Eye of the Storm

The circumstances are always different, but the emotions are the same in bear markets: Despondency, despair and fear that the worst is yet to come.

The good news is it’s never as bad you think. But navigating your way through bear markets is as much a part of successful investing as making the most of bull markets. Asset values fall in a bear market, so odds are heavy that you’re going to lose money. Even those solidly short are always at risk because volatility tends to also be extremely high.

In the eye of the storm in this bear market–or, basically, the storm itself–are the financials. This bear market and the economic downturn in the US began when the mortgage market began to crack. And it’s accelerated with the discovery of every new fault line, which has been happening all too regularly.

The latest to hit the headlines is the roiling of the markets for so-called “variable-rate demand securities,” which essentially have allowed a wide range of entities to borrow for less in a tightening credit market. The $73 billion of these securities issued by municipalities in the first half of the year alleviated the strain when the market for another derivative security—auction-rate securities—collapsed earlier this year.

The twist of variable-rate demand securities is the buyer can sell anytime back to the market maker, typically banks. Given the hit to their balance sheets from the mortgage meltdown, banks have become noticeably less willing to support this market. The result is soaring interest rates for borrowers, including some municipalities paying more than 10 percent.

To reduce its exposure to the auction security meltdown of earlier this year, Citigroup (NYSE: C) announced this week that it would buy back $7.3 billion of them from a range of mostly smaller owners. That was part of a settlement with the US Securities and Exchange Commission, and it may alleviate the stress on the banks from this quarter.

The fallout downstream, however, remains a worry. A number of companies have purchased these securities as a place to park their cash. This is working through the system now in second quarter results.

Municipalities, however, are especially vulnerable. These have become increasingly cash strapped as real estate property values have fallen and other costs–such as transportation–have risen. Many have turned to auction-rate securities and variable-rate demand securities as alternatives to refinancing soaring debt costs.

The problem came when the bond insurers backing this debt lost their investment-grade ratings earlier this year. That allowed banks to back out of their obligation to buy back the auction securities.

With issuing auction-rate securities no longer an option and variable-rate demand securities scarce as well, municipalities are rapidly running out of options to support themselves, even as the economy weakens. That has very bad implications for city services in the most hit areas, as well as for municipal bonds.

And munis aren’t the only area hit by financial system’s plight. The mortgage arena is still critically weak. Government affirmations of support for Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) have prevented their outright collapse. But they’ve done little to halt the erosion of this industry overall, as defaults on even-higher-rated mortgages have begun to rise.

Weakened mortgage markets mean potential further hits to the banks that own mortgage-backed securities, as well as writedowns at the regional banks for whom they’re the bread and butter. That’s one reason why regionals are also almost surely not through with their writedowns, despite the recent string of poor results.

The US residential real estate market–and all businesses related to it–is, of course, hurt by the continued deterioration of mortgages. Property values are now falling in earnest all over the country, with only a handful of areas still holding up, such as Washington, DC, and its immediate environs. Rents have remained stable for apartments, in part because of greater demand from former homeowners. But growth has noticeably slowed here as well.

Unemployment insurance claims hit a multiyear high last week, a sign the heretofore solid jobs markets is at last coming under pressure. That won’t help the market for office space. Nor is it a plus for businesses that depend on consumer spending, as recent results for companies ranging from retail to automobiles clearly show.

The worst thing about a crisis in the financial system is virtually everyone depends on credit to some extent. When the banks are stretched, credit conditions tighten. And the more a company or individual depends on credit to finance daily business, the more exposed they are to trouble.

On the other hand, it’s clear from second quarter earnings–just as it was from results in first quarter 2008 and fourth quarter 2007–that some businesses are making it. Simply, the combination of tighter credit, rising raw materials prices and sluggish US demand isn’t yet hitting profits to any appreciable degree. As a result, earnings are still strong, and dividends are safe and growing.

Were this recession getting progressively worse, you might expect at least some of the good performers from the first quarter, for example, to falter in the second. That, however, doesn’t appear to be the case–at least not yet.

This week’s batch of earnings in the utility sector is almost universally positive. In fact, the stars continue to be companies with the most developed unregulated operations, from Exelon Corp (NYSE: EXC), with the strong performance of its nuclear power plant fleet, to Verizon Communications’ (NYSE: VZ) robust wireless operation.

As management has maintained repeatedly, the storm that is US financials clearly isn’t hitting these businesses; demand for their services remains robust, and they navigate financially sound courses. They’re not in the direct path of this storm.

Of course, even the utilities and telecoms with blockbuster earnings have taken a hit over the past month, as the financials’ storm has worsened. That’s how the storm has hit them. The difference is, when this thing does eventually blow over, the companies hit only as stocks–not as businesses–will rebound in short order.

The key for investors is to ensure their holdings do continue performing well as businesses. And solid second quarter earnings–the fourth quarter of the slowdown that began in mid-2007–are the best possible indication that a business is holding its own.

Note there are also definitely sector weaklings, even in these industries. Pure wireless play SprintNextel (NYSE: S), for example, reported very dismal results as it continued to lose customers to rivals despite the obvious good health of its core industry. Even the company’s sole bright spot–a slightly less-than-expected loss of customers to rivals–was tempered by management’s forecast that loss rates would accelerate yet again in the second half of the year.

Upstart Voice over Internet Protocol provider Vonage (NYSE: VG) managed to narrow its operating loss again but only because it slashed marketing efforts. That’s basically boosting “earnings” by not investing in your business, and it’s a formula for oblivion that the company now seems to be nearing.

Overseas, Deutsche Telekom (NYSE: DT) has hardly been a picture of vitality for more than a decade, losing customers and spending billions on expansion that’s yet to benefit shareholders. But the company’s huge earnings shortfall in the second quarter is the worst news yet, particularly because the T-Mobile division appears to be paying the price for not having a US-wide network.

The bottom line is you can’t count on a particular sector or type of investment to be proof against this bear market. In fact, every company in every industry is vulnerable to the storm that’s beating around the financial sector. And as the selloff in energy stocks last month showed, even the strongest-performing sectors with the most powerful underlying fundamentals aren’t immune.

In my view, the damage has been done in energy. We may see a bit more of a pullback in crude oil and natural gas prices. But the stocks are now priced back where they were when oil traded in the $60 to $70 range, and gas was in the $5 to $6 range. Those aren’t levels energy prices are going to hold for very long, given strong global demand, no matter what the US economy does. It’s time to be buying, not selling.

But energy’s demise does make the clear point that you can’t count on any type of investment to pull you through this. Instead, you’ve got to focus on the individual companies and their earnings, and that’s precisely what I’m doing in Utility Forecaster and Canadian Edge.

Note my advice remains to continue holding the best representatives from a range of sectors, even if one of them seems to falter. Wells Fargo (NYSE: WFC) or Berkshire Hathaway (NSYE: BRK.A/BRK.B), for example, is a good bear market financial. So is Flaherty & Crumrine Preferred Income Fund (NYSE: PFD), which combines bank-issued preferred stocks with preferreds of utility companies into a high-yielding, diversified portfolio.

Financials are the market storm now. But eventually, they’ll again lead the market higher, as they’ve tried to do abortively in recent weeks. Keep some good ones, and stay balanced.