A Small Window

There are only a few moments in an investment lifetime where there is fear so thick, panic so diffuse, and thus pricing so low that great riches await those willing to bear the risk of buying. This is one of those times: a small window of opportunity through which the landscape looks so darkly menacing that few would try.

A run on Bear Stearns has hobbled this storied firm, causing rumors of further brokerage flame-outs. The financial crisis has sparked fears of another Great Depression. There's talk of soup lines and a foreclosed America, the end of fiat currency and the start of a brave new world--presumably governed by barter and gold specie and ruled by hunter-gatherers of another epoch. For the apocalyptically inclined, it doesn't get much better than this. The end of the world seems to beckon, with almost feverish promise.

The reality, as usual, will be much more mundane: the recession will be deep and difficult, followed by a recovery of the most banal and cyclical. Fear will recede, turn to realization, then consolation and finally optimism--until it turns back to greed--and the whole mess repeats. This is the eternal story of business and markets.

Financial stocks are priced for perdition, which is just when you want to buy them. They're up from the January and March lows but still cheap enough to buy with all that juicy pessimism priced in. The XLF (the broad ETF basket of financial stocks) is trading at $26.32--after hitting intraday lows of $24.11 on January 22 and $22.29 on March 17. If the collapse of Bear could not topple them far below the capitulatory pricing of January 22, not much will. Those who buy financials here and now, during this small window of opportunity, will do very well over the long term. In the same way that Uncle Joe puts one avuncular hand on our shoulder, the other to the horizon and asks: "Why didn't I buy up all that land back when?" people will look back in ten years and ask: "Why didn't I buy those financials then?"

The answer is always the same: fear. The opportunistic pricing that eventually spawns such regret is always accompanied by great apprehension. Those who look past the fear and buy good quality assets will be well rewarded. But most people just can't do so. The fear is borne out of real consequence and observation. After all, it's no fiction that Bear Stearns was sold out for pennies or that the housing market is suffering its worst decline in history. The recession is no hallucination. But in the same way that people tend to oversimplify and undercomplicate, they tend to extrapolate the most recent news to all future events. And so Bear Stearns becomes all brokerages and banks. No distinctions are made between degrees of leverage, management or asset quality. The consensus is one of panic and panic doesn't have the luxury of nuance.

Those who predict another Great Depression--and are thus dumping financials at these prices--are making the cardinal mistake: ignoring the odds. Is another Great Depression a possibility? Yes. A probability: No. Those who mistake the two are like the gambler at the roulette wheel: 26 red is not a probability, only a possibility--but what a possibility! And so the chips go down, never to be seen again. Here too a Great Depression is improbable--but what a possibility! Better safe than sorry, better to sell out than stay in, better to panic than make distinctions. After all, distinctions take time and the wheel is about to spin. Selling everything in a panic is like putting it all on 26 red: embracing the one improbable possibility because of its imagined intensity.

But another Great Depression is extremely unlikely for the following reasons: the Fed is being brilliantly activist and accommodating; in the period following 1929, it was passive and restrictive. The Fed is using every lever at its disposal to promote liquidity without an arbitrary standard tying its hands; in the early thirties the Fed was held back by the partial gold backing required at the time (the M2 measure of the money supply shrunk by over 30% in the four years following 1929). The Fed is offering flexibility to constrained banks and brokerages, allowing unbridled access to the discount window; in the thirties the Fed refused to increase its lending. FDIC insurance and Fed vigilance should constrain runs on banks. During the Great Depression, the lack of insurance and backstopping caused 9,000 banks to fail.

Bernanke has performed like a crack surgeon, stemming the bleeding here, deploying a shunt to reduce pressure there. He'll continue to receive criticism from anyone and everyone, but that's the nature of the job. As the world's leading academic expert on the causes of the Great Depression, he's uniquely qualified for his post. This unprecedented monetary stimulus will lead to inflation, but you don't worry about water damage when fighting a fire.

A collapse of a major financial institution like Bear Stearns often signals a market bottom, because the event is so terrifying that it shakes out the last weak holders of stock. James Finucane, a former Stifel, Nicolaus analyst who called the bottom after the '87 Crash, argues the time is now in this week's Barron's. He lists prior financial disasters (the 1970 Penn Central bankruptcy, the collapse of Continental Bank in 1984, the 1994 Mexican peso devaluation and the 1998 implosion of Long Term Capital Management), all of which marked spectacular buying opportunities. Punk Ziegel and Company's Richard Bove, one of the few bank analysts who correctly turned negative in mid-2007, terms this a "once in a generation" buying opportunity. They are still lonely voices, which increases their chance of being right.

There are those who will "wait for things to calm down to buy," not realizing that such a strategy seals its own undoing: once things appear calm and safe, opportunistic pricing will be long gone, outsized returns will already be in pocket, and the timing of re-entry will be complicated by the worry whether it's only a false bounce overlooking a retest of the lows.

I made a case for buying stocks in my quarterly client letter of July, 2002. It seemed silly in the depths of the bear market. And went on to look sillier as the market made new lows in August and September. But October 9, 2002 marked the bottom of 7286 on the Dow--amidst the gloomiest mood--and the Dow returned more than 92% over the next five years. Anyone who sold out in the summer of 2002 suffered a calamitous result. Anyone who bought made good money, even including the recent declines.

I'm not whistling past the financial graveyard. The recession will grind along. The headlines will be grim. Many weak lenders will disappear; a couple more high-profile, overleveraged companies like Bear Stearns will go belly-up. But the vast majority of sound, well-capitalized banks and insurance companies are now great values. J.P. Morgan Chase, Citigroup, American Express, AIG and Moody's (all of which I own or am buying in my fund and separate accounts) are all likely to be fine investments over the long-term. There will be those who conquer their fear, buck the conventional wisdom and buy. Those who instead await the end of the world will be waiting a long time.