Get Ready for the New Reality

• ByTim Melvin, RealMoney.com Contributor
• On 4:01 pm EDT, Friday June 19, 2009

I was in one of my favorite dining and drinking establishments the other night when an old friend happened to drop in to pick up some takeout. While he was waiting we shared a drink and caught up on the world. After talking boats and debating the merits of scotch over bourbon for a bit, we turned to markets and the economy. He has particular insight because he has been a bond trader for 25 years and a keen observer of markets.

He surprised me by generally agreeing that green shoots are just head fakes and the economy remains as weak as he has ever seen. (For the record, he favored selected junk corporate and California general obligation bonds. Although the ride may be bumpy, he opined that there was no way general obligation paper would be allowed to default. That's pretty much in line with RealMoney contributor Tom Graff's excellent analysis of the California situation posted yesterday.)

After we finished our distilled beverages of choice, we parted ways. I found the conversation enlightening. Although there are selected opportunities created by special situations, like the California bonds or selected preferred stocks like TCF Financial yielding better than 10%, the broad picture is not as bright. The shotgun approach of buying a large basket of stocks needs to remain locked away in the cabinet -- this is very much a rifle market where investments need to be carefully selected and monitored.

If the green shoots are really so wonderful, why does the recent Nelson Rockefeller Institute report on state tax collections read like a disaster novel? State income tax revenue fell 26% in the first four months of the year. This may be backward-looking, but with no job growth anywhere to be seen, I doubt the number is improving. States are required to balance their budgets, so this is going to mean cutbacks. Cutbacks mean even more job losses by one of the largest providers of jobs. The other choice, raising state taxes, is just too disastrous to the economy to even contemplate right now.

I would rather be bullish and celebrate the green shoots and imminent economic recovery, but abandoning caution here could be very dangerous for my account balances. I think the economy needs to stop weakening -- not just get worse at a slower pace -- in order for stocks to be a raging buy. We have had a tremendous period of excess, and we need to establish a new level of economic activity. The level will be lower than the peak period of 2005 to 2007 and expectations need to be adjusted accordingly. A new reality is coming, and part of that reality is likely to be lower earnings and stock prices.

We are also entering a new period of financial regulation. These changes will be the biggest since the 1930s' remaking of Wall Street. While I agree with Doug Kass that Wall Street deserves to be spanked for the credit mess, these regulations are going to set the bar for stock prices lower. Forcing all hedge funds and advisers -- regardless of size or location -- to register is going to take some demand for stocks out of the marketplace. Increased oversight and higher capital requirements are going to take a toll on profits for large banks like Bank of America and Citigroup for years to come. It is going to be a new world in the financial markets -- one that carries lower price tags for financial stocks.

It took a decade to get into this mess. Expecting things to be all clear after less than two years is too much to ask. Government stimulus and intervention is no reason to rush out and snap up shares of General Electric . The stimulus plans are not going to cause people who are in constant fear of losing their jobs to go on a spree at Nordstrom . It may eventually benefit some of the construction companies like Granite and LB Foster that specialize in infrastructure, but the money won't show up on the bottom line for quite some time.

Let me be clear: I am not completely out of stocks. I still hold some of my book-value beauties and lower-than-cash stocks. But I have cut my exposure back to where it was last summer. I find it impossible to make myself sell something trading at half my appraisal value, but that doesn't mean I'm rushing to buy more.

I am quite content at this level to be wrong and miss part of a sustained rally in order to avoid what I see as a real possibility of permanent capital impairment. I am willing to be a chicken in this market. There is no merit badge for losing money.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider LB Foster to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Buzz up!