Make no mistake, says this Canadian analyst, the market is going farther down. Here’s what you should expect and what you should buy.
“Don’t look back. Something might be gaining on you.” Those were the words of baseball immortal Leroy “Satchel” Paige.
But we could also apply them to the financial crisis that won’t quit. Financial institutions keep insisting that the worst is over, but glance in the rear view mirror at the mess behind us and you’re liable to run smack into the next obstacle.
Like the seizure of IndyMac Bancorp in the U.S. and the desperate attempts to rescue mortgage twins Freddy Mac (NYSE: FRE, Stock Forum) and Fannie Mae (NYSE: FNM, Stock Forum).
Pay attention, says Mr. David Chapman in Investor’s Digest of Canada. “The financial crisis that started last summer with the sub-prime mortgage crisis is not over.”
Far from it. “The worst is ahead of us and investors should understand this.” Here is what lies ahead, in this analyst’s opinion, and what you should do about it.
Credits going sour
The problem goes far beyond sub-prime mortgages – “an entire menu of credits is going sour,” says Mr. Chapman. The fall in housing prices in the U.S. now rivals that of the Great Depression.
Foreclosures are at record levels – one in every 100 mortgages fails. Think of all the houses built across America and that’s an astonishing number. And sub-prime mortgages are now being joined by higher-quality mortgages in the foreclosure parade.
“There is evidence of growing defaults in car loans, home equity loans, student loans, credit card debt, medical loans, and more,” says the analyst. “Credit standards have been tightened at nearly all financial institutions, making it harder to get new loans.”
Of course this has spread to corporate debt, where auction-rate securities (corporate and municipal debt) and asset-backed commercial paper (mostly credit card, car, student, and home equity loans) were shut down.
The market for these securitized debt obligations is still frozen. U.S. financial institutions have written off over US$300 billion already, and we have seen plenty of evidence in recent days that it will go much higher, maybe as high as US$1 trillion.
What were they thinking?
Many big institutions are floundering. Bond insurers like MBIA Inc. (NYSE: MBI, Stock Forum) have been downgraded to little more than junk, putting billions more dollars worth of debt in doubt.
And the US$62 trillion credit defaults market is in trouble. These are derivatives between two parties in which one can purchase the promise of a payoff if a third party defaults. If this sounds like trouble, it is. Credit spreads have exploded, says Mr. Chapman, and defaults are growing, putting even more pressure on financial institutions.
After investment bank Bear Stearns hit the wall, could Lehman Brothers (NYSE: LEH, Stock Forum) be next? It is raising billions to cover its write-offs and its largely junk bond portfolio isn’t the best security. What were these people thinking?
The declining U.S. dollar
Unemployment in the United States is officially listed at 5.5%. But the real figure is closer to 10%. The official inflation rate is around 3.9%. The real thing is as high as 12%.
There is evidence that the U.S. has actually been in recession for close to a year. And you have undoubtedly noticed that oil prices, after a brief plunge, are right back at the $145 level. And what if Israel decides to take on Iran?, asks Mr. Chapman. Where would that send oil prices?
Canada is not immune. The first quarter showed a 0.3 decline in GDP (surprisingly, U.S. GDP did not go down).
The strength of Canadian markets depends almost entirely on energy, gold, metals, and agriculture. Although demand remains buoyant, much of their current prosperity hinges on the declining U.S. dollar. “Any stability in the Canadian dollar against the U.S. dollar will benefit the stocks in these sectors as commodity prices rise,” says the analyst.
And that’s where Canadian investors should be looking for relief. As long as the U.S. economy deteriorates, the dollar will be down, and Canadian commodities will be up.
10% in bullion
So here’s how you prepare yourself for this badly bashed market.
“We continue to emphasize that you should have at least 10% of your portfolio in bullion,” advises Mr. Chapman. You don’t have to own the ingots and store them in the cellar; you can invest in a bullion fund.
When it comes to equities, energy and gold top this analyst’s list. His top choices in energy are two big trusts. Canadian Oil Sands Trust (TSX: T.COS.UN, Stock Forum), which owns 37.6% of the Syncrude project, pays a $1 distribution quarterly and yields 7.9%. ARC Energy Trust (TSX: T.AET.UN, Stock Forum) pays $2.88 annually and yields 8.7%.
Both of these trusts have deep strength in reserves.
Reserves also count in gold stocks. Kinross Gold (TSX: T.K, Stock Forum) is the third-largest producer in North America by reserves, with operations in the U.S., Brazil, Chile, and Russia. Eldorado Gold (TSX: T.ELD, Stock Forum) is an intermediate producer, but is headed for 500,000 ounces of production annually by 2010, with operations in Brazil, China, and Turkey.
The problems that caused this mess have not been cleaned up, concludes Mr. Chapman. He tells his Investor’s Digest of Canada readers frankly, “contrary to what you are being officially told, the problems may get worse.
“Given that this is an election year in the U.S., efforts will be made to stabilize the market. But ultimately the market is headed lower.”
In this analyst’s opinion, the way to survive a falling market is not to flee in the opposite direction, but to find the strengths in a sea of weakness. In this crisis, Canadians have one advantage – those strengths are commodities.
