If you liked Act 1,just wait until Act 2!

[CrackSmokeRepublican]

If you liked Act 1,just wait until Act 2!

John Riley
Chief Strategist

We've broken down our view of the markets
and economy into several acts, like a play. Act
1 is full of surprises and designed to bring the
audience into the play quickly. Act 2 is where
the meat of the play is. It explains the story
and sets up the resolution in Act 3.

Act 1

With the passing of the Bailout Bill by Congress
and the subsequent global market sell-off,
Act 1 appears to be coming to a close. Did it
get your attention? Because if you liked Act 1,
you are going to love Act 2.
Act 1 was characterized by the realization of
the excesses of the previous 13 years. The
country was drunk on debt and derivatives
which had gotten out of control. And the
regulatory authority that was supposed to control
such excesses was instead pouring the
drinks. Instead of putting a stop to derivatives
and debt growth, the Federal Reserve encouraged
both by keeping interest rates low, money
supply growing and blocking regulation on
derivatives.
The housing collapse, market crash and derivative
mess were all subjects of reports by Cornerstone
for years, (See Cornerstone
Commentaries) yet in interview after interview,
"The Maestro," Alan Greenspan denied
there were bubbles about to burst. If you want
to blame anyone for today's financial mess,
blame Mr. Greenspan's policies.
More of the same
The Fed's response to the financial crisis has
been more of the hair of the dog that bit ya.
Virtually everything the Fed is doing is increasing
debt, not decreasing it. It seems that the
Fed's theory is to keep the drunk drinking to
avoid the inevitable hangover. As we have
said many times, the longer you put it off, the
worse the hangover will be. And we are due
for a whopper, thanks to the bartender, I mean
the Fed's irresponsible actions.

Act 2

Like it or not, and there is no way around it,
years and years of financial excesses have no
choice but to result in a reversal of those excesses.
The height of the excesses gives an idea on
the depth of the aftermath. Its going to be bad.
Act 2 will be characterized by rising inflation
and a widening of the financial crisis. We do not
expect a "V" bottom. The economy won't rebound
sharply from the lows. The market will
probably mirror the Japanese market from 1989
through... Don't expect the market to have a
sharp recovery and then everything will be alright.
The market will likely have rallies followed
by lower lows.
Corporate and Municipal bond defaults could
cause the credit squeeze to continue. Long term
interest rates will probably reverse and start a
new bear market in bonds. Housing will be
caught in a vortex of rising unemployment, rising
interest rates and declining prices.
Rising inflation (Hyper-inflation?)
Today's actions by the Fed are inflationary.
Pumping the system with liquidity normally results
in higher inflation and a lower currency.
Today's low oil and Gold prices will be a distant
memory as inflation heats up. The danger of the
Fed's actions is that it may result in hyper-inflation.
How bad can hyper-inflation get? Zimbabwe
is currently experiencing one million
percent inflation. While that would be nice for
those on Social Security getting COLA's, it
won't be good for our economy! (I don't' really
expect that type of hyper-inflation here.)
Dollar collapse
The Fed's actions have deteriorated the quality of
the assets at the Fed and by running the printing
presses full tilt, they have diluted the value of the
Dollar. Although other currencies are also in
tough shape, (Euro), the damage that the Fed has
done puts the US Dollar at risk of a collapse.
Currencies trade on intrinsic value and intangibles.
At this point, the Dollar's strength is coming
from the intangible of being a safe haven.
But as the panic part of this crisis subsides, we
believe the intrinsic value of the Dollar will be
exposed as lacking and the decline will resume.
Major Bank Failure
It is pretty much a pick'em. Any one of the "Big
Three" could be "the" failure. Their irresponsible
continuous growth of derivatives and the
purchases of failed financial institutions could
be their undoing.
We expect the Fed's response would be the
nationalization of the failed bank. (They have
a mortgage company and an insurance company,
why not a bank too?!)
Banking Holiday
In conjunction with a major bank failure, a
banking holiday is possible. This would probably
include the closing of most banks and stock
markets. Like the last time a banking holiday
was called, the Fed would have to send out
teams of auditors to check the viability of banks
before they are allowed to re-open. It would be
a slow process with a consolidation of banks as
the Fed facilitated the combination of weaker
and stronger banks.
How long would it last? For some banks it
might take months to re-open, for others it
might be a matter of days. The markets would
stay closed for as long as it took to settle investors'
nerves and be able to insure that the reopening
would be orderly. A week, a few
weeks? Unknown.
Our estimate of the probability of this happening - 50/50.
Failure of Electronic Banking
The failure of a major bank could cause the
electronic bank systems to fail leaving people
without ATMs and retailers without credit card
services. Our personal experience with the
failure of RISDIC (state bank insurance in RI)
gives us a unique perspective on what a failed
banking system looks like. It wouldn't necessarily
be a national outage. It might be regional
or limited to certain banking systems and not
others.

Crisis Spreads

The financial crisis will likely spread to other
industries outside of the financial industry.
Candidates for trouble immediately are the
autos. Ford and GM are being locked out of the
credit markets. Things weren't very good for
the autos anyway, and higher interest rates and
a slower economy won't help.
Small businesses could be hit hard. Many small
businesses have lines of credit with their local
bank which are renewed annually. This year
may see a freeze in credit. The expected renewal
of the line might be denied or the line of
credit lowered. This could force many small
businesses to pay down their debt with the bank
at a time when the economy is slowing, making
it harder for them to come up with the cash.
Retailers are probably going to be hit hard as the
economy contracts. Store closures will only
make things worse as they add to the growing
unemployment problem.

Industries that rely on debt to finance their
growth will be stifled. Companies like GE, Ford
Motor Credit and Citigroup are already finding
the commercial paper market difficult.
Municipalities around the country are facing
growing deficits and with rising interest rates,
they will have a tough time borrowing to make
up the difference. This puts pressure on municipal
services, which will be reduced and taxes
will have to be increased. (A good article to see
how your state stacks up is in BusinessWeek,
titled "States That Can't Pay For Themselves.")
No housing recovery
Although inflation drives asset prices higher, it
won't help housing as the supply of houses for
sale will continue to hold the market down.
Rising unemployment could force delinquencies
and foreclosures even higher resulting in even
more supply to hit the market. With rising long
term interest rates, few will see the advantage of
buying a house in this environment.
Strategy

We expect Act 2 to look much like Japan since
1989 and the US during the 1970's. The market
will probably drop and stay down, other than a
series of failed rallies. The economy will probably
go through a series of bouts with inflation as
the Fed desperately tries to keep liquidity flowing
in an ever tightening credit cycle.
The duration could be years. Years and years.
It all depends on how bad things get. It depends
on how much the Fed intervenes. The
more they interfere, the longer it will last.
We are in the "Let it all fall apart and start over
again." camp. The Fed is in the "Put it off as
far as we can" camp. Knowing this gives us
some insight into what strategy will work.
Like the paradigm shift in investment strategies
that occurred early 2000 (what we recognized
and Wall Street didn't) another paradigm
shift is happening.

This period will require much more of a nimble
approach. Buy and hold is completely dead
and indexers will suffer as will those married
to Modern Portfolio Theory and US Stocks
and bonds.

Investment performance will benefit most
from market hedges, gold and hard assets (oil,
Ag). If I were to have a gun against my head,
I'd say the asset allocation for this period
would be 20% market hedges, 20% gold and
20% hard assets. But even these allocations
would be cut to zero at certain points in the
cycle, and then filled back up again. The rest
in cash, ready to trade investments (Stocks, bonds,
ETFs) as the opportunities present themselves.
At some point, the Fed's interference will finally
fail and they will stop injecting liquidity into the
system. This will bring on the final act, Act 3.

Act 3

Deflation is the final act. As the economy falters
through inflation and the Fed becomes less and
less relevant, the final collapse of the economy
will be with a deflationary thud.
We are not painting a pretty scenario. We warned
investors about derivatives and debt for years
going into Act 1 and not enough people listened.
Our analysis of Act 2 and Act 3 will become
clearer as we continue from here. Are there things
that could change our vision? Of course. There is
always the unknown. But the unknown will probably
not be on the upside.
Hiding in cash or CDs in the bank won't protect
investors from the ravages of inflation. Investors
will need an advisor that understand just how bad
the next act will be and has an understanding of
how to negotiate around the problems and to benefit
from the negatives.

http://www.cornerstoneri.com/comments/Act1.pdf