Column by Jim Flinchum, Inside Business - Hampton Roads, October 13, 2008

Original article here

During the fourth quarter of 1941, the United States came under attack and the country rallied to become the dominant power on the planet.

During the third quarter of 2008, the United States again came under attack, which Warren Buffett described as a financial "Pearl Harbor." Congress dithered for weeks. They even dithered through the single one-day record loss of 777 points on the Dow, which vaporized $1.2 trillion in market value and helped make September the worst-performing month in six years. After even more dithering, Congress finally passed the "bailout/rescue bill," which was the most badly needed piece of bad legislation in American history. It was bad legislation because it focused on the symptoms of the credit crisis, and it was badly needed because it may have bought us enough time to focus on the cause – falling home prices.  After all, that is the collateral for all those mortgage loans. Loan quality is increased when collateral quality is increased.

Jim Flinchum

My concern is that the best Congress can offer is merely "too little, too late, as usual."

During the debate in Congress, many complained that the finance sector of the economy was only one of 10 sectors. What about the others, they asked? This type of thinking compares to wearing a noose around your neck; no problem until the trapdoor opens. The finance sector is the noose around the neck of the economy.

CNBC’s Jim Cramer compares the financial markets to a large ice cream sundae, with the little cherry on top being the stock market, and the larger ice cream underneath being the bond market. The bond market got too big and is melting rapidly. The third quarter saw us deleveraging and sobering up from a debt party.

Despite our massive credit crisis, the U.S. economy continues to rumble along, although slower and slower. In fact, the GDP for the second quarter was actually revised upward from 1.6 percent to 2.8 percent, almost entirely from the 13.2 percent surge in exports. When the dollar depreciates, our goods become cheaper for foreigners to buy, and they did.

However, the dollar did the opposite for much of the third quarter, which will weaken the third and fourth quarters. When the government releases the Q3 growth rate in GDP on Oct. 30, I expect it will be slightly negative, remaining that way for at least three more quarters. Important factors include auto sales, which have virtually collapsed and are down 23.7 percent, and 760,000 people losing their jobs this year. Many labor economists see the 6.1 percent unemployment rate rising to 8 percent before this recession abates next year. As tragic as that is, nobody foresees the 25 percent unemployment rate in 1933 during The Great Depression.

Other economic data suggest underlying strength, such as increased durable goods orders, increased consumer income, increased confidence, but there is no increase in consumer spending, another sign of deleveraging.

It was only nine years ago that we worried that the possibility of $100 billion in losses from Long Term Capital Management could destabilize the whole financial system. Fast forward to our already infamous Q3, when the Treasury Department put both Fannie and Freddie into conservatorship. Certainly, both were simply too big to fail. So was Bear Stearns and AIG (but inexplicably not Lehman). That the system has already withstood $550 billion of write-offs, with another $500 billion expected write-offs, tells me the financial system may be stronger than most analysts expect. I am not worried about a depression, just the severity and length of the recession.

One piece of data near and dear to economists’ hearts is the TED Spread. It measures the difference between the interest rate paid on U.S. Treasury bills and Eurodollars, but is also an important proxy for international confidence. It compares the most risk-free rate of borrowing (Treasuries) with the second safest rate (between banks). A wide spread means low confidence. The normal spread is about 50 basis points or half of one percent. Currently, it is six times that, reflecting very low confidence, which is not good for any financial system. This finally brought the crisis to a head! Obviously, the rest of the world is very worried about us. Not only have foreign countries been pulled into our recession, their stock markets have been hurt even worse than the U.S. stock market. As of Sept. 24, the YTD comparison of losses (in local currency) is:

U.S. (Dow)......... 18.4
Switzerland........ 20.1
Japan................. 20.9
Germany............ 25.0
India.................. 32.5
Saudi Arabia...... 35.4
Russia............... 41.5
China................. 57.8

Because the international markets were late entering the recession, I expect they will be late escaping it.

Decades ago, noted historian Arthur Schlesinger wrote that the political pendulum swings between conservative and liberal every 25 to 30 years. He pointed out that pendulums always swing too far. My interpretation is that we swing from over-regulation to under-regulation, at least in financial services. Economist Charles Morris thinks "liberal cycles usually succumb to the corruptions of power, conservative cycles to the corruptions of money."

Sometimes, the hardest thing to do is be patient. As the U.S. market is approaching a bottom, my investment firm has been preparing for the rebound we expect next year by selling into strength all of this year. Our cash levels are at an all-time high.

We are especially interested in the beat-up stocks of financial firms and consumer discretionary companies, particularly the mid-cap value stocks. Value stocks continued to out-perform growth stocks in the third quarter, losing 9.66 percent versus 15.75 percent. Small cap stocks continued to beat large cap stocks in the third quarter, with the Russell 2000 down 6.97 percent and the Dow down 8.53 percent.

In the meantime, we like the current yields on short-term municipal bonds. Surprisingly, as attractive as international markets are over the long run, there is no hurry to commit fresh money to those markets right now. We have repositioned our model asset allocation to be much more U.S. focused for now, but not for long.

As part of the upcoming re-regulation of America, one important long-term tactic we’re taking is to develop a list of companies that can benefit from re-regulation – the food industry in particular.

As we end the long, dark night of regulatory sleepiness, I hope the re-regulation will be more effective than past attempts. Good intentions can easily produce bad laws, such as parts of Sarbanes-Oxley. But, the excessive financial deregulation has clearly given us a hangover!

Jim Flinchum, a CFP practitioner as well as a Certified Investment Management Analyst, is the managing principal of Bay Capital Advisors, an investment advisory firm in Virginia Beach. He can be reached at www.baycapitaladvice.com.