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Don't be Trapped by Bear Market Rallies

March 19, 2008



Click here to watch a video of Toby's rant. Or click here to listen.

The Federal Reserve is on the job, ladies and gentlemen. They followed the March 16 surprise 25-basis-point cut with a 75-point cut on March 18.

We should all be grateful for the bear market rallies that followed, because they gave us another opportunity to lighten up on stocks and build cash in preparation for the real end of the bear market.

I hate to be the bearer of bad news, but the worst of the subprime mortgage mess hasn't even begun. We have more pain to go through before we can call the bottom.

Now, the post-rate-cut question is:

A) Do the worst offenders in the subprime market have a liquidity problem?

Or …

B) Do the financial institutions heavy with subprime debt -- Washington Mutual (WM), National City Corporation (NCC), etc. -- have a solvency problem?

The correct question to ask is B, and we should expect to see lower housing prices and more liquidation, a la Bear Stearns (BSC), before the "all clear" signal is sounded.

Before this is over, we'll see more of these investment banks carried out in body bags to reconcile the enormous level of bad judgment and runaway greed that is behind this whole fiasco.

Now let's not get too bearish here -- we're making progress. Personally, I can't wait to take advantage of some of the great opportunities that lie ahead.

As a matter of fact, at ChangeWave Investing, we're already taking advantage of some opportunities that are just too good to pass up -- particularly in the Freddie Mac and Fannie Mae guaranteed mortgage paper owned by mortgage real estate investment trusts (REITs). That paper is discounted 50% below its actual value.

We're buyers now, and in six to 12 months, I think we'll see 50% to 100% gains, plus we get to collect great dividends along the way.

Come Back to Reality

As with all problems in life, we have to leave the denial zone and enter reality.

Remember, in August, the turmoil in the financial markets was characterized as a "temporary liquidity problem." The B&P Paribas and Bear Stearns hedge funds blowups were seen as isolated incidences.

Now, seven months after this "temporary" problem, and $200 billion (probably headed to $500 billion) in bad loans write-offs later, the politicians are still in denial.

We need to step back and recognize that the current situation is not a liquidity issue, and hasn't been one for a long time.

The problem is the genuine uncertainty about the underlying value of the assets, and that's a solvency problem, which is exacerbated by the fact that many of the entities that own these bad assets are financial companies with 20- to 30-to-1 leverage.

There are still dozens of these special purpose entities out there sitting on a pyramid of paper that's supported by leverage -- and no one has any idea what they're actually worth.