Surer Footing

This has, in every respect, been a busy year. My masters program is wrapping up now and I finally have some free time.

Where to start? Just after my last post, Lehman fell and took the rest of the market with it. I went to grad school and was working nonstop. So here we are almost a year later and it's a little like not much has changed. The S&P 500 is now at mere 30% below where its frothy levels of 2007. This is, in no small part, due to the decisive actions of Mr. Bernanke and Mr. Paulson.

We are now, as the consensus goes, somewhere between a reasonably assured bottom and an impressive 20% rally in the S&P that is getting a bit ahead of itself. My take is that we're a whole lot better off than we were 6 months ago and, frothy or not, the bounce is a decisive step in the right direction. We've come a long way.

And we have a ways to go still. Commercial real estate and credit card loans are of particular concern. But in all likelihood the financial markets are not going to fall into complete decay and a second great depression is not at hand. This is no small resolution. It could easily have happened.

Interestingly enough, I picked up some of Ben Graham's writings that he published just after the crash of 1929. He was discussing the role of insurers ("surety companies") in guaranteeing mortgage bonds. The parallels of today are eerily similar:

"During the 1924-1930 period several of the independent surety and fidelity companies extended their operations to include the guaranteeing of real-estate mortgages for a fee or premium. Theoretically, this should have represented the soundest method of conducting such operations. In addition to the strength and general experience of the surety company there was the important fact that such a guarantor, being entirely independent, would presumably be highly critical of the issues submitted for its guaranty. But this theoretical advantage was offset to a great extent by the fact that surety companies began the practice of guaranteeing real-estate-mortgage bonds only a short time prior to their debacle, and they were led by the general overoptimism then current to commit serious errors in judgment. In most cases the resultant losses to the suretor were greater than it could stand; several of the companies were forced into receivorship (notably National Surety Company), and holders of bonds with such guarantees failed to obtain full protection."

Yes, AIG jumped to my mind as well. This was published in 1934. We appear to have learned little of consequence since.

It also makes me question whether these problems were actually driven primarily by the complexity of the instruments as the consensus seems to follow...

Strains

As the Dow's bear awakens for the first time since 2002 and S&P's bear is beginning to stir out of its own 6 year slumber, prospects for the US economy are becoming increasingly dim. As the dollar falls and inflation rises commodities such as oil and steel continue to rise rapidly. Inflation is now the largest threat the global economy faces. At home we can see its effects as individuals are beginning to shut themselves in their homes to protect them from the discomforts that these predators may have to offer.

China is in a different bind. Its economy, despite having a sharp prick of its own market bubble and a moderate slowing, is still roaring ahead. Its own inflation rates have recently hit upwards of 7% by official accounts and its government is increasingly running out of options. In its efforts to push back upon these powerful forces, the Chinese government is imposing strict price controls on staple goods and fuel. Inevitably these measures will crack under the weight of underground market activies. The government will need to raise interest rates or take other measures to curb inflation.

In order to maintain their currency peg to the dollar in this environment, the government is currently adding to its foreign-exchange reserves with voracious rigor. If China wishes to quash the current levels of inflation the appropriate reserve levels will most likely be unsustainable. Something will have to break. In my opinion, the most obvious choice would be for a significant revaluation of the Yuan. Fortunately, there is a new and relatively easy way to take advantage of this situation. WisdomTree is now offering a new Chinese Yuan Fund (NYSE: CYB ). This approach, in my opinion, offers limited downside and significant potential upside - a rarity in such a difficult market.

WindFalls

Overall, the market is steadily receding from it's recent high-water mark in the wake of a reckless financial sector and an over reliance on debt for insipid and poorly vetted acquisitions. Yes, cheap money abound, the market is apt to become gluttonous and binge on such sugary delights as hyper-complex securitized instruments based a single asset class that is inherently illiquid (i.e. real estate). CDOs gave rise to CDOs "squared" and teams of lawyers worked furiously to assemble ever larger reams of documents to strap them together. Today, they are putting together different and more familiar documents in the form of class-action lawsuits aimed at the people who unluckily lost the most money when these instruments fell off a cliff.

It's not, I would say, that the smart people involved in these activities generally lack the perspective to recognize similarities to the countless historical market bubbles and pops, but that they do not care so long as they are careful enough to not be stuck with the fan when the waste is furiously racing towards it at 100% gains per year speeds. Indeed, many didn't get out of the way in time.

Of course, none of this is surprising. Even today, as we have a series of similar gains being posted in the energy commodities area, the same smart people are echoing the familiar refrain that "this time it's different". This conventional tale will continue to get respectable clout for a period, but will ultimately go stale as oil falls into its perpetual cyclical trends.

So, what to do now? The financials are dropping steadily. China and other emerging markets are dropping too. The price of oil is starting to show alarming similarities to the recent real estate bubble. Inflation is up across the boards...

Well, let's start with, as I always do, what looks cheap? Financials are starting to look attractive from a long-term perspective. One stock stands out in particular to me. JPMorgan Chase & Co. (NYSE:JPM) looks particularly attractive here at 1.0x price to book. Their management team is as strong as they come. I believe the Bear Stearns deal will turn out to be one of the more prescient moves of this decade. Start nibbling at this stock over the next 6 months as it moves below $40/shr. Housing will most likely continue to fall for a while longer through 2009, but as it does, consider slowly buying into this stock on the resulting pullbacks.