The sell-off that swept through the market was driven by a shift in sentiment, not a shift in fundamentals. A shift from the view that any U.S. recession will follow normal lines (as in what we have been seeing for the past twenty years), to a “this-time-is-different” scenario. That this recession will hinge on the integrity of the financial system.

To that end, I am reminded of comments made many years ago, by former Bank of Montreal CEO Matthew Barrett. He was asked to comment on a survey in which consumers had registered their anger against banking practices and higher fees. He responded that the survey was asking the wrong question; (I paraphrase) the question is not whether consumers like the banks, the question is whether consumers “trust the banks.”

If consumers/investors have lost confidence in their financial institutions, it is the economic equivalent of removing one leg from a three legged chair. Rate cuts and liquidity infusion will not solve that problem.

If we are to buy into a view that the US will experience a normal slowdown recession, then we have to believe that;

Financial institutions will:

• come clean with the extent of their exposure to bad loans;
• demonstrate that they can raise cash to offset their exposure (i.e. something we have already seen at Citigroup, Merrill Lynch and CIBC); and,
• buy up lending institutions that will not survive without deep-pocketed parents (i.e. the buyout of Countrywide Financial by Bank of America being a case in point).

The Fed will act to:

• pump money into the system so that banks can survive while writing down their sub-prime indiscretions and allow for a secondary market of some kind for product already in the market;
• make serious cuts to interest rates (like the 75 bps we have already seen) to prop up the housing market and help homeowners keep their homes;
• hope that these steps do not ignite inflation.

The U.S. consumer and investors wil:

• overcome a serious crisis of confidence in financial institutions;
• clean up their personal balance sheets likely through bankruptcy court; and,
• start spending.

If this happens, how will it impact the markets?

First, we have to recognize that macro economic policies only serve to shift investor sentiment. When you replace fear with clarity you begin to focus on the outlook for earnings growth. Earnings growth will not likely kick start until the third quarter, which means the equity markets will take notice in the second quarter. Financial institutions, particularly Canadian banks, will most likely lead that parade.

Having said that, I am not looking for sharp gains in the equity markets during 2008. At best single digit year-over-year returns in both the U.S. and Canadian equity markets. Most of that growth coming in the second half. Which is to say, option writing strategies in the first half of the year are the strategy of choice.

As always, some sectors will do better than others. Gold and financials being the sectors of choice. Although, with gold, much of that updraft may have already occurred. Gold buffs are speculating that the yellow metal will hit US$1,000 this year. But as I have talked about before, sentiment may take it there. Clarity will not take it much beyond that.

I think, once investors conclude that the worst is over in the credit markets, and that consumers have been revived, there will be a shift out of gold and into the broader market. Which means, dare I say it again, into the Canadian banks!