Turmoil on the Wall Street

You've seen it yesterday: Lehman Brothers filed for bankruptcy protection after failing to reach a deal with potential buyers (Barclay and Citi were rumored to be the interested parties) over the weekend. Meanwhile, Merrill Lynch, one of the marquis investment banks on the Street, agreed to be bought by Bank of America in a deal valued at $50B. This deal was viewed as BoA bailing out Merrill. Furthermore, rumors about impending bankruptcy of AIG caused people to believe more bad news is yet to come. Stock sold off around the world, with Europe down more than 4% and Asia down close to 5% before US stock market opened. As you would expect, the Monday trading on Wall Street was bloody. Dow declined more than 500 points, or 4.4%, worst single day decline since the burst of dot com bubble seven to eight years ago. It was indeed a "black Monday".
To make things worse, pundits were all sounding doom and gloom. A NYU economist, Nouriel Roubini, even warned that American's deposits in the banks are at risk (I think he should shut up, or be locked up for inciting run on banks). Our old pal Allan Greenspan said this is the worst crisis in last hundred years. That means the 1929 depression was even better than current financial and economic crisis. I think all these pundits have their ulterior motives (not very noble often time) to try to scare people, and further weaken people's confidence.

I think the current crisis in a large part is a crisis in confidence: people don't know how to evaluate the risky assets after having burned by subprime mortgages. So they start to sell all the assets for cash. So if you take a look, ALL asset classes are under selling pressure, even the darlings just a few months ago (oil and commodities). It will take a long time to restore confidence.

I have been a critic of the Fed and US government for creating such crisis in the first place. But the action, or lack of action of the Fed and the Treasury department over the weekend, was a wise decision. I think history will prove that not bailing out Lehman was the right move. Collapse of Lehman is no big deal. The Fed should not even have bailed out Bear Stearns earlier this year. But Fannie and Freddie were entirely a different matter. Taking out Fannie and Freddie was necessary and a right move, in my opinion. Today, the Fed maintain the Fed Funds rate at 2%, which is a big sigh of relief. I was really worried about that Fed would cave in to the pressure from the Wall Street and lower the interest rate. At this point lowering interest has no positive effect at all. It in fact would be counter productive, causing further panic in the financial markets. Lowering interest rate would do nothing to reduce investors' risk premium, which is very high right now.

So what is my assessment of the situation? Should we sell stock and stay in cash, or this is a great opportunity to buy? Before I tell you my opinion, let me show you my thought process:
If one looks at the entire US economy in three segments: household sector, government sector and corporate sector, and then analyzes the health of each sector, he or she should be able to see more clearly where problems lie and what are the solutions.

1) US household is under stress, there is no doubt about that. Consumer spending has been outpacing consumption for a long time, financed by cheap credit provided by foreign investors. Since 2000, medium household income actually shrunk in real term by $1000, according to some reports. Wealth gap has widened significantly. The ultra rich have seen their wealth grow fastest in decades, while middle to lower class people are suffering. When the US consumer cannot borrow against their future income, they started to borrow against their assets, their houses. Due to the artificial low interest rate engineered by Allan Greenspan and the Fed, Americans were able to extract tremendous amount of cash from home equities, and spend the cash as on home remodeling, vacation, or buying bigger nicer cars. Then the house prices start to decline, that is when many people begin to see equities in their houses evaporated. Mortgage default rate start to rise rapidly, creating a chain reaction in the world financial institutions who willing lent to these overstretched homeowners.
Now US household is deleveraging, trying to repair the balance sheet. That is a good thing. But expect consumer spending to decline in the next few years, and financial service industry will have to de-leverage, too, to shrink their balance sheets as well. So the demise of a few financial institutions is just the normal course of the consumer adjustment we are witnessing now. That is good in long run, painful in near term.
2) The government sector is also under stress. Tax revenue has not grown, due to the big tax cut Bush enacted back in 2002. In the meanwhile spending has rocketed, largely due to twin wars we are fighting in Iraq and Afghanistan. The government cannot continue to rely on printing money to finance the deficit spending. So we either have to raise the tax or cut spending, or both. You can't raise tax on middle class in this economic environment. I support Obama's tax plan to raise taxes on the wealthy, who have disproportionally benefited under the Bush tax plan. In the meanwhile, we have to cut spending. That is difficult: you cannot cut social security or medicare. Healthcare for the uninsured will be extra money the government has to spend. And the national infrastructure is also in dire need of repair (bridge collapse in Minneapolis was an indication). We also have to invest in alternative energy (wind mills) to wean our dependence on fossil fuel. So where the cut can come from? The only place is Iraq and Afghanistan war spending. The whole war on terror is a self inflicted pain. As you know, the US government had all the tools to prevent 9/11 from happening. If you don't believe they made 9/11 happen, you should at least believe they LET 9/11 happen. So the whole war-on-terror spending is just waste of money and resources. We can save that for more productive use, such as building the national energy and transportation infrastructure and investing in healthcare. That is why it is so important to elect Obama as President coming November.
3) US corporate sector, apart from the financial institutions or auto industry, is very healthy. Profit margins are at all time high. Earnings have been strong. Corporations are awash with cash, balance sheet is pristine. US companies are very competitive compared with companies of other nations. So the US corporate sector is very strong. We have to encourage corporations to invest in the US to create jobs and grow household income. I think Obama has detailed plan for that.
So what is my opinion?
If Obama wins, I will buy stocks with all the money I have. If McCain wins, and he continues the Bush policy, then I will have to cash out to invest in gold and swiss franc.
We got to elect Obama!