The past week witnessed an extraordinary set of events on the financial front, a rogue trader creating havoc at Société Générale, and wild swings on global stock markets as mounting concerns about a recessionary US economy and the implications for global growth continued to weigh on investor sentiment.
The week started off with sharp declines on European and Asian stock markets on Monday (when the US markets were closed in commemoration of Martin Luther King). This was followed by the Fed’s emergency 75-basis-point-cut of its benchmark rate to 3.5% before the opening bell of the US markets on Tuesday, aiming to help support the troubled financial sector and stabilize the economy. The move, which came before the Central Bank’s formal meeting next week and marked the largest cut in the Fed funds rate in more than twenty years, helped prevent a larger drop in US equity prices.
Although investors’ initial reaction was lukewarm, stability returned to stock markets as they took heart from a possible rescue plan for troubled bond insurers (so-called monolines). In addition, the unveiling of a $150 billion US fiscal stimulus package by the Bush administration was viewed in a favorable light even though it was criticized just a few days earlier.
Before highlighting some thought-provoking news items and quotes from market commentators, let’s briefly review the financial markets’ movements on the basis of economic statