Moving Further into the "Middle" Stages of the Crisis

We've discussed some of the indications we're looking for in order to declare "the beginning of the end" of the financial crisis. Signs would include: meaningful commodity price pullback, one or two upper-tier bank defaults, and/or financial crisis in parts of the Developing Economies, for example. These would be important indicators to us that the financial crisis is moving into a later stage, and opportunity to buy higher-risk assets.

We've also written about the other possibility: that we could "muddle through" without another extremely painful stage of crisis.

In the past week, "muddling" has come out ahead.

As a result we've slightly raised our U.S. equity exposure, by about 1% (though we're still underweight our strategic asset allocation target).

A few of the most recent contributors to the "muddling through" picture: Commodity prices have pulled back a bit, governments have become increasingly aggressive in trying to alleviate the problems, Lehman has been able to raise capital and even up-sized the deal from its initial target, Blackstone has raised a $10.9bn in a new fund for real estate, UBS has taken a gigantic writedown but confidence (at least today) is improved enough to send the stock higher, Thornburg Mortgage escaped bankruptcy for now, corporate M&A and new greenfield projects have been announced, the IMF's latest data has indicated no real evidence of major nations diversifying their reserves away from U.S. dollars (and the Middle East made some reassuring sounds), foreign currency reserves keep rising significantly (further increasing hope that they'll serve as a buffer against non-U.S. economic crisis), and Developing Market inflation pressures have caused some market-unfriendly numbers and social unrest but have not yet provoked major crisis with its own contagion effect, and China's economy has shown real evidence of slowing (raising hopes, at least for now, of a "soft landing").

And in general, our readings have crossed seemingly hundreds of examples to support the idea that the pace of global innovation is increasing, perhaps rapidly, as startups and collaborations are attacking needs in every sector, and notably energy, financing, trade, agriculture, and water.

We still think the financial crisis is in its middle stages because some underlying pressures are increasing even while others may be abating. We think that markets will rise and/or fall significantly as these ultimate questions are gradually resolved: (1) whether the massive U.S. and lesser European credit bubbles can deflate without triggering systemic breakdown, (2) now that "the great unwind" of the global currency imbalances have begun, whether Developing Markets can sustain gradual currency appreciation toward fair value without triggering another contagious financial crisis at home or abroad, (3) whether the war in Iraq eases, (4) whether we see a major intensification of a current challenge (food prices, economic nationalism, etc) or an entirely new challenge.

As a result of seeing ourselves is in the "middle stages" of crisis, we aren't planning to re-balance our equity weighting fully ahead of our mid-year rebalance. Only further dislocation, or signs of further "muddling through," will move more of our cash into equities before mid-year.