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This week has been no different than the last two. We are still in circus mode over here on Wall Street. The government has stepped in tuxedo and all. The latest figures have put the government’s bailout amount at $700 billion. There are loose estimates that say this number can climb to a trillion dollars.

Do you realize how many zeros that is? Twelve. $1,000,000,000,000.

What a joke. I am NOT an economist and it’d be foolish for me to presume that I know what is going to happen in the long run. There are people much smarter than I who are chest-deep in Microsoft Excel calculating that. But here’s my speculation.

Where is this trillion dollars coming from? You can’t raise a trillion dollars from tax payers. Not possible. You can only borrow so much from abroad. So the result seems to me like an overtime on the Xerox printing presses. If we are just printing money, this gradually will decrease the power of the dollar over long-term. Not to be confused with short-term fluctuations, the long-term decrease indicates a substantial shift in the intrinsic value of the dollar. No more “oh it’ll bounce back - this is America.” Forget it.

The result of a weakening dollar is increased commodity prices. Energy, food, metals, and the like will rise. Meaning we still will be complaining about our ridiculous corn prices and fuel prices, and we won’t be able to leave the country and take advantage of the conversion. On the flipside, when we leave the country, we’ll be spending money faster than we even realize. Do you remember going to the U.K. a few years ago? A burger would cost you $12. That $12 burger is now available all over the world.

Since the onset of all this news, the dollar has seen a 10% drop against all major currencies. We’re already looking gloomy.

What I’m particularly curious of is how on Earth did the government come up with this thirteen digit figure? For years, the world’s smartest people have been trying to pinpoint a value on this credit crisis and have come up empty handed. But in a matter of a few weeks, the Fed has it all figured out? We are talking about crummy mortgages bundled up and resold, and then bundled up and resold again, and then bundled up and resold yet again in even different countries. The bottom line is that nobody really understands this thing - perhaps two or three people who certainly have sold out a long time ago and now have a private bungalow in the Cayman Islands. Did the Fed magically figure it out?

In my humble opinion, a bailout of this magnitude will result in several years of stagnant or zero growth by the US economy. With all that said, I do think that some action had to be taken swiftly. This may have rough long term consequences, but lack of action would have resulted in catastrophic short term movements. This bailout has indeed brought about some type of resolution to the profound risk of an entire systematic collapse. As I’ve said in other posts, this entire mess will pass. The Fed’s move has ensured that will happen. But we just shot ourselves in the foot to save our leg.

Last week the federal government took over Fannie Mae and Freddie Mac, the nation’s largest mortgage institutions, in a move to save the companies from completely going under. By the end of the same week, speculation and rumours started to surface about Lehman Brothers and a financial crisis. Over a hurricane-filled weekend, Lehman Brothers declared bankruptcy and AIG asked the Federal Reserve for liquidity assistance. Meanwhile, Merrill Lynch was taken over by the Bank of America powerhouse (who will soon indeed become the bank of America). On a sunny Monday morning, investors pulled out enough funds from the market to tank the indices over 500 points, or down nearly 5%. The only other thing that could tank the market in this fashion is the day two planes flew into two skyscrapers, permanently affecting the Manhattan skyline (dramatic enough for you?)

On Tuesday the Federal Reserve refused to cut rates and refused to provide support for Lehman brothers, sending the markets down even further, but fortunately enough half-full kind of guys bid it back up. But Wednesday’s trifecta perfected the bloodbath on Wall Street, resulting in further triple digit losses. The government agreed to bail out AIG, and speculation ensued on “who’s next”? Goldman? Morgan? Only time will tell.

So what is happening?? The headlines spell financial crisis.

What we are dealing with here is a major broad-based price correction in the markets. As the Washington Post described earlier this week - we are in the midst of building a new architecture for the financial world. After years of record earnings and creative new methods of financing, the titans and powerhouses of Wall Street have to reckon with the reality that the financial sector they built has grown too large and is unsustainable given the amount of leveraging and debt usage they’ve incorporated. The economy is in danger due to incessant greed.

The regulators and the financial institutions themselves completely miscalculated the risks they were putting the economy and the country into. When wealth grows beyond sustainable levels - it will correct itself. The timeless mantra of Benjamin Graham and his disciples such as Warren Buffett and Phillip Fisher states that the natural law of time will indeed correct overpriced companies and simultaneously reward and correct underpriced valuations. We are well into correction phase. When institutions dream up crafty new ways of building wealth in the markets - they are forgetting the fundamental rule of business - offering a quality product or service for the right price to the markets and monitoring competitive threats every step of the way. Instead of offering quality mortgage loans to the buyers/lenders/borrowers, crummy mortgage loans were offered and then repackaged. No matter how many times crummy mortgage loans are repackaged into clever packages (and then offered as bonds to the public), they are still crummy.

