Longer term… Concern

short term option traders, this liquidity crisis is simply a question of timing. Such as when bullish investors should step in, or for speculative traders, if there are opportunities to take advantage of short-term gyrations.

The next phase depends on how bad it is likely to get? That will be determined by the extent to which deteriorating lending conditions hurt consumer spending. Should US homeowners start to de-leverage – i.e. pay down their mortgage – that will stunt spending, which in a consumer driven economy, will have serious implications for US GDP growth.

As such, it is unlikely we will see further interest rate hikes this year. On either side of the 49th parallel. In fact, we may see rate reductions in the fall, which may or may not spur markets. Lower rates are normally positive, but if that market reads fear into an interest rate cut, watch out.

Look for Fed to lower rates, which analysts suggest may be as much as 50 to 75 basis points. I think the lower end of the spectrum is the most likely scenario, probably in two 25 basis point increments.

Expect the Bank of Canada (BOC) to follow the Fed’s lead, when it sets rates in September. If it follows in locksteps, the Canadian dollar will probably settle at US 95 cents for the time being. If not, look for CND / US dollar parity by the end of the year.

I raise this issue, because it has short and medium term implications for Canadian investors. As the market works its way through the crisis, there may be opportunities for short term put buys. The BOC’s interest rate stance in September will go a long way to determining whether bullish buying opportunities will come to the forefront. Or more specifically, whether or not Canadian investors should buy assets outside Canada.

Which is to say, after a pullback, should you buy undervalued US investment banks or undervalued Canadian banks? The point being, if and when this crisis is resolved, both US and Canadian banks will likely lead the market higher.

For clues as to time lines, consider the three to six month time lines that accompanied previous crisis. In 1997, for example, when the Long Term Capital Hedge fund (LTC) collapsed, it took three months to unravel. But the LTC collapse was the result of an offshore credit crisis in Russia, not the result of a domestic credit crunch. And by the way, the LTC problems while not the cause, did precede an Asian crisis a year later.

The longer term issue rests with investor perception as to how this crisis was dealt with. If the market perceives that central banks will always be there to backstop higher risk investments, then higher risk investments will continue to be exploited. Meaning that the band aid we apply today will have serious repercussions in the future.

For one thing it is inflationary. For another, it plays to the psychology of those who would exploit the next wave, on the belief that at the end of every bubble is a Central Bank with a pot of gold.

From my perspective, if we are able to avert this crisis – which I believe we will – it will lead us right into another crisis. In much the same way as the bail out of LTC lead into the Asian crisis, which lead to the internet bubble, which in turn, lead to the domestic real estate bubble.

More disturbing, as the last ten years have demonstrated, how this approach to crisis management has shortened the time line between problems. Which means at some point, the current approach to crisis management may no longer work. In the end, unravelling the fundamental relationship between risk and return, and by extension, the very fabric on which investment management is predicated.

For long term investors, the longer term solution is not about trying to time this turnaround, but rather to construct a portfolio that will survive the worst case scenario. Options can play a major role in that model.