The credit crunch is lingering says The Times. And it means more layoffs for Wall Street suits.

Citigroup, America’s largest bank, is about to slash 10% of its roughly 65,000 workforce. That’s a whopping 6,500 former high-fliers who are going to wake up a a new jobless reality. “Some staff could be told today that their services will no longer be required,” says The Times.

A “new wave” of the credit crisis is now battering banks and lenders that steered clear of toxic subprime-related loans, says The Washington Post. Ordinary borrowers simply can’t pay back their loans thanks to the downturn in the US economy.

Billionaire speculator and head of Soros Fund Management says we’re facing the worst financial crisis since the Great Depression.

But many in the financial community are saying the worst is over. Why? Merryn Somerset Webb in Money Week says most fund managers are still in denial about the state of the market.

Merryn reckons you first need to believe in it to know how to invest…

How do you cope with a credit crunch? That’s the question I was asked to address in a talk to a group of Dutch pension fund managers earlier this week. The answer? First, you have to accept that it isn’t going away.

And this is where the problem seems to lie for much of the financial community – my reluctant audience included. For months now, we have had to put up with listening to men with important job titles telling us that the worst is over, and that we can “look across the valley” to the good times beyond the current gloom. But looking at the way this crisis is playing out, I’m pretty sure we won’t really be able to do that for some time to come.

In a recent note, James Montier of Société Générale reminds us of the stages of the average bubble. First comes a perfectly legitimate boom of some kind. Then comes the credit creation that makes it into a bubble. Next up is “euphoria” as “everyone starts to buy into the new era” as prices are seen as only ever rising. New valuation measures are introduced to justify absurd prices, and a “wave of over-optimism” means even the cleverest of people end up overestimating potential profits and underestimating risk. Sounds familiar doesn’t it?

Then the bad bit comes. First, “distress,” as the huge amount of leverage built up in the euphoria stage starts to be a problem and the market in question tanks. And finally “revulsion” – the stage where “investors are so scarred by the events in which they participated that they can no longer bring themselves to participate in the market at all”.

So where are we now? Well, we most certainly aren’t at revulsion. There are a few panicky voices out there. Witness the report out from analysts at RBS (NYSE:RBS) this week. It comes a little late to the table (after the market stripped of energy and mining is already down 30-odd per cent), but forecasts a “potentially very nasty August to October period” and notes that the housing/credit downturn will last “a long time”. Cash, says its author is “the key safe haven.” You can add to that the very public worries of George Soros – “we are now in a period of wealth destruction,” he says – plus a few other überbears.

But while they all make a lot of noise (and good headlines), there aren’t actually that many of them. Most ordinary fund managers are sticking with the echoes of their euphoria and lacing their strategies with copious quantities of hope. They think that equities are cheap and that the anti-crunch measures taken by the central banks over the last 10 months have pretty much done the trick.

I had a meeting with one manager recently who had a vast holding in Bradford & Bingley (BB) and said that he could see fabulous bargains emerging all over the UK market. B&B is clearly one of these would-be bargains, despite its exposure to the most obviously bad thing in the UK economy (buy-to-let), but he also pointed to Home Retail Group, owner of Argos, a company that looks cheap in price/earnings (p/e) terms.

I suspect he hasn’t a good year ahead of him. Equities only look cheap because most of the earnings forecasts are wrong. The ‘e’ bit of the p/e equation in the case of most retailers is probably more of a fantasy than a forecast – and, if you accept that collapsing house prices and falling real wages aren’t good for consumption, then it is likely to remain so.

Profit margins in the west have been at record highs for years. This looks to be just the time for them to revert to the mean. That implies a fall in company earnings in Europe of at least 20 per cent, say analysts at Morgan Stanley (MS).

Right now they are still forecast, for reasons I can’t begin to understand, to grow an average of over 10 per cent in Europe and 8 per cent in the UK. At the same time, the credit crunch is still very much with us. Try getting a mortgage, raising the limit on your credit card or borrowing money to start a new business if you aren’t convinced. There is also now no denying that the crunch is hitting real economies, nor that there are probably some very unhelpful rate rises ahead.

Both the Bank of England and the European Central Bank have made it clear that they haven’t gone soft on inflation, so with it looking increasingly entrenched everywhere from the UK to Argentina and Vietnam they are, as Hugh Hendry of Eclectica Asset Management puts it, looking more and more likely to “turn Austrian” (the Austrian school is pretty strict on inflation). Given the astonishing amount of debt in the system at the moment – both personal and corporate – that’s going to hurt. Mortgage debt alone, says Hendry, is more than 100 per cent of GDP. Look at all these elements and we seem to be more at the “distress” stage than at the end of the crunch, or indeed the bear market.

It’s verging on the impossible to predict the short-term movements of markets but it’s worth bearing in mind that a good rally doesn’t tell you a nasty bear market has ended. More often than not it’s just the bear keeping your hopes up, so it can have a good stamp on them a few months later.

Montier’s “road to revulsion” is littered with false hopes – just ask the Japanese, who in their grindingly awful bear market of the last 15-odd years have had to put up with several 40 per cent-plus rallies followed by similar mini-crashes.

The road can also take valuations down lower than anyone could consider reasonable and it can do so very slowly: the average duration of a real bear market, say Morgan Stanley analysts, is 14 years. If ours really started in 2000, that means there are six years to go.

So, returning to my opening question – how do you cope with the crunch? First you need to believe in it and then perhaps you need to make sure you have a lot more cash in your portfolio than you have shares in B&B and Argos.

Source: How to cope with the credit crunch