When markets need to correct - you generally see it gradually over several years. The good guys end up watching the bad guys suffer as earnings prove unsustainable, and vultures pick up the pieces left by companies falling part. But when there has been a gross and broad-based miscalculation by just about everyone, what we see is a dramatic series of midnight meetings, last minute bailouts, triple digit losses, and what looks like the entire American financial system crumbling in front of your eyes.

But I suggest to my readers - fear not. Keep the cash on the sidelines ready to pounce when the iron is hot. A correction does not mean meltdown. It simply is the path necessary to return to normalcy and rationalism.

This too, shall pass.

In light of the crisis going on in our financial markets,the CEOs of three companies came together and discussed the situation. Don’t take what’s written below as gospel - but I found it rather insightful - and determining what major companies are doing to combat the economy may be a way for you to spend more time enjoying yourself in the Investment Playground. McGraw Hill, Verizon, and Xerox CEOs answered questions from reporters at a press conference on the Business Roundtable’s competitiveness agenda this morning in a Washington hotel. Here’s what they had to say about the current crisis and the economy: 

Anne Mulcahy, CEO, Xerox

“I think [the crisis is] going to last a lot longer than perhaps we would have anticipated. The bump up might be a little bit further out.”

“It’s fundamentally not a credit problem for business right now. What you do have is a very nervous business environment in the U.S. that’s quite frankly a little hesitant in terms of decisions and clearly has caused a slowdown.”

More than half of Xerox’s business comes from outside the U.S. “When you have weakness in an economy or in an industry, a diverse structure becomes really important. That has been a great hedge against some of the local softness.” 

On the response to the crisis: “You can see that they’ve wisely acted in a situational way.” The outcomes for AIG, Fannie Mae and Freddie Mac were different from the crisis around Lehman Brothers and Merrill Lynch, she said. “It may not be perfect, but it was timely and I think it was situational as it should be.”

Ivan Seidenberg, CEO, Verizon

Up until the weekend crisis — which provoked layoffs on Wall Street — unemployment hadn’t risen as much as some people had expected. “We haven’t seen a big retrenchment because we haven’t seen big layoffs or big consolidation.” He now expects some further layoffs due to consolidation in financial services.

“We haven’t yet seen this financial crisis translate into fewer jobs, less companies starting up, less research and development, less marketing. We haven’t seen that yet. I’m sure every company is keeping their eyes on it.”

Harold McGraw, CEO, McGraw-Hill Cos.

He said the global implications of AIG failing were too high. “There needed to be a way to step up… Whether you agree with the specifics or not” he praised government officials for stepping up quickly with a “very creative” response by taking a loan in the firms.

I always like to look at the lessons we can learn from history. Humans don’t change - we’re fickle-minded impatient people and we have been forever. So in this current official bear market, what can history teach us about the future?

First of all - stop panicking. We’re in a bear market, again. This isn’t some life-threatening ordeal. It amazes me how in every bear market, people always put the US up for sale in a heartbeat, but never seem to learn. Sure things are bad. Very bad - a perfect storm is indeed brewing with real estate, oil prices, job losses, etc. But this too, shall pass. The S&P’s peak was October 12 at 14,093 - we’re off over 23% from those highs. That’s a pretty steep drop. It gets me excited to start dumping more money in. Here’s why.

The average decline during the last nine bear markets was 31%. This means that it’s possible, yet unlikely, to fall further down to 9,700. But with that said - most of the drop has already happened, historically speaking. Most, but not all of the bad news is already priced in. Now is the time to start buying up into indexes slowly and methodically. After falling 20% - the last nine bear markets have returned a positive average of 3% within just one month of crossing that negative 20% threshold. And within twelve months, the last nine bear markets have returned an average of 17%.

17% - that is not chump change. This means that if history proves true, and we invest today given that we’ve crossed the 20% threshold, we’ll earn about 17% in the next twelve months. And if we’re no where near the bottom, we still stand to gain perhaps 10% (also not chump change).

History can’t always prove correct, but it’s definitely a good indicator. So far, this bear market has unfolded exactly as the past nine have. On average, the nine crossed the 20% decline point nine months after beginning their decline. We’re right on schedule. The past bear markets lasted, on average, another five months.

Things are pretty bad out there. But let’s get things in perspective. In the 2002 crash, irrational exuberance ruled, which is something we are all protected against today. Contrarily, when we hit 14,000 back in October, industry experts were wondering “how did it get this high?” as opposed to “how much higher?”. The market was selling at a P/E of 35 before the 2002 crash. The P/E was even higher at 40 times earnings in the 1973 crash. Back in October - we were at a mere 19 times earnings. Sure things were overvalued, but not anywhere near historical records. If that’s not enough to convince you: the 1987 crash showed a 23% drop in one single trading day. It took us eight months to do that this time around. The 1970s showed double digit inflation couple with record oil prices. Perhaps today’s 6% inflation is high, but its still manageable.

In 1990, thousands of savings and loans banks failed, and the financial sector went kaput. This caused a 20% drop in about three months. This one resembles 1990 quite closely.

I do think we have quite a bit more to go, but I wouldn’t bet the horse on it. I’d slowly start putting my money back into the market. The lower it goes, the more aggressive I’ll invest. 10,500 will indicate more deposits into my Scottrade account, and at 10,000 (if we ever get there), I’ll probably dump a ton of cash into the markets. It’s easier to hold long-term than to try and time the market.

So everyone relax and let this bear market unravel itself. It’s happened nine times before since 1956. Turn off the TV Chicken Little - we’re not done investing quite yet.

Much of this article is derived from a great piece written by Kiplinger’s.

I’m not one for doomsday scenarios and melodrama. But I do sincerely believe that one should always protect the downside, and the upside will take care of itself. This doesn’t mean running away from any type of risk faster than Hillary from the White House. What I mean is to err on the side of caution and build nets in place to protect yourself from the downside. With that said - the first part of protecting the downside is KNOWING the downside.

Consumers and corporations have been irrationally spending and borrowing for far too long. The end result of what we’ve seen in the last ten years is going to bite us in the ass hard. And the timing just couldn’t be more awful. Previous slowdowns in the economy hit a low point and then bounce off faster than Michael Jackson in DisneyLand. But this time things are bound to be a bit different. Michael’s in Bahrain, DisneyLand is polluted, and a slew of other problems will make this recession last a bit longer (potentially).

I’m not giving my opinion on the economy. To be honest I don’t have one. But the facts are clear. The economy is facing a serious credit crunch. Consumers and corporations need money now more than they did in earlier years, yet banks are hesitant to lend. Interest rates as low as they are aren’t spurring enough motivation for banks to lend their capital, and in turn are fueling inflation. The housing crisis has left millions of people owing more to the banks than their property’s are valued (including myself). Consumer money is kept on the sidelines as people are terrified of buying homes, and further are unable to sell theirs (including mine). Falling home prices and the negative equity effect has seen an increase in foreclosures, rising inventories, and also has made refinancing a lot tougher. The homeowner is screwed.

High oil prices in an inflationary state have resulted in a very large band aid being taken off little by little. I was quite proud of myself last December when I bought a luxury car - my arrogance made me feel like I’m unaffected by the credit crunch. $70 to fill up my ridiculous loan-on-wheels has made me realize what we’re up against. Most of the country has already begun making ultimatum decisions: do we fill up on gas or do we pay the rent? Sounds dramatic - but its true. Go ahead and try this - ask a coworker that hates your guts if you’d like to carpool with him. Positive response? I thought so. A match made in heaven.

As far as the corporation is concerned - the overall business cycle is dragged down by consumers refusing to buy (see Starbucks’ latest earnings release), otherwise known as weakening consumption. This coupled with low investment has resulted in every company in the country cutting costs (including mine). There’s only so much a company can do. Subsidized lunches? Gone. Free coffee? Deposit quarter here. Health club free for employees? New low price! Need a new piece of equipment? HA! After all these avenues have been trudged through - there’s one place left to go. Lose the employee. The average employee makes over $95,000 per year. If we get rid of merely ten of these guys who aren’t working hard enough - despite the fact that they all have babies and mortgages and ridiculous new car loans - we as a company can save a million dollars a year.

The moral of this story: 1) Watch your back. 2) Work harder now than you ever have before. In an age of outsourcing and cost-cutting, you better be sure that the company declares you damn near irreplaceable. 3) Hedge yourself, find alternative methods of income. and 4) We haven’t seen the end of this downturn quite yet. Again - I’m not forecasting the economy. Leave that to the overpaid Bernankes of the world. All I’m saying is - know the downside and start to protect yourself.

IP