More Pain, No Gains

10/14/2008 1:00 pm EST


Tobin Smith

Founder and Chief Research Analyst, Transformity Research LLC

Tobin Smith and Josh Levine of ChangeWave Research say the financial crisis will take longer to unwind and will cause a lot more damage.

The idyllic world of Wall Street—where money begot more money and all activities in the name of profit were considered good—no longer remains. What is happening today is referred to, in modern terms, as "creative destruction."

The real problem, however, is that the tearing down of the financial edifice is bringing everyone and everything else down along with it—around the globe.

In fact, the contraction in the US economy has dramatically accelerated since early September, and the markets apparently got the message. The credit plague that infected Lehman Brothers and led to its fall was only the precursor to the consumer spending recession, which the ChangeWave Allliance has been forecasting since early 2008.

The $10-trillion shadow banking complex is in full meltdown, and now the equity market is being dragged along. Roughly $2 trillion in hedge fund money under management is being slashed by one-quarter ($500 billion) this month. Forced selling of assets in commodity-related stocks and elsewhere [has brought] the Dow Jones Industrial Average below 9,000.

And that's hardly the only problem hanging over the market. We can look forward to a corporate debt default wave led by private equity deals as junk bond defaults rise from 2.7% to 7.5% next year. Approximately $1 trillion of leveraged buyout (LBO) deals were done between 2004 and 2006, and many have significant risk of default.

What is occurring is the first simultaneous global financial crisis since World War II. The bankruptcy of Lehman triggered a whole set of capital destruction events that has caused mayhem with all financial institutions that hold counterparty risk (i.e., Lehman owes them money on default-swap payments it is not going to make).

We are now talking about the previously unthinkable possibility of entire countries going bankrupt, with Iceland potentially the first to slide into the water. Is the United States next?

Not a chance.

The United States has a $14-trillion economy that is set to shrink 2% to 3% in the recession. Public debt (the money we owe others) is about $5.4 trillion, or about 38% of our 2008 GDP.

If we got to 120% of GDP in World War II, we should be able to handle the financial system bailout with relative ease. So, let's not lose sight of the big picture.

Still, we are nowhere near a bottom to the financial crisis—which means we are nowhere near an equities market bottom.

Keep riding your short ETF positions, and if you have not taken the plunge, then make sure to accumulate shares in the UltraShort Consumer Services ProShares (Amex: SCC), the UltraShort Financials ProShares (Amex: SKF), the UltraShort Russell 2000 ProShares (Amex: TWM), and the UltraShort Semiconductors ProShares (Amex: SSG) on sharp market rallies. (All of these ETFs rallied Monday, but they remain well above Smith's recommended buy prices—Editor.)

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