Special Credit Crisis Commentary: Don't Let the Market Rally Steal Your Long-Term Profits

[Although the Dow Jones Industrial Average soared 936 points yesterday (Monday) to post its biggest one-day gain ever, Money Morning’s Keith Fitz-Gerald cautions against abandoning defensive positions.]

By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

With the huge rally we saw yesterday (Monday), the question most investors are going to ask themselves is this: Is this the real deal, or is this yet another “head fake” in a long string of downdrafts?

It’s too early to tell which way stock prices are headed from here. Indeed, traders could take this market in either direction in the weeks to come. So, before you abandon your defensive portfolio positions, here are several key points to consider:

• The London Interbank Offered Rate (LIBOR): Despite the fact that it came down over the weekend, LIBOR is still near all-time highs, which continues to suggest that banks prefer not to lend to one another – even after the trillions of dollars in bailout-related investments that we’ve seen in the past 72 hours. In very plain English, this means that the banks still don’t trust each other and that they, above all others, are leery of the smoke-and–mirrors show that we all know as the “credit crisis.”

• The real economic growth rates in the financial sector are unclear. To say that it’s an accounting nightmare is an insult to the Hollywood honchos who actually make their living transforming nightmares into movies. Fiction writers could not concocted a better horror story than the one that’s rocked world financial markets since last November. Despite all the mergers and acquisitions, and the emergency bailouts, that we’ve seen to date, Wall Street hasn’t even begun to address the underlying business prospects – on anything more than a superficial level – of the lion’s share of the companies that are being bailed out. Unfortunately, that means that nothing’s been clarified – despite the trillions of dollars in handouts we’ve seen.

• We continue to watch the trading in the Chicago Board Options Exchange Volatility Index - usually referred to as the VIX Index. Generally regarded as a proxy for fear in the markets, the VIX Index continues to trade at historically unprecedented levels. Under normal conditions, that could be associated with a pending turnaround as investor “fear” climaxes. But these are hardly normal conditions. And that means that, coincidentally, the VIX may not have gone high enough for true, hair on fire capitulation. At least not yet.

Here’s what to do now:

• Make sure your portfolio is concentrated in the stocks of stable, income generating companies – preferably companies with an international business exposure. It is clear that the United States economy will hurt for a long time to come, and exposure to the international markets offers investors the best lifeline.

• If you’ve been tempted to let go of your municipal bond-holdings, you may want to reconsider that move and hold on. If there’s one thing that’s clear about the bailout, it’s that virtually all of the government’s ammunition is being concentrated on the credit markets, of which municipal bonds are a substantial part. That means that we could see significant appreciation as these markets unlock. Many muni funds and exchange-traded funds (ETFs) are trading substantially below their net-asset values (NAVs) right now. But we suspect that won’t last for long as additional resources are brought to bear on the credit markets: The architects of these bailout plans want to unblock those markets like a plumber unblocks a drain.

• Under no circumstances should you abandon your carefully crafted defensive portfolio positions right now. There are simply too many unknowns to be able to say that we “know” the recovery is under way.

At the end of the day, whether there is a recovery or not is a moot point; history shows that the steepest correction eventually gives way to rallies. Instead, the goal for every investor right now should be to maintain a defensive posture that does not dismantle your upside potential. The two – defense against the downside with an eye toward the upside – are not mutual exclusive.

News and Related Story Links:

• Wikipedia:
  London Interbank Offered Rate.

• Money Morning Credit Crisis News:
  Credit Crisis Update: Rising LIBOR Hints at Bigger Problems to Come.

• Wikipedia:
  Municipal Bonds.

• Money Morning Special Investment Report:
  In Search of a Market Bottom: Position Yourself for Profits No Matter Which Way the Market Moves.

• Money Morning Market Commentary:
  A Currency Conundrum: Beware of the U.S. Dollar’s “Head Fake” Rally.