You can’t deny 2007 was the year of living dangerously in financial markets. So far this losing streak has continued through the first quarter—with the notable exception of soaring commodity markets!

According to Business Week, a shocking 80% of the companies in the S&P 500 index watched their market-caps shrink from October through the end the April.

At last count, banks and other financial institutions have written down nearly $320 billion from their books, in a desperate attempt to keep their heads above water. The International Monetary Fund estimates that institutions will write a cool TRILLION off their books before this sub-prime mess finally ends.

And the carnage continues. In just the past week: mortgage lender Fannie Mae posted a US$2 billion loss for the first quarter. Insurance giant American International Group posted a US$7.8 billion loss thanks to a big write down of its derivative holdings (that’s on top of a US$5 billion fourth-quarter loss). Yesterday, Citigroup announced plans to “wind down” about US$400 billion in assets to try to dig itself out of debt. Even Warren Buffett’s beloved Berkshire Hathaway lost a BILLION bucks on derivative investments last quarter.

But few know that while institutions and individuals alike bled funds through these last nine months, a small group of investors quietly reaped the rewards of these unforgiving markets. I can site one particular disparity that bred a much-needed trend change — a change that many were late to recognize.

And while this trend change paid off nicely already — if you were positioned for it — the potential for a second round of gains is quietly approaching. I’ll tell you how to jump on that trend in just a second. But first, let me set the stage…

You Needed a Strong Stomach to
Ride Stocks Last Year

Last year, global stocks experienced quite a rollercoaster ride. Last spring, things were flowing smoothly and markets were shooting higher. Emerging markets were some of the biggest winners, but equities as a whole were sucking up investment capital all over the world.

Then the global credit crunch hit the markets in July 2007. This market shock upset the risk-taking attitude among global traders and shook the life out of stocks.

Since then, the S&P has fallen sharply from its October 2007 highs. Even Chinese stocks, among the largest pre-credit-crunch gainers, are still well off their highs.

The last six months have not been kind to the risk-taking investor class. There have been very few positive developments to support a market rebound. Even still, many stock market participants are holding onto hope in the face of a laundry list of problems.

Too Soon to Raise the White Flag?

But are the warning flags being reined-in prematurely? After all, the risks are not necessarily subsiding:

• Financial firms all over the U.S. and Europe are still struggling to cope with the credit crunch, taking write-offs in the tens of billions of dollars
• Sub-prime mortgage losses and write-downs are expected to grow far larger. Market cuts and bruises are likely to morph into gaping wounds for major lending institutions
• Banks are unable or unwilling to expand lending practices — net losses and ratings downgrades are taking their toll on the banks overall capital

As I said the IMF says institutions will write-down a US$1 trillion from their books before we’re done. Current losses-to-date stand at US$300 billion. So apparently we’re only a third of the way through this mess, I think we can only credit the resiliency of the stock market bulls to the Federal Reserve.

They’ve lowered their Fed funds and discount rates substantially and given investors reason to believe stocks are set to turn back higher, sooner rather than later. It’s a classic case of the “mama-bird-will-save-us” mentality. Investors have expected a hand-fed meal and the Fed is doing what they can to deliver it.

This is One Mess the Fed Can’t Clean Up

Sub-prime mortgage problems in the U.S. morphed into a global credit crisis. And banks got themselves into trouble by investing in what has turned out to be complicated bundles of bad debt tied to sub-prime mortgages. And even though central banks have aimed their focus towards this ultimate concern, they’re dealing with seriously large masses of confusing debt-backed derivatives. And central bank efforts may not be enough to clean up this mess in a timely fashion.

It all started when financial rocket scientists in white lab coats created the most complex investments they could dream up. These irresponsibly contrived investments became known as derivatives.

Turns out, this breed of derivatives act a lot differently in the real world than their creators expected. And now banks are stuck cleaning up losses on investments they don’t understand. The result: Banks have become reluctant to lend money because the need to stockpile extra funds as a sort of “complicated investment insurance” is growing.

Already, hundreds of billions of dollars of bad debt has surfaced on institutions’ balance sheets everywhere. And while the Fed and others have made various efforts, it’s still bad debt and it’s still going to take time to account for the balance of this ill-advised decision making.

It’ll take a while for banks to get back to doing what banks do best — lending money comfortably.

Introducing the Ugly Sister of the FX Markets

Much of last year I focused on a large imbalance that had developed in the foreign exchange market. The British pound had risen substantially to levels well beyond reasonable valuation. And while the pound became exceptionally overvalued versus the U.S. dollar, it was the widening gap between the British pound and the Japanese yen that caught my eye.

As the pound became increasingly overvalued and the yen increasingly undervalued, it became more and more likely that the gap would soon collapse. The agonizing credit crunch became the catalyst that would begin to close this gap.

The chart below compares the British pound to the Japanese yen. Clearly, the British pound has appreciated substantially against the yen over the past seven years. The simple fact that traders and investors shunned low-yielding assets (like the yen) in favor of high-yielding assets (like the pound) explains this major separation.

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