Ken Kam's Best Ideas Blog

The threat of a massive credit crunch that could send the economy into a severe recession has been a drag on the market. Almost any negative news sent jittery investors scrambling to sell, oftentimes indiscriminately.

The threat is largely over but the fear remains. This is a good time to look through your portfolio to free up cash to invest in your best ideas.

Fear spreads quickly...

In November, when Goldman Sachs said that sub-prime mortgage losses could cut the banking system's credit capacity and reduce the money supply by a whopping $2 trillion, they said it could trigger a "substantial" recession. Fear spread quickly sending the market tumbling downward.

Fortunately, Goldman Sachs was wrong.

The sub-prime mortgage losses so far have been around $100 billion and according to the Fed could go as high as $200 billion. While this sounds like a lot of money, it is a pretty small part of the $14 trillion U.S. economy. This is a problem the markets and the Fed can manage.

Banks that took too much risk from the sub-prime market, had to raise capital. Citibank, Bear Stearns, Merrill Lynch, and many others got fresh infusions of capital, often from foreign investors, to strengthen their balance sheets.

And the Federal Reserve continued to drop interest rates from 5-1/4 in Sept. to 4-1/4 in Dec. with further cuts expected. Not only did this inject money into the system, more importantly, it helped shore up the balance sheets of banks by increasing the value of ALL their assets.

In stark contrast, European regulators and central bankers seem to be sitting idle. Troubled European banks have not attracted similar infusions of new capital, and neither the Bank of England nor the European Central Bank have cut interest rates. For now it looks like the U.S. and European central banks are not coordinating their efforts as they have in past times of crisis.

When the Federal Reserve cuts interest rates and others do not, the value of the U.S. dollar falls. A weaker U.S. dollar means U.S. products are cheaper and more competitive in a global market. And more importantly, because financial markets are global, companies can borrow money cheaper to fund projects around the world. Lower rates by the Fed will fuel growth globally at a time when the U.S. is more price-competitive.

The threat has past so the biggest risk going forward is fear. Fear can cause consumers to stop buying, investors to start selling, banks to stop lending, and companies to stop investing.

...Restoring confidence takes time

There is little the President, the Federal Reserve, or Congress can do to restore confidence quickly. It is going to take time for investors to realize that things are not as bad as it seems. In the meantime, this is a great time to look for bargains.

After the technology stock bubble burst in 2000 many people exited the market altogether. Others held on to technology stocks, and some even bought more, hoping for a turnaround. Both of these strategies were mistakes. It took nearly three years to reach the bottom, and even today many of these companies are well below where they traded in 1999. Don't make the same mistake with financial and real estate stocks now.

In early 2000, before the technology bubble burst, the S&P 500's weighting for technology stocks was at its peak. Because of this, as tech stocks fell, the S&P 500 also fell, giving the false impression that the whole market was falling apart.

In fact, the Fed dropped interest rates to the lowest levels over the past 50 years, which pushed natural resources, financials, and real estate to the top of the performance rankings. In hindsight, selling technology stocks and investing in these areas was the right thing to do.

Something similar is happening now with financial stocks. After years of out performance, the financials sector is the most heavily weighted sector of the S&P 500. When financials go down, the S&P 500 is dragged down, but that does not mean that the whole market should be avoided.

This time, it looks like financials and real estate stocks will be the "dogs." But the liquidity the Fed is creating is eventually going to find its way into other segments of the market. Once the hysteria subsides, it is likely that market leadership will change and the new leaders will deliver the best returns we'll see for the rest of this decade.

The market's selloff has been so widespread that many stocks are cheap, selling at fire sales. Because it takes time for confidence to return to the market, there is no need to rush to buy stocks, but it is a good time to reevaluate all of our stocks to make sure we still like them in light of current market conditions, and to take another look at the stocks on our watchlist that used to be too expensive, but perhaps now aren't.

Ideally, we want Best Ideas stocks that can grow even if the economy is in recession, are unaffected by the losses in the banking system, and will benefit from lower interest rates.