When the president, the chairman of the Federal Reserve, and the U.S. Treasury secretary are all talking about the prospect of an economic meltdown, it is a safe assumption that the situation is very dire.

As we all should understand by now, the United States has a credit-based economy. A credit economy can only function as long as there is honesty and trust by the vast majority of parties involved. A bank is willing to loan me money in exchange for my promise that I will repay that loan. My ability to pay is based on the promise of my employer that I will be paid for the work that I do. My employer’s payment to me depends on clients who have promised to pay for the services they receive.

There is an interconnecting chain of promises and the current economic trouble is a result of breaks in that chain. Right now the banks have born the brunt of the damage because they are the ones who have lent money that is not being repaid. If enough banks fail, then there is a danger that the entire system could break down.

It is important to note that not all banks have been equally hurt. For example, the chart below shows the stocks of three different banks. The black line is Wells Fargo, which is considered by many to be the strongest major U.S. bank. Notice that for the year, the stock price is actually showing a gain of almost 20%. Compare that to Citigroup (gold line), which is down almost 40%, or with Downey Savings and Loan (blue line), which is currently off about 80% in 2008.

It is far too early to know what impact today’s announced government bailout will have on the banking industry. Certainly Wall Street is pleased that some action is being taken, as evidenced by today’s rise in major indices.

Over the short term–in spite of today’s stock market advance–the bailout is likely to change very little. The trust that is the foundation of our economic system has been compromised. Trust is something that will need to be rebuilt over a period of weeks and months. In the meantime, expect to see credit remain very tight and stock market volatility to continue.

For now, investors following our advice should be safely on the sidelines or in assets that do not correlate to daily market movements. At some point in the not too distant future, this situation will turn around and investors are going to be presented with a great opportunity to re-enter the markets. 
F.S.

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