Step 1 of the Bailout Plan

This morning I woke up to see the market up over 200 points in the USA. Last night I had seen that the Japanese Stock Market (Nikkei) was down over 5% before I went to bed. It actually closed down 5.42%. That is a huge move down. I had expected another major decline in the USA today, but instead the market was rallying huge. I didn't know why. Then I received a phone call from a friend telling me the Fed had cut the discount rate from 6.25% to 5.75%. I am not going to use this article to explain the discount rate mechanism or dispute the significance of this action, I will leave that to the pundits which are having a field day with the news.

I think what we want to focus on is the psychology behind this statement. The Fed and the Government have told use for months that the USA economy has never been better. Unemployment rate is at record lows, Corporate Profits are at all time highs, and the US economy was supposed to be so hot that the Fed had to tighten just to simmer things down a bit. None of these underlying metrics have really changed YET. What did chance is we have seen the panic in the credit markets over the past few weeks and the major market declines in Asia last night. I think the Fed has committed to propping up asset prices via growth in the money supply and jawboning. I guess the takeaway here is that they CANNOT PREVENT a collapse in asset prices by the bailout alone. The bust is already underway and in force, but their best bet is they have decided to attempt to ensure an orderly decline.

There is a major difference for investors from losing 30% of the stock portfolio and home equity overnight versus an orderly decline over a 1-2 year period as happened after the tech bubble. The economy is really straining under an insolvency crisis at this point as the amount of leverage at play in the financial system as well at the micro level in the residential housing market shows just how sensitive the economy is to declines in asset prices.

So what kind of conclusions or hypothesis can we make for testing at this point. I will put forth the following:

1) The major rally in the financials that began today and likely will continue for a bit should be shorted.

2) Gold should be treated with skepticism. There is a temptation to buy gold hand over fist here as the money printing bailout has begun, but this is only Step 1 in probably a 100 step process. Even before the year is over we should see major bailout packages from Congress including an increase in the Conforming loan limit so that mortgages as high as $600K are now government insured vis a vis Fannie Mae and Freddie Mac as well as multiple Fed Funds cuts. The way to know the correct point is just to let the market prices guide us. Watch how the US dollar trades relative to Euros and Yen as well as gold. Once the psychology gets behind it, the train will be difficult to stop.

3) We are just beginning the BUST for real estate and leveraged finance in this country. The unwinding is going to take YEARS not days. The takeaway is to raise cash and SAVINGS not "equity" in imaginary asset price increases. Well we may not have an overnight route in asset prices I expect an orderly decline to occur slowly and painfully as many more hedge funds, banks, and lenders fail.

4) This is not a great opportunity to "buy the dip" in real estate. Sure if you want to be a homeowner - and you have the means to do it - go for it. There is no need to time the market for your first home purchase and place of lodging. But any real estate investment in residential or commercial for speculative or even investment purposes should be deferred until cap rates return to a sane level above 10% and asset prices have declined by at least 50%. We are getting there in residential at least in San Diego with prices probably down about 20% in many areas, but the Commercial has not budged yet.

-BG