Market Update:  2008-09-17

Well, what a great time we are having!  I just got back from a two and a half week business trip in China late Monday night, and I am just super excited about all the market action of late.  As I have been saying all year now, I expected the markets to remain turbulent through this fall, and so far we are right on track.

The U.S. investment banking sector is amazing!  We first lost Bear Stearns in March.  The U.S. government was wrong to bail out Bear, because it set a moral trap that the market has now fallen into.  Over the past three days we have lost two more investment banks including Lehman Brothers and Merrill Lynch.  (See what a bunch of Ivy League MBAs are able to accomplish when they put their limitless knowledge and skills to use?) 

As of this afternoon, we have two big guys left, Morgan Stanley and Goldman Sachs.  And guess what, it looks like Morgan Stanley is right in line to be the next to go.  Their stock is down 37% as of 12:00pm today, and the rates Morgan Stanley has to pay to service their CDS debt obligations jumped 1% today to almost 9%!  Sounds like somebody is in deep water.

Goldman Sachs' stock is down around 25% as I write, which means they aren't doing so hot themselves.  But of the two U.S. investment banks that are left, Goldman has the best chance to actually survive this mess.

There is no need to panic, except for the fact that the Treasury just came out with news that they are willing to back up the Federal Reserve.  OK, so that could be scary, because the U.S. government is now admitting that we might not be able to handle what comes next.  And my guess is that within three months a major U.S. commercial bank, such as Wachovia or Washington Mutual, is going to go bust.  If that were to occur, then you can bet the farm that we will have a run on all U.S. banks.  And the U.S. government, whether it be the FDIC, Federal Reserve or Treasury, will not be able to help because the U.S. is bankrupt.

It is such a shame, but what we are witnessing unfold before our very eyes is what has been expected by many economists and myself for years now.  No country can be allowed to take on so much debt to the extent that the debt load far exceeds a country's ability to repay.  Over the past 20-30 years, America as blown up a debt bubble that recently hit 350% of our annual GDP.  In other words, the total debt in our economy (government, private and corporate debt combined) amounts to 3.5 years worth of U.S. GDP.  By 1929, just before the U.S. financial system collapsed, we also had hit a record level of debt, but the total debt load then was under 300% of GDP.  In other words, our debt level now far exceeds the unsustainable level that we reached in the 1920s.  And we all know how the story ended then!
 
Now it is payback time.  Our debt bubble is bursting, and that is why so many well-known Wall Street giants are failing.  Our whole economy and the financial system it is built upon is at risk of default.  I anticipate that we will pay for our mistakes with high interest rates and inflation in the short term, but eventually a prolonged period of Japanese-style economic stagnation and price deflation may set in (we are already seeing real estate prices deflate).  Going forward, owning foreign stocks and hard commodities like gold may help to offset U.S. stock losses and risks, but nothing is 100% safe in this market. 

What am I doing now?  I am sitting back, enjoying the ride, and faithfully continuing to invest in sectors that have huge long-term potential as they are being driven down in the short term during this market selloff.  If you are serious about investing for the long haul, then the next few months will present the opportunity of a lifetime to pick up quality positions at "blue-light special" prices!

Yesterday I finished selling out of my airline holdings that I recommended in this letter on June 23, 2008 (see posting "You have to pay $15 for your first checked bag...") when I bought United Airlines (UAUA) for $6.00 and Delta Airlines (DAL) for $5.00.  I sold UAUA a month ago with an approximate 70% gain (it has since gone much higher) and I sold DAL yesterday at $10.00 for a 100% gain.  Yesterday afternoon I took the proceeds from my DAL sale and bought XES, an oil and gas services ETF. 

Now is the perfect time to start accumulating XES, as oil and gas services stocks are being beaten down as the price of oil retrenches.  I am convinced that oil and gas services stocks will continue to rise in the future, even if they suffer over the next 12-18 months.  I plan on buying more XES over the next few months as oil tries to find a bottom.  NOTE: For this sector I previously recommended PXJ, but now I recommend XES as it has a lower expense ratio than PXJ with nearly identical market returns.

Both yesterday and today I bought more FXI, a Chinese ETF.  The Shanghai Composite Index has fallen below 2000 this week (the high was 6092 in October 2007 the day after I warned of a top in Chinese shares in my newsletter).  In my opinion, Chinese shares are now undervalued.  While I was in China earlier this month, I heard several locals say how frustrated they were with the Chinese stock market.  Such strong negativity is one of the key identifiers of a bear market bottom.  China's stock market is down nearly 70% from its high and back to where is was at the beginning of this decade.  Begin (or continue, in my case) to accumulate Chinese shares now and you absolutely cannot lose money if you are willing to hold on until the next bull market appears.  I am really excited about the opportunity to buy Chinese shares so cheaply right now, and expect to make a ton on China in the next 5-10 years!  Having said that, during the next few months we could continue to witness China's market fall further.  This is why accumulating over time is a good strategy, as it will allow you to take advantage of lower prices later should they occur.  But with the Shanghai Composite Index under 2000, I don't expect Chinese shares to stay this cheap for too long, so you must build your position during these rough times if you want to make money when the bull rages again.

Will Morgan Stanley and Wachovia be the next financial giants to fall?  I don't know, but I do know that we will know more later.  Until then, Happy Investing!!!

Gregory