Bernanke & Paulson Get Creative

This week has been more volatile than I could have imagined, especially given that we have had three days with intraday Dow moves of 500 points or more.

Traders are reacting quickly to the ever evolving events, which has included the bankruptcy of Lehman (LEH), the government takeover of AIG (AIG - Analyst Report), the closing of a Putnam money market fund, an infusion of liquidity by several central banks and a proposal for a massive bailout of financial firms. Not to mention that short-selling has been banned on nearly 800 financial stocks here in the U.S.

In describing the week's events to David Gaffen, who writes the excellent MarketBeat blog for the Wall Street Journal, I opined, "Throughout the year there's been so many people saying this is bottom, and we hear about (the major financial firms) throwing in everything including the kitchen sink, but now we're finding they're throwing in the dishwasher, the refrigerator, and who knows what else."

Treasury Secretary Henry Paulson's and Fed Chairman Ben Bernanke's latest response to the financial crisis is the creation of a new entity that would purchase a significant amount of the distressed debt plaguing many financial firms. The assumption is that if the toxic debt can be moved off of corporate balance sheets, calm will be restored to the financial system.

Taxpayer money could be used to fund this entity, which is why the proposal is being brought before Congress. And, since this is an election year, it is highly likely that some type of bailout for homeowners at risk of defaulting on their mortgages will be included.

Rest assured, the decisions being made right now will be criticized in the future. But in a crisis situation, fast action is often better than no action. Give Bernanke and Paulson credit for being creative.

At the root of the credit crunch is a psychological problem - lenders don't trust borrowers. The entire financial system is based on the expectation that both parties engaged in a transaction that will meet their obligations. When counter-parties don't trust each other, deals don't get done and loans don't get made. It was a lack of trust that caused Bear Stearns to collapse so quickly, and it is a lack of trust that has created questions about the viability of Morgan Stanley (MS - Analyst Report) as a stand-alone firm.

Strategies for the Current Environment

I wish I could tell you that a bottom was established earlier this week and that a rebound in the markets is underway, but there are too many variables at play.

What Thursday did show everyone is the importance of maintaining an allocation to stocks. Anyone who did not have money allocated to stocks at lunchtime on Thursday missed out on the big rally. The biggest rallies happen very quickly and without any forewarning.

Therefore, it is important to continue to focus on the long-term. Over time, stocks have consistently created more wealth than any other investment vehicle. A diversified portfolio will weather bear markets and will thrive in bull markets.

Investors looking to use the current environment to get back into the market should consider researching shareholder friendly companies such as CSX (CSX - Analyst Report) and Smith International (SII). Both pay dividends and are buying back stock.

I would warn that the risks of investing in MBIA (MBI - Analyst Report), PMI Group (PMI), National City (NCC) and Zions Bancorp (ZION - Analyst Report) remain high. The latest proposal is still under discussion, and therefore we don't know how it will affect those or many other financial firms.

Read the full analyst report on LEH

Read the full analyst report on AIG

Read the full analyst report on MS

Read the full analyst report on CSX

Read the full analyst report on SII

Read the full analyst report on MBI

Read the full analyst report on PMI

Read the full analyst report on NCC

Read the full analyst report on ZION

Read the full analyst report on PMI

Read the full analyst report on NCC

Read the full analyst report on ZION

Read the full analyst report on MS

Read the full analyst report on LEH

Read the full analyst report on AIG