Amid the worst U.S. financial crisis in a generation, investors continue to dump stocks and flee to the relative safety of Treasury bills, foreign currencies and commodities in 2008. Stocks are now comfortably in bear market territory, defined as a loss greater than 20% from all-time highs.

And the panic selling lately has been global…

Global equities, as measured by the MSCI World Index, have now declined more than 20% from their October 2007 all-time highs, while U.S. broader aggregates are down in excess of 21%. Since late May, more than six trillion dollars’ worth of equity values has been erased worldwide in the worst bout of selling since 9/11.

Investors now sit on two opposite sides of the fence.

The optimists continue to allocate assets globally while maintaining high cash reserves and believe this crisis, like all previous economic disasters, will eventually bottom. Stocks and bonds will recover. They point to previous shocks in 2000 (tech bust); 1998 (Long Term Capital Management); 1997-1998 (Asian crisis); the S&L Crisis (1989-1990), and the October 1987 stock market crash as examples of great buying opportunities for long-term investors.

But the other side of this contentious fence, the bears, believe we’re at the cusp of a major financial unwinding that will parallel the events of the Great Depression in the 1930s.
Which side is right? Both market forecasts will determine the ultimate value of investment portfolios for years to come.

A Case for Financial Armageddon

Many bears contend 2007 marked the “beginning of the end” of the global financial system.

The devil threatening the financial order is Wall Street’s creation called “securitization.”

The securitization beast was allowed to develop into a monster following former Fed Chairman Greenspan’s relentless push to bring interest rates down to 1% by 2003 in an effort to stave off deflation following the mini-2001 economic recession. Though that monetary policy gamble worked combined with the Bush tax cuts to boost GDP growth, it also created a leveraged beast whereby Wall Street packaged and repackaged mortgage-backed securities tied to leverage. Low rates always entice financial product innovation; with U.S. money literally for “free” at 1% or less by 2003, the securitization monster went wild. In a low interest rate world in the post-2003 environment, credit spreads for all types of fixed income securities plunged to historically low levels by mid-2007. Then the party ended.

Deep Economic Recession or Worse?

With housing values accelerating their decline across most U.S. markets, the entire gamut of mortgage-backed securities and other opaque markets tied to leverage began to unravel by August 2007. The toxic spillover has since spread to other segments of credit, including consumer loans, corporate loans, credit card debt, mono-line insurers, auction rate securities and other synthetic derivatives. The result is a massive policy challenge for the United States as the banking system remains heavily stressed. Worse, surging food and energy prices have cornered the Bernanke Fed, the dollar and U.S. asset markets.

How does the United States -- the world’s largest and still its most influential economy, control deflation in housing and bank credit combined with skyrocketing food and energy prices? You could say 2008 is a bizarre twist of 1930s deflation mixed into a deadly toxin of 1970s stagflation.

The economic challenges are truly formidable, and at this stage will certainly require more help from the Federal government (a.k.a. taxpayers’ bail-out) because the Federal Reserve is running out of options and has already exceeded its chartered mandate following the Bear Stearns’ rescue in March.

According to the bears, a deep economic recession in the United States will morph into a Great Depression as mortgage giants Fannie Mae and Freddie Mac eventually collapse, housing values continue to deteriorate and a greater number of banks fail. Unemployment will soar, bread lines will re-emerge and the dollar will become worthless as America’s largest trading partners dump Treasury’s.

An Optimists’ View

The modern financial system will not fail. Since the advent of modern capitalism under the British Empire, global crises have unfortunately surfaced regularly as asset bubbles deflate or unwind. This one, triggered by a housing bust, won’t be any different. The response by governments and corporations under times of economic duress is to throw bundles of money at the problem until the crisis stabilizes and eventually, fades.

The consequence of this policy response, like most others, will ultimately lie in higher inflation as world governments are eventually forced to print credit to arrest deflation in bank credit and plunging asset markets. Gold and most other commodities should continue to perform well as this recovery scenario occurs; eventually, distressed stocks will also make a strong comeback but will unlikely surpass their all-time highs for many years to come in a fractured global financial system.

Deflation Intense in Asset Values

There’s no hiding the damage already inflicted to global portfolios this year and over the last 12 months.

Since July 2007, global markets have declined 20% or more. The majority of non-Treasury securities markets have also been pummeled and housing values across several industrialized countries continue their downward spiral. Global balance sheets, both personal and corporate, continue to hemorrhage in the worst attrition of values since the 2000 to 2002 bear market.

Unless your portfolio is over-weighted commodities and foreign currencies this year, you’re under water. Even cash or T-bills are no panacea in real or inflation adjusted terms because they trail official CPI (consumer price index) by approximately 200 basis points or 2%.

At some point, according to the stock market bulls, markets will form a bottom. At that point, a recovery will ensue as enormous values are embraced by investors.
Many market indicators already point to massive contrarian buying opportunities in late July.

Institutional and individual cash reserves now sit at their highest levels in six years, representing almost 25% of total U.S. stock market capitalization. That’s an enormous amount of buying power. Short-selling, or the level of institutions betting against further market declines is now in record territory on the NYSE and the NASDAQ. And the Investors Intelligence Bull/Bear Ratio now stands at 0.58 – the lowest reading in almost six years. In short, nobody is buying stocks.

Dividends, which barely existed 12 months ago, are now scattered across the landscape in the United States and Europe; in Japan, which barely paid dividends to shareholders ten years ago, companies now distribute the highest after-tax profits to shareholders in history.

Plus, dividends, compared to bond yields and money-market rates, also look very attractive. The majority of non-financial companies continue to raise payout ratios – far outpacing the rate of inflation in most countries and superior to staid CDs or T-bills.

These and other market based ratios do not suggest stocks are excessively valued in July 2008. What they do suggest is that the market is heavily oversold and might embark on a powerful liquidity driven rally, probably as seasonal strength begins later this fall accompanied by U.S. Presidential elections in November. Historically, the best time to buy stocks for the long-term is from May to September.

In the end, the best strategy is probably a mixture of quality assets. Diversification is an investors’ best defense.

Don’t abandon stocks at these levels. Stick to blue-chip global multinationals now trading at multi-year lows and paying attractive dividends. Investors can select their own blue-chip stocks or buy diversified exchange traded funds (ETFs) and global value equity funds. These securities have all plunged over the last 12 months and continue to provide optimal entry points for the dollar cost averaging investor.

Also, gold and gold stocks should play an important role, including other commodities as central banks eventually lose control of inflation.

Foreign currencies – mainly in Asia, should remain a primary focus for dollar based investors over the next decade and should be accumulated. Corporate investment-grade debt continues to trade at attractive levels compared to Treasury bonds and also offer good values. Finally, don’t forget to apportion a reverse-index fund to hedge your market exposure.

On the other hand, if you truly think we’re approaching financial Armageddon, I strongly suggest hoarding gold coins and selling everything else. It won’t be a pretty world if the bears win this fight.