Important Juncture
The stock market has rallied nicely off last week’s lows and now it’s “crunch time”. Many events occurred last week to suggest a panic low was made: The Fed came to the market’s rescue and in a 5 day period cut interest rates, guided a bailout of Bear Stearns, bailed out Fannie Mae and Freddie Mac by relaxing capital requirements, allowed member brokerage firms to borrow from its discount window for the first time, set up a variety of other lending facilities for the same institutions, provided a minimum $260 Billion in liquidity (internationally in some cases) and, they cut rates once again. Clearly the US Government is stepping up as lender of last resort to protect our banking system and economy. They did not do this because things were status quo. The Fed did those things because we were on the edge of a market and system meltdown – a true crisis was at hand. They saved the day and since then the stock market has jumped 8%. Perhaps betting against Uncle Sam is a bad idea and the panic is over. And that enormous stimulus to the banking system should spur economic growth producing stock market gains.
At market lows, various indicators should reflect greater anxiety than normal. The anxiety levels in Aug ’07 and late Jan ’08 reached more significant levels than last week. Trading volume, which often surges during sharp sell-offs, was running just above average for most of this recent 3 week decline. The VIX, a fear ratio, got close to but well shy of those other panic levels. Other indicators like new lows, proximity to the 50 day moving average, & other short term ratios did not expand widely either. We sure got the newsworthy anxiety but in many ways the market’s reaction was ho-hum. One could say the government should get their due for that – their actions prevented the crash so the anxiety level was muted. Further, we could deduce that the muted response for whatever reason suggests that sellers were not motivated by the news any more than they had been and that their continued impact on prices would be much less than anticipated. For these and other reasons we could build a convincingly bullish case for that stock market.
One could also ask that if this low wasn’t the major washout then when will that other shoe drop? Shouldn’t a bear market end in a crescendo of technical indicators at extreme anxiety levels? There doesn’t have to be another shoe at this point – there is no rule that the market has to do that. And as it turns out, a quick study of various technical indicators going back to the early 1970’s don’t show consistency with regard to technical indicators and market declines. Sometimes they “do”, sometimes they “don’t”. (The tightest correlation seems to be the rate of inflation, recessions, and bear markets.)
Yet, despite all this evidence, there are concerns about the current environment that could delay all the gratification. The rally from S&P 1256 on Mar 17, 2008 has been impressive but volume has lessened the last two days suggesting demand for stocks at this level is softening. Often stocks will revert to their 50 day moving average. The decline we are in began October 2007 – at first it was simply a reversion to the 50 day line following a strong rally. Since then, every decline bounced back to the 50 day +/- a small % and faded as quickly. We are right at that point now but still in a confirmed downtrend and that pressure has to be respected. There is also the issue of overhead supply. This phenomenon occurs when holders of a security have paid prices higher than the current level. In this environment, most anyone who has bought the “market” in the last 15 months is losing money. The concept is that as prices eventually rise those unhappy holders will unload as they near a breakeven, having held on for so long and finally able to cash out without a loss. This headwind should continue for as long as the “top” took to form. In that regard, even if the low was set last week, the top was 13 months long in forming and we’re only 2 months into the overhead supply phenomenon. As prices rise they become vulnerable within this technical pattern so perhaps this is just a relief rally that’s going to fade and we’re still headed lower.
While the Fed changed some important rules for our financial system, there are other elements of the economy that appear to be suffering. For example, there are 10 major S&P sector indices. None of them show strength, 6 are outright bearish, 4 are questionable at best. This suggests that weakness persists now and will for the foreseeable future. One theory explains this overall malaise. Financial institutions have written off' nearly $200 Billion in assets. Those assets factored into the banks' capital ratios. Without them, the ratios suffer and capital must be increased or the loans written against them must be decreased. If de-leveraging is the answer then $1 – 2 trillion in loans must be eliminated. De-leveraging would affect nearly every sector of the economy. Given the U.S.’s $14 trillion GDP, de-leveraging of this magnitude would be significant, enough to pressure economic growth for some time. It’s no wonder the Fed came to the rescue as the de-leveraging effect became pronounced and dangerous. But much of the Fed’s response can also be viewed as inflationary which would introduce another set of problems, perhaps as bad or worse than our current set of problems.
Of course, the biggest question is how much of the future has been discounted by today’s price structure? The panic lows set last week can initiate a bull market and we have to respect that. But, the de-leveraging of the financial system may continue to put pressure on the economy and profits. And we have to respect that, too. Don’t fight the Fed and don’t fight the tape. Although I date myself that way (alas, there are no more ticker tapes) the best answer is to listen to the market. If it takes out previous highs and then corrects but holds above the recent lows then maybe the tide will have turned. Eventually that will happen and maybe it’s happening now. However, until certain market indicators begin to show strength (or stop showing such weakness) a cautious approach is warranted. Long positions will be built in stocks that have weathered the storm and appear poised for future growth – don’t fight the Fed. But positions in mining companies (gold) and short ETFs will be maintained to offset the risks that still persist – don’t fight the tape. We will hope for the best and prepare for the worst.
At market lows, various indicators should reflect greater anxiety than normal. The anxiety levels in Aug ’07 and late Jan ’08 reached more significant levels than last week. Trading volume, which often surges during sharp sell-offs, was running just above average for most of this recent 3 week decline. The VIX, a fear ratio, got close to but well shy of those other panic levels. Other indicators like new lows, proximity to the 50 day moving average, & other short term ratios did not expand widely either. We sure got the newsworthy anxiety but in many ways the market’s reaction was ho-hum. One could say the government should get their due for that – their actions prevented the crash so the anxiety level was muted. Further, we could deduce that the muted response for whatever reason suggests that sellers were not motivated by the news any more than they had been and that their continued impact on prices would be much less than anticipated. For these and other reasons we could build a convincingly bullish case for that stock market.
One could also ask that if this low wasn’t the major washout then when will that other shoe drop? Shouldn’t a bear market end in a crescendo of technical indicators at extreme anxiety levels? There doesn’t have to be another shoe at this point – there is no rule that the market has to do that. And as it turns out, a quick study of various technical indicators going back to the early 1970’s don’t show consistency with regard to technical indicators and market declines. Sometimes they “do”, sometimes they “don’t”. (The tightest correlation seems to be the rate of inflation, recessions, and bear markets.)
Yet, despite all this evidence, there are concerns about the current environment that could delay all the gratification. The rally from S&P 1256 on Mar 17, 2008 has been impressive but volume has lessened the last two days suggesting demand for stocks at this level is softening. Often stocks will revert to their 50 day moving average. The decline we are in began October 2007 – at first it was simply a reversion to the 50 day line following a strong rally. Since then, every decline bounced back to the 50 day +/- a small % and faded as quickly. We are right at that point now but still in a confirmed downtrend and that pressure has to be respected. There is also the issue of overhead supply. This phenomenon occurs when holders of a security have paid prices higher than the current level. In this environment, most anyone who has bought the “market” in the last 15 months is losing money. The concept is that as prices eventually rise those unhappy holders will unload as they near a breakeven, having held on for so long and finally able to cash out without a loss. This headwind should continue for as long as the “top” took to form. In that regard, even if the low was set last week, the top was 13 months long in forming and we’re only 2 months into the overhead supply phenomenon. As prices rise they become vulnerable within this technical pattern so perhaps this is just a relief rally that’s going to fade and we’re still headed lower.
While the Fed changed some important rules for our financial system, there are other elements of the economy that appear to be suffering. For example, there are 10 major S&P sector indices. None of them show strength, 6 are outright bearish, 4 are questionable at best. This suggests that weakness persists now and will for the foreseeable future. One theory explains this overall malaise. Financial institutions have written off' nearly $200 Billion in assets. Those assets factored into the banks' capital ratios. Without them, the ratios suffer and capital must be increased or the loans written against them must be decreased. If de-leveraging is the answer then $1 – 2 trillion in loans must be eliminated. De-leveraging would affect nearly every sector of the economy. Given the U.S.’s $14 trillion GDP, de-leveraging of this magnitude would be significant, enough to pressure economic growth for some time. It’s no wonder the Fed came to the rescue as the de-leveraging effect became pronounced and dangerous. But much of the Fed’s response can also be viewed as inflationary which would introduce another set of problems, perhaps as bad or worse than our current set of problems.
Of course, the biggest question is how much of the future has been discounted by today’s price structure? The panic lows set last week can initiate a bull market and we have to respect that. But, the de-leveraging of the financial system may continue to put pressure on the economy and profits. And we have to respect that, too. Don’t fight the Fed and don’t fight the tape. Although I date myself that way (alas, there are no more ticker tapes) the best answer is to listen to the market. If it takes out previous highs and then corrects but holds above the recent lows then maybe the tide will have turned. Eventually that will happen and maybe it’s happening now. However, until certain market indicators begin to show strength (or stop showing such weakness) a cautious approach is warranted. Long positions will be built in stocks that have weathered the storm and appear poised for future growth – don’t fight the Fed. But positions in mining companies (gold) and short ETFs will be maintained to offset the risks that still persist – don’t fight the tape. We will hope for the best and prepare for the worst.
posted by David Geller at 11:03 PM
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