The World Economic Forum is under way in Davos, Switzerland, and the star of this elite gathering is none other than New York University's perma-bear economist Nouriel Roubini. In 2005 he wrote in Fortune magazine that, "home prices were riding a speculative wave that would soon sink the economy." Back then his nickname was, "Dr. Doom," and he was generally thought of as a kooky Cassandra. Today he's a sage.

On Wednesday morning Roubini was interviewed on CNBC's Sqwauk Box and when asked if there was any light at the end of the tunnel, his response was, "the only light is one of an oncoming train wreck." Not very promising.

Roubini's apocalyptic outlook stems from what he calls "global synchronized recession" and the bottleneck to our domestic recovery that is the insolvency of our banking system. He postulates that peak bank losses -- commercial real estate, credit card, auto, consumer credit, etc. -- will reach $3.6 trillion in the near-term and that our banks only have $1.4 trillion to $1.8 trillion in equity capital. Hence, he claims they're technically bankrupt. As a result he fears that instead of a typical U-shaped recession, we could be entering an L-shaped, decade long drought similar to what Japan experienced in the 1990s when its Nikkei stock market index fell from a high of 40,000 in late 1989 to a low of 12,000 by March 2001.

When asked about how we can avoid this L-shaped phenomenon, Roubini said we need a coordinated effort by the governments of the major economic powers to ease monetary policy, significantly lower interest rates, greatly expand government spending and take extreme measures to bolster banks. In particular, he recommends our federal government nationalize our banking industry the way Sweden did. In essence, let weaker banks fail, and nurture the stronger banks. Once this housecleaning is done, the government could resell the good banks back to the public.

Given that we're now debating an $825 billion stimulus package and the Federal Reserve announced that it's contemplating buying treasury bonds from its bank members -- not far from printing money -- we've virtually embraced all of Roubini's ideas. As far as bank nationalization, on Wednesday the Obama administration proposed the creation of a "Bad Bank." It's not nationalization, but it's a close second.

What's a bad bank?

According to Robin Sidel of the Wall Street Journal ( "Primer: Basics of 'Bad Banks'" on Jan. 28) a bad bank would be a government-owned and operated entity that would buy up the assets that have troubled our banks for almost a year. Those would include those "toxic" mortgage-backed securities that have scant marketability. Without a market for these assets, they've been written down to almost nothing and are crushing the balance sheets of the banks burdened with them. That would leave the burden of these assets in the hands of the federal government, and the banks could go back to the business of making loans.

As you might expect from Dr. Doom, these announcements didn't deter his pessimism. But I doubt anything would be enough for this hard-core bear. Nonetheless, it's apparent that Roubini's suggestions are being taken seriously. His ideas represent a major policy shift. Whereas we were trying to stimulate the economy, we're now trying to thwart the consequences of deflation, especially in the housing sector, by throwing buckets full of money into the system in every conceivable manner. Will it work? Yes, we'll avoid a depression, but inflation will be the cost.

This extreme policy shift will require some very nimble investment strategy down the road.

Next week fireworks will light the skies in Washington D. C., but those luminous streaks and loud booms are only a prelude to the titanic overhaul that team Obama plans for the faltering economy. 

The twin meltdowns – financial institutions and real estate – have led to the worst recession since the end of World War II.  Early in 2008, amid signs of a downturn, the government launched a $165 stimulus package (remember those $600 checks last summer?) that barely made a ripple in the downward spiral.  Then, after the Lehman Brothers crash that awakened the world to multibillion losses in the financial sector, a new bailout bill was passed and TARP (Troubled Assets and Relief Program) was born with a $700 billion silver spoon in its mouth. 

Since that didn’t work immediately (we’re so impatient) the Federal Reserve virtually shot all of its monetary ammunition with interest rate cuts to almost zero and lending bags full of money to virtually every nook and cranny of our financial world.

When December’s unemployment figures were released – they shot up to 7.2 percent – the current and future Washington economic advisors started drawing up new plans to deal with the crisis.  Yes, of course, we’ll drop the “elect” part of the President-elect moniker for Obama, but since he won the election last November, he and his advisors have essentially been calling the shots: note that lame duck President Bush released the second half of the $700 billion TARP funds earlier this week upon Obama’s request.

As investors, therefore, we must be mindful that significantly more federal deficit spending is on the horizon and that it will greatly influence Wall Street and Main Street.  The incoming and outgoing administrations are attacking today’s economic crisis in a manner similar to Franklin Roosevelt’s wartime mobilization efforts in 1940 when he prepared the nation to fight Hitler and Tojo.  In 1939 the total national debt as a percent of the nation’s GDP was some 45 percent, and the annual federal deficit was less than 3 percent (source: Economic Report of the President 2007).  In 1944, the national debt hit 117 percent of GDP and that year’s deficit was 32 percent of GDP (source: wikipedia.org/wiki/national_debt_by_U.S. presidential_ terms). 

By the end of the federal government’s fiscal year (September 30, 2009) the national debt and annual deficit could reach 75 percent, and 9.0 percent, respectively, of projected GDP.  As recently as fiscal 1998 the debt was under 60 percent and we were running a small surplus.

Interestingly enough, the Obama stimulus package is starting to look bipartisan.  Granted, a lot of horse-trading will occur before this massive spending package is enacted but the initial ideas being proposed include billions for (1) a temporary “holiday” on payroll taxes, (2) a one-time boost in Social Security benefits, (3) additional business write-offs to encourage capital spending, (4) building wind, solar, and other renewable energy sources, (5) local housing authorities to spur home construction, (6) tax credits to first time homebuyers to encourage home sales, (7) direct appropriations for highways, bridges, etc,  (8) increased unemployment insurance, Medicaid, education, and healthcare for the poor, and (9) direct aid to the states suffering budget deficits.  All told, the two-year stimulus package is projected to total some $850 billion, all of which will be borrowed. 

Are there some successes to report? 

Mohammed El-Erian, a managing director at California-based Pacific Investment Management that manages over $500 billion, said on yesterday’s CNBC’s Squawk Box (hear him at http://www.cnbc.com/id/15840232?video=999364836&play=1 ) that the government’s efforts to shore up the short-term capital markets are now working; last year they weren’t.  That government spending will bring about a “sequential healing process,” and that investors should look for ways to “stay under the government umbrella.”   

What this boils down to is that a bumpy, uneven, slow economic recovery will start to emerge toward the end of 2009. 

What are these “under the government umbrella” investments?  I would say healthcare, education, infrastructure, and alternative energy, just to name a few.  Will the market continue to be volatile?  Absolutely.  Will the November 20^th Dow Jones low of 7,552 hold?  No one knows for sure but if El-Erian is right, that low should mark the bottom of this bear market.

Obama’s stimulus package won’t instantly turnaround our sick economy, but with a spending package that breaks all records (save for the defeat of the Axis Powers in WW II) it will stir up things and help investors recoup some of last year’s losses. 

OK, 2008 was a disaster and it blindsided just about everyone.  The giants of Wall Street ate huge slices of humble pie and precious few escaped the claws of the mighty bear.  But it’s 2009 now, and hopefully, the tire tracks on our back will help us navigate the rough waters ahead. 

So what did we learn in 2008?  I think we learned that any asset class can be destroyed not because of fundamental weakness, but because of irrational trading by those who own that asset.  The most obvious example is crude oil.  Those who thought demand was pushing the price of crude above $140 a barrel must now acknowledge that speculators – followed by such stalwart investors as the California Public Employees’ Retirement System (CalPERS) – with tons of cash were creating the oil price bubble that burst last August.

Now we’ve seen oil prices gyrate down to $36 a barrel, ratchet up to $50 a barrel, and down again to $42 a barrel in less than two weeks.  Such price swings shouldn’t surprise us given that hedge fund managers and speculators are still in the oil game.  Those who thinks they can predict their trading patterns are playing with fire. 

These same managers can even upset the most conservative of asset classes.  Look what happened to municipal bonds last year.  iShares S&P National Municipal Bond (MUB $100.25) is an Exchange Traded Fund that essentially duplicates the bonds in the S&P National Municipal Bond Index.  Now this index is not a junk bond index yet that’s what it traded like last October when it lost over 15 percent of its principal value because the dominant traders (hedge funds) of municipals acted like drunken Army recruits running from the MPs.  That’s right, hedge funds loaded up on muni bonds with borrowed capital – at rates lower than muni bond yields – to make what they thought was easy money on the yield spread.  Unfortunately, when their gambit backfired they were forced to sell massive quantities of munis into the traditionally staid muni bond market and prices fell to ridiculously low levels.  When the dust settled, however, and the quality issue was resolved, the ETF regained its former price level. 

Thus, the lesson is that when speculators jump into an asset class, no matter the traditional risk parameters, that asset now has more risk.  Conversely, when the speculators exit an asset class, there may be buying opportunities. 

Thus, it makes sense to divert some of our portfolio to assets that are hidden from these speculators.  In recent columns we mentioned several fixed income ideas: iShares Barclays TIPS (Treasury Inflation Protected Securities) Bond Fund (TIP $98.51), BlackRock High Yield Bond Fund (BHYAX $5.28), and to these we would add the iShares S&P National Municipal Bond (MUB $100.25). 

In the equity area we think an old favorite should be revisited, First Eagle SoGen Overseas Fund (SGOVX $16.73).  The manager, Jean-Marie Eveillard, employs an eclectic style of buying and holding stocks of companies that lack - how should I say it? - pizzazz.  Dull, staid companies, both large and small, that fly under the radar screens of most speculators. 

During the 2000-02 bear market this fund produced exceptional returns.  While the S&P 500 lost money, Eveillard’s overseas fund gained 5.7 percent, 5.4 percent, and 12.5 percent from 2000 to 2002, respectively.  In 2008, however, Eveillard’s magic could not avoid the trauma that afflicted just about every nook and cranny of the global market and lost 21.1 percent.  However, it did beat the 37 percent loss recorded by the S&P 500.

This current recession has been and will continue to be brutal for some time.  Since none of us can predict when it will bottom and when the stock market will recover, we need some exposure to the asset classes that will recover when this mess sorts itself out.  Money market funds are not a safe haven.  They earn almost nothing and it’s almost assured that investors will over stay this asset class and miss the biggest part of the eventual stock market recovery. 

U.S. Treasuries are also iffy.  Huge chunks of money have entered the Treasury market and as a result, Treasury yields are at historic lows.  Short term Treasuries now yield less than a percent.  Have the speculators invaded this sacred turf? 

So we need a few hiding places.  TIPS pay a decent yield and they protect us from the almost inevitable inflation given the federal deficits.  The high yield bond funds have stabilized after the speculators exited that sector, plus they pay handsome returns while we wait for the recovery.  And Jean-Marie Eveillard’s overseas stock fund gives us out-of-the-way exposure to any stock market recovery.

When Gentle Ben turns out to be an angry Grizzly it is important to know what to do.  It’s important because your reaction determines your likelihood of continued existence.  One wrong move and the beast can destroy you.  Notice that when discussing bear attacks, no one ever gives advice on “Three easy steps to place a bear into submission” or “How to make a bear scream ‘Uncle’.”  The objective is not total domination; it is survival. 

 In my wallet, there is a quote from well-known finance author Peter Bernstein that I have carried with me for years.  It says, “Survival is the only road to riches.”  That quote has come back to me several times over the course of the recent bear attack in the stock market.  When AIG, Lehman, Bear Stearns, Fannie and Freddie imploded, their investors did not survive.  Thus, they cannot recover.  Hedge funds that shut their doors this year with steep losses cannot recover.  Most recently, investors in Bernie Madoff’s alleged Ponzi scheme lost every penny.  While surviving is not something we normally cheer about, surviving is actually the most important first step in anything.  Investors should have taken note of this during the tech bubble. $100 stocks that go to zero do not come back. 

 I am not going to tell you that the market being down 40 percent is good news.  What I am saying is “Survival is the only road to riches”.

 One of the first things people tell you when confronted with a bear is DON’T RUN!   You can’t outrun a bear, so don’t try.  Running will just make the bear work up an appetite while chasing you.   The same is true with a bear market.  The fear of flight will likely not hit you until your portfolio is well into dangerous category. Selling everything at that point will likely make matters worse.  To profit from such a move you have to go back in when the market is worse (which investors virtually never do), or hold the cash and miss out on the future recovery.

 The next step is to back away slowly, if possible, or drop to the ground and cover your neck.   This form of protection, curling into the fetal position and covering your vital organs, provides protection during an onslaught.  In the market, “protection” is raising a little cash, reducing exposure to high-risk investments, or rebalancing into beaten down areas.  Seeking a form of short-term safety to endure this is the main objective.

 Lastly, Play dead. Interestingly, when a grizzly thinks you are no longer a threat, he might leave you alone.  The same is typically true with a bear market.  When the bear thinks Wall Street has been tossed around enough, it will leave.  However, just because the bear walks away does not mean the attack is over.  A bear typically watches patiently to make sure their prey doesn’t get back up.  We have been experiencing this characteristic since the lows reached October 10^th and again on November 20^th.  It’s wise to wait a while before you make a move. 

 Note that knowing what type of bear you are encountering is also vital to how you handle it.  Not all bears or markets react the same way.  Black Bears differ from Grizzly’s.  We have discussed actions for dealing with a Grizzly above.  When confronted with a Black Bear, you can use intimidation and fight back (Think REITs during 2000-02).  Black Bears are prone to backing down when a battle is hard fought.  The bear market of 1998 was not like that of 2000.  Running for your life because the market is in official bear market territory (down 20%) may not be the wisest choice.  In 2000 it took 7.2 years to recover (Grizzly).   In 1998 it took roughly 3.5 months (Black Bear).

 These survival tips appear general and passive at first glance.  Not the case.  You have to actively read the situation, react cautiously, seek protection, and avoid panicking.  Once you have done all you can, you have to wait it out.  When encountering a bear, remember, the bear is in control.  All you can do is control your own emotions and make your own investment decision. The moment you think you can predict the short term swings in a bear market, you risk making matters worse. As Peter Bernstein wisely said years ago, “Survival is the only road to riches.”

On Thursday my colleague Greg Jones and I listened to a conference call sponsored by global mutual fund manager BlackRock. They manage more than $1.25 trillion in assets in 60 countries. The conference call centered on high-yield fixed income securities. If you think common stock investors took a shellacking in the market, wait until you hear what happened to high-yield bond investors since September.

Mitchell Garfin, a BlackRock director and fixed income portfolio manager, started the presentation with a blow-by-blow account of how bond investors were treated like crash dummies hurled into a concrete wall at 65 miles per hour. Yes, it was that bad.

As a worldwide investor, BlackRock has incredible research and intelligence-gathering capability so they know their markets. Their mantra is risk management. Nonetheless, its High Yield Bond Fund A (BHYAX $4.83) -- like its high yield bond fund peers -- lost more than 20 percent of its principal value since the onslaught that began a few months ago.

How and why this happened requires a bit of background. First, in the parlance of bond managers, high yield bonds are referred to as "junk" bonds because their ratings are below investment grade. Standard & Poor's bond rating system starts at AAA (highest), followed by AA, A, BBB, BB, and down to C. Bonds rated BB and lower are considered below investment grade and hence, "junk" because they are deemed "predominately speculative." Moody's Investors Service uses a slightly different system, (Aaa, Aa, A, Baa, etc.) with junk designated as Baa and lower.

When the economy enters a recession, bond investors tend to sell lower grade bonds and buy higher-grade corporate bonds or U.S. Treasuries to reduce the chances of owning bonds that default. This so-called "flight to quality" response is actually measured by what traders call the "yield spread," the difference between what U.S. Treasury obligations yield and what junk bonds yield. Since bond values are inversely related to yield, it's easy to see how yields rise when bonds fall in price. For example, if you bought a corporate bond for $1,000 (let's not worry about maturity for the purpose of this example) that pays $50 per year in interest, the yield would be 5 percent ($50 divided by $1,000). But if you decided to sell the bond at the market, and $700 was the only bid, the bond at that price would yield 7.1 percent ($50 divided by $700) to the new owner. You, on the other hand, just lost $300 on your original $1,000 investment.

If U.S. Treasury obligations are yielding 2 percent, the yield spread between the bond you just sold and the Treasury would be 5.1 percent (7.1 percent less 2 percent). More jargon: bond traders use "basis points" to measure this spread with 1 percentage point equaling 100 basis points. So bond traders would say the yield spread was 510 basis points.

Take a wild guess at what the yield spread was during the 2000-02 bear market? According to Garfin, the peak was 1100 basis points (11 percent) between junk bonds and U.S. Treasuries. What is it today? Try almost 1900 basis points, an all-time high.

What caused this sudden collapse? Again, the trail leads directly to our friendly hedge fund managers. Garfin's bond market operatives tell him that hedge fund managers used leverage -- they borrowed 4 to 5 times their equity investments -- to build their junk bond portfolios. When their lending banks called in their loans they were forced to sell. In fact, they HAD to sell regardless of market conditions. Potential buyers saw this unfold and they just lowered their bids accordingly. Others, fearing defaults, just went on a buyers strike. The resulting carnage produced the highest yield spreads on record.

So are high yield bond investors overreacting to potential defaults? According to John Lonski, chief economist at Moody's Investors Service, about 5 percent of all junk bonds default in a typical economic cycle: obviously more during bad times and fewer during good times. The current default rate is just 1.1 percent, but Lonski expects defaults will exceed the 5 percent average in 2009. The managers at BlackRock, however, are anticipating defaults to hit 8-12 percent in 2009.

With that background, let's get back to Garfin's presentation. Using simple present value math, Garfin calculates that today's yield spreads discount the most dire economic possibilities. His figures that if an investor put $1,000 into a junk bond fund today and if that fund suffered 20 percent defaults -- each year -- for five straight years, and if only 25 percent of the principal value of the defaulted bonds are recovered through bankruptcy court, the fund value would still be worth $1,000 at the end of those five years.

Five years of annual 20 percent defaults? That's Armageddon. If that doesn't happen, junk bond funds could produce double-digit returns when the economy recovers. For those who want to assume some risk, junk bond funds now look mighty interesting.

Note: Forward Investment Advisors, Inc., has been acquiring various high yield bond funds for its clients and principals.