Don't be Trapped by Bear Market Rallies

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.

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If this were a simple liquidity problem, then the action that's been taken by the Federal Reserve and other Central Banks ($1.5 trillion worth) would have solved things -- but it hasn't. Instead, the Fed's actions have resulted in bear market rallies, followed by pullbacks.

If you still think we're dealing with a liquidity problem, consider the following:

1) Credit spreads -- the cost of buying credit is higher today than it was seven months ago.

2) Mortgage rates -- these are also higher today than they were seven months ago, even with all of the liquidity that has been pumped in by the Fed.

3) Corporate debt spreads for banks -- corporate bank debt is now paying a higher rate than what they can hope to get lending the money out, which is unheard of.

We are now experiencing the classic example of what George Akerlof described in "The Market for 'Lemons.'"

He basically said that, absent better information, it is perfectly rational for the buyer of an asset to assume that the assets offered for sale are lemons, i.e., the bad stuff.

This is why we're currently seeing the flight to quality in the way of Treasurys and other things that people can value, while the rest of the stuff is floating out in la-la land.

Well, at ChangeWave Investing, we are turning lemons into lemonade, so to speak, by taking advantage of some of these situations.

But until the financial institutions and politicians come out of denial and we get to the hard business of triaging the dead loans from the live ones -- and, unfortunately, moving about 1 million unqualified homeowners back into the apartments they can really afford -- we have more pain to go.

However, we don't need all of the pain out of the markets to get the "all clear" signal for stocks -- we just need to get about halfway there.

Don't kid yourself, the Bear Stearns takeover is not the last chapter in this story. We are at the end of the beginning.



Toby

P.S. The Fed is stepping up to the plate, but it can't fix the solvency issues that need to be worked out before we can start to see a turnaround. But, just because we're in a bear market, that doesn't mean your portfolio should go into hibernation. Try ChangeWave Investing risk-free for 90 days and learn how we're surviving and thriving in this tough market. Click here to join.

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Tobin Smith is the founder of ChangeWave Research, the editor of ChangeWave Investing and ChangeWave Microcap Investor and a contributing market analyst for Fox News Channel. His market commentary can be found in the ChangeWave WaveWire and he provides more specific recommendations and advice through his ChangeWave Investing service. Click here to learn more about ChangeWave Investing.

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