Van Knapp On The End Of The Credit Crunch

Contributor Dave Van Knapp of Sensible Stock Investing updated his thesis on the credit crisis yesterday, and sent it to me last night. I’m pleased to share it with you:

I believe that the credit crisis of 2007 is over, at least insofar as it is likely to impact the stock market. To be frank, it ended somewhat sooner than I expected.

A few weeks ago, I published a thesis about the credit mess. In a nutshell:

1. The credit crunch, begun by sub-prime mortgage lending in the USA, had spread into all areas of the credit markets. Ill-advised loans, over-reaching by unqualified borrowers, and over-leveraged purchases of loan packages had led to spreading defaults, the failure of some hedge funds, and the tightening or withdrawal of credit availability not only in the USA but around the world.

2. Investor sentiment had been badly shaken and would continue to yo-yo. Investors would fret over the credit situation, possible effects on the economy, and the ability of the Fed and central banks around the world to contain damage. They would have hair-trigger reactions to any signs, positive or negative. Therefore, severe market volatility was inevitable. Up and down days would exceed 200-300 points repeatedly, with an overall downward trend until the situation clarified. At the time of the article, stocks had already dropped 6% to 7% from their high on July 19.

3. The Fed and other national banks had begun to respond by injecting massive amounts of money into the financial systems to stave off panic, illiquidity, and recession. It was not at all clear whether such moves would stave off a true economic crisis. However, the initial moves did suggest that the central banks recognized the gravity of the situation and would try to head off grave damage.

4. Investors were likely, but not guaranteed, to recognize that in the overall scheme of things, the credit crisis was limited in size and was unlikely to drag the economy into recession. Pullbacks from the market had driven many stocks down to attractive valuations, and investors were more likely than not to see these as entry points if they could regain confidence that the economy was not going down the tubes. While investor sentiment would swing wildly, on balance it would tilt positive, and the markets were likely to be higher than lower six months hence.

5. Therefore, I recommended that investors (a) look for excellent companies with strong balance sheets; (b) loosen or eliminate sell stops to allow for the likely market volatility over the next few weeks or months; but (c) limit their stock investments to 1/2 or 2/3 of available “stock money” as a hedge against the thesis being wrong.

That thesis has proved quite prophetic. The markets, while extremely volatile, did start to bottom out and trend upward again. It did become more clear that the credit crisis was unlikely to topple the economy into recession.

Now, with Tuesday’s slashing of the federal funds rate by 0.5%, and an equal lowering of the discount rate (the amount the Fed charges banks for loans from the government), along with similar moves by central banks around the world, I believe we can declare that the credit panic of 2007 is over.

This does not mean that there won’t be more bad news. Some over-leveraged hedge funds and investors may still go belly-up. More borrowers will default, especially as adjustable-rate mortgages reset. Credit will be harder to obtain generally (which is a good thing).

But I now believe it is clear that the Fed and other central banks will contain the damage from the credit crisis. Stock investors can return to more “normal” strategies. Using appropriate caution, they can take advantage of good valuations to purchase shares in excellent companies. If they use sell-stops, they can return them to more normal levels. And they can become fully invested again. There is now a very high probability that the market will continue on an upward trend, and move toward more normal volatility ranges, over the next few months.

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