When to Buy Stocks?

What Is the Problem?
Almost a year ago, I was on television talking about the credit crisis. Everyone was still calling it a "liquidity crisis" back then, and I absolutely disagreed. I said it was a solvency and information crisis. I reiterated my point that our financial system is effectively insolvent again in March. The statement generated some controversy at the time, but it seemed plainly obvious to me. You can sum up all the mortgages outstanding in the system along with the home equity cushion and mark that down to a point where home prices made sense relative to fundamental values like rents and incomes. Then compare that mark to the total amount of capital supporting the financial system, and there you have it: insolvency. At least our leaders have finally realized the root of the problem is not liquidity, but solvency. The $700 billion Troubled Asset Relief Program will hopefully recapitalize the financial system.

The information crisis is twofold. First, financial institutions know too much in the sense that if  Bank of America (BAC) knows what kind of junk is on its balance sheet, it can guess at the kind of junk  Citigroup (C) has on its balance sheet. On the other hand, we all had too little information, so there is a complete lack of trust by counterparties. To make a macabre analogy, our financial institutions are like victims of various contagious diseases. You know that the other people in room probably have some disease because they were infected by the same outbreak that infected you, but no one is willing to get tested and instead insists they are in perfect health. What's the rational course of action in this case? Avoid everyone else like the plague. That's our financial system right now--no one is willing to extend credit to anyone else.

What Can I Do Now?
Sit tight. If you haven't put on your rain gear by now, it's time to wait for the storm to pass. The most important thing during a bear market is to keep your emotions under control. I have been strongly urging my GrowthInvestor newsletter subscribers to hold some cash because at the bottom of bear markets, when everyone else has thrown in the towel, you want both the capital and the emotional fortitude to pick up the bargains.

I certainly should have listened to my own advice, as some recent purchases for GrowthInvestor, such as  Quicksilver Gas Services ,  Legacy Reserves , and  Denbury Resources , have been clobbered. I knew the deleveraging cycle would be bad, but I thought fundamentals would matter somewhat. Wow, I was absolutely wrong about that. Fundamentals don't matter in a bear market. Fear is the only thing that matters.

However, I still don't think I'm wrong about the fundamentals. If I had told you a year ago, when oil was trading at around $70 per barrel, that we would be standing on the brink of global economic collapse and oil would still be around $90 per barrel, would you think I was crazy? Yet, here we are. The fact that oil is still around $90 per barrel speaks to the magnitude of the supply constraint. Of course, the economic picture could get a lot worse. That's why I mentioned a few months ago that I wish I could run the Growth Portfolio long/short. Holding Legacy as it got cut in half (and now yielding 17%!) is painful, but shorting an investment bank or two into oblivion can help to ease the pain.

If I were stranded on a desert island for the next 10 years, I'd want all my money in domestic sources of oil. The central banks around the world are doing everything in their power to reinflate, and this means printing money. Real assets will have value. Moreover, before the credit markets shut down, we were fighting a tough battle against the inexorable decline of existing oil production. Current oil prices won't shut down existing production because the variable costs are still far below, but new exploration should slow significantly. Also, without a functioning credit market to finance new production, the supply constraint could become much worse. This is by far the most depressing aspect of the credit crisis for me. We face real problems as a civilization with energy and our energy infrastructure. Without financing, new power plants get shelved, new oil production is slowed, and investments in alternative energy are scrapped. We may have endangered the foundation of our civilization because we wanted to flip some houses.

When to Buy Stocks?
By traditional measures, plenty of stocks look cheap. High-quality companies are trading at single-digit multiples and the master limited partnerships (MLPs) are trading at insane yields. However, I have concerns that the opportunity cost of capital is incredibly high right now. I've been buying lots of things recently, but not equities. If you want real bargains, go poke around the debt markets. When I talk to my friends in the hedge fund and private equity worlds, all I hear is that the new money being raised now is slated for the debt markets. Equities will have to compete for capital with the debt market, and given the relative values right now, I have no idea why anyone would buy equities. Either the debt market has to recover (bringing down yields) or the stock market has further declines ahead (bringing up yields).

So is this a good time to buy? It probably is, but until the credit and debt markets recover and the opportunity cost of capital declines, there may be more buying opportunities ahead for equities.