The events of last week were astonishing! Two men, both pro free markets and anti moral hazard, travel to Capitol Hill to meet with Republican and Democratic leaders, who are normally divisive, especially six weeks prior to a presidential election. What they said essentially was that, if a major plan to restore confidence in our financial markets wasn't approved immediately, commerce in this country would grind to a halt. The looks on the faces of the participants coming out of that meeting were as if the Congresspersons had just seen "Jaws" and were told they had to go scuba diving the next day. Talk about fear! And apparently, the plan, which involves purchasing the toxic debt instruments from financial institutions, insuring most money market investors from loss, and restricting short selling in the financial services industry, has a very good chance of being approved quickly, of course with some modifications and add-ons.
What led to this? One event was an unintended consequence of the Lehman bankruptcy. A highly regarded money market fund held some Lehman paper, which was worthless, and as a result the fund's price fell to "under a buck". This led to a fleeing from this particular fund and money market funds in general, with the money pouring into Treasury bills. In fact, I understand at one point the Treasury bill yield was below 0 percent! A buyer was paying the U.S. government to hold his money! Since commercial paper financing is essential to the liquidity of major companies in the U.S., a freezing up of this market would have dire consequences unless something were done quickly.
Another event which occurred Thursday was the unraveling of the common stocks of Morgan Stanley and Goldman Sachs, the two large investment banking houses left standing after the collapses of Bear Stearns and Lehman, and the announced merger of Merrill Lynch with Bank of America. This happened after both banks reported better than expected earnings. If allowed to continue, Morgan Stanley, in particular, would have had to link up with another entity, and still may have to do so. The waterfall decline of these stocks, if writ large to encompass the entire market, would have produced the long awaited capitulation phase. More about that later.
And finally, Paulson and Bernanke had been fighting this financial contraction on a case by case basis and probably realized that some major policy change had to be in place to stem the downward spiral.
Will this plan work? If by "work" one means averting a depression by restoring confidence in our financial system, I believe the answer is yes. I applaud what Paulson and Bernanke did. And the cost to taxpayers may not be as much as the pessimists expect. It depends on the prices at which the Treasury purchases the toxic debt. However, the deleveraging of this country's balance sheet will continue, although this plan will help move this process along. And home prices haven't yet started to climb again. The financial companies still must raise equty capital to replenish their balance sheets. In short, the plan avoids a disaster but doesn't avoid a continued recession.
Was last week's low of 1156 for the S&P 500 Index the low of this bear market? It is my sense that, had the meeting among Paulson, Bernanke, and Congress not occurred, the stock market was heading toward a classic selling climax, which I have discussed ad nauseum in previous postings. We will never know. However, while last week's action didn't fit the precise characteristics of one, particularly because the decline and rally didn't occur all in one day, from peak to trough, the S&P 500 Index declined roughly 9%, then ralled back to almost even. And the volume of trading was at record levels. The CBOE volatility index, called the VIX, reached 42, an unusually high level that only occurs near major turns. While this index has been reliable, it has not existed for very long. The I.I. percentage bears indicator has been around for more than forty years. The lastest week's figure will be out Wednesday. However, the survey is taken on Fridays, so the sentiment of advisors would have been measured after the rally on Thursday afternoon and won't be representative of the fear levels immediately prior to that.
The good news is that even if last week's bottom were THE BOTTOM, there is almost always a test of it in future months. If that test is successful, that would be an opportunity to put more money to work.
Sunday, September 21, 2008
Tuesday, September 16, 2008
One/half Retracement of 2002-2007 Bull Market
In my last posting entitled "A Topsy-Turvy Economy", I indicated that I was awaiting the following conditions before I put more money to work: 1) a one/half retracement of the entire Bull Market that began in 2002 and ended in 2007, which would be roughly 1170 in the S&P 500 Index; and 2) a level of 60% or more bears in an Investors Intelligence weekly sentiment reading. One of these conditions occurred this morning when the S&P 500 Index broke through the July 15 low of around 1200 and penetrated 1170 on the downside.
Unfortunately, the latest I.I. percentage bears is under 42 and the highest level thus far in this bear market is 50. A weekly reading is forthcoming tomorrow, but I doubt it will be 60 or higher.
Like the proverbial single phone call allowed one under arrest, if I had only one call to make regarding market timing at major turns, it would be to I.I. Why? The reason is that bear market bottoms occur when there is a maximum of fear. Fundamentals don't really matter because stock markets are a discounting mechanism and bottom well before the fundamentals improve. In fact, usually at bottoms, the fundamentals look dire.
In an early posting in 2007 I discussed that the long term trend line of the S&P 500 Index should be kept in mind because it represents the worst case downside scenario for the market if one assumes that the world isn't coming to an end. That trendline was almost met at the bottom of the last bear market. I refer to it as "Wall Street's Dirty Little Secret" because The Street thrives during bull markets not bear markets, so that trendline is rarely mentioned.
The trend line at this juncture is slighly below 1000, and the Index just broke through 1200. Let's assume that I had been stranded on a deserted island without any news input for the last year. I was then told that home prices had declined 15 to 20%nationwide, Bear Stearns and Lehman were no more, Merrill Lynch was no longer independent. Freddie and Fannie debt had to be bailed out, and AIG was teetering on the edge of bankruptcy. Then I was asked, "Where do you think the S&P 500 Index is trading?" I would answer "Near the trendline!" I would be flabbergasted that the Index was 20% higher than that.
In short, the market has held up extremely well. Unfortunately, the two primary sources of the unusually high profit margins last year, namely the financial and oil industries, do not have bright profit outlooks near term. The earnings of the Index, which peaked in the high 80's, could drop to the 60's at the trough. That would justify an S&P level closer to the trendline.
While the rate of decline in home prices is dropping, absolute prices are still in decline. The deleveraging of our nation's private balance sheet continues. Alan Greenspan recently mentioned that this was "a once in a century situation". In my opinion, this warrants a fear rating that accompanied the major bottoms of 1974 and 1982, when the percentage bears were 67 and 61 respectively.
One event that would warrant putting more money to work would be an old fashioned selling climax, with a sharp drop (perhaps 10% or more) on extremely heavy volume and a rally that brings the market back to unchanged or higher, all during the same trading day. That would present a buying opportunity perhaps before the fear indicator had reached extreme levels.
Unfortunately, the latest I.I. percentage bears is under 42 and the highest level thus far in this bear market is 50. A weekly reading is forthcoming tomorrow, but I doubt it will be 60 or higher.
Like the proverbial single phone call allowed one under arrest, if I had only one call to make regarding market timing at major turns, it would be to I.I. Why? The reason is that bear market bottoms occur when there is a maximum of fear. Fundamentals don't really matter because stock markets are a discounting mechanism and bottom well before the fundamentals improve. In fact, usually at bottoms, the fundamentals look dire.
In an early posting in 2007 I discussed that the long term trend line of the S&P 500 Index should be kept in mind because it represents the worst case downside scenario for the market if one assumes that the world isn't coming to an end. That trendline was almost met at the bottom of the last bear market. I refer to it as "Wall Street's Dirty Little Secret" because The Street thrives during bull markets not bear markets, so that trendline is rarely mentioned.
The trend line at this juncture is slighly below 1000, and the Index just broke through 1200. Let's assume that I had been stranded on a deserted island without any news input for the last year. I was then told that home prices had declined 15 to 20%nationwide, Bear Stearns and Lehman were no more, Merrill Lynch was no longer independent. Freddie and Fannie debt had to be bailed out, and AIG was teetering on the edge of bankruptcy. Then I was asked, "Where do you think the S&P 500 Index is trading?" I would answer "Near the trendline!" I would be flabbergasted that the Index was 20% higher than that.
In short, the market has held up extremely well. Unfortunately, the two primary sources of the unusually high profit margins last year, namely the financial and oil industries, do not have bright profit outlooks near term. The earnings of the Index, which peaked in the high 80's, could drop to the 60's at the trough. That would justify an S&P level closer to the trendline.
While the rate of decline in home prices is dropping, absolute prices are still in decline. The deleveraging of our nation's private balance sheet continues. Alan Greenspan recently mentioned that this was "a once in a century situation". In my opinion, this warrants a fear rating that accompanied the major bottoms of 1974 and 1982, when the percentage bears were 67 and 61 respectively.
One event that would warrant putting more money to work would be an old fashioned selling climax, with a sharp drop (perhaps 10% or more) on extremely heavy volume and a rally that brings the market back to unchanged or higher, all during the same trading day. That would present a buying opportunity perhaps before the fear indicator had reached extreme levels.
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