two markets to be in balance given the crisis and future expectations. It has become almost commandment that thou shalt not sell stocks in the midst of a meltdown. In most cases I am a huge proponent of said commandment, but not when we are facing a once in a hundred year event that darn near and still could lead us to depression (see also, “Profit from the Market Meltdown“).
That makes no sense to me. In a way, I think many investors are reacting to this crisis with a deer in the headlights mentality. They are simply dumbstruck over the complexity and enormity of it all. It is a problem that is difficult to grasp on the individual level for even the most intelligent of us. That would explain why stocks have hung in there so well while the credit market plummets. That’s your gain in my opinion. The laissez faire attitude of stocks gives you the time to Rationally react to the crisis. I’ve already figured out what I would do and have acted accordingly in my Rational Investor model portfolio. I’ve sold stocks and raised cash — dropping to about 30% exposure to stocks. I’m convinced stocks must have lower prices in what is now an essentially deflationary period even with a bail out.
Rosy Grier once sang, “It’s All Right to Cry.” We may have to change that tune to “It’s All Right to Sell.”