And now a few words about the current financial crisis.  Exactly one year ago I wrote the following in Cabot Wealth Advisory on the subject of financial stocks.

“On the surface, the problem appears confined to the sub-prime residential lending market; thus the calls to regulate that industry better.  But the sub-prime market only developed to serve the demands of the market, which insisted on buying/speculating on assets it assumed would be worth even more in the future.

“In a free market, for every buyer, there is a willing seller, and vice versa.

“And the sub-prime market that developed (just like the Internet bubble) was really the final act in a play that had been going on since 1980!

“Yes, you’ll remember 1980 as the year that gold and silver and interest rates peaked.  A long-term perspective reveals that the 26 years from 1980 until 2006 were characterized by increasingly loose credit.  This easy credit enabled expansion in a host of industries, but none was more visible than the housing industry.

“Now the days of easy credit are over.

“And the collapse of the sub-prime market is just the beginning.  Those loans, you see, are still on someone’s books.  Debt may be marked down as it’s transferred from one owner to another, but it doesn’t just disappear.  So as the prices of the residential real estate that formed the foundation of those loans are re-priced lower and lower, the value of that debt shrinks again and again.  And because real estate is a relatively illiquid asset, the transfer of these assets takes a lot more time than the transfer of stocks and bonds.

“Eventually, the malaise of the residential sector will spread to the commercial sector as well, because at bottom, this is not about houses, it’s about credit, and credit holds for those valuations as well.

“The question now is whether the long re-pricing that evolves will last five years or 25 years!

“No one knows, of course, and you don’t need to know.  But you do need to remember that trends, once in effect, tend to persist for far longer than originally expected.  Which is why I’m happy none of my kids are going into the real estate business!

“As for the credit business, it’s obvious that the more exposure a firm has to the residential housing industry, the greater its risk, but it’s entirely possible that the paradigm shift from increasingly looser credit to increasingly tighter credit could impact even the “best” companies in the industry.”

At the time I wrote that, I had no idea the domino effect would eventually bring down Fannie Mae, Freddie Mac, Washington Mutual, Lehman Brothers, etc., and I didn’t need to.  All I needed to do was stay away from financial stocks, and that’s what Cabot investors have done in the past year.

And now what?  Throughout the course of the one-year bear market, investor sentiment has progressed through the three typical stages, Complacency, Concern and Capitulation.  In the latest phase, stock prices plummeted as investors rushed to the exits, eager to flee to the safety of cash or government bonds, and the result is that today numerous high-quality companies are now selling at a fraction of their fair value.

At the same time, confidence in our government and our banking institutions has evaporated.  The common wisdom today is that America’s best days are behind us and that digging out of this hole will be a long difficult job.

But that’s typical of sentiment at market bottoms!

After bottoms come rallies, and then new bull markets.  My best guess is that a rally will start very soon, and will take us into November, but will eventually lead to a re-test of last week’s lows.  During the re-test, the best stocks will hold up extremely well, and those are the ones you’ll want to own in the new bull market.  But that’s getting a little far ahead, and it’s dangerous to tell the market what to do.

Nevertheless, I suggest that you get ready by building a watch list of likely top performers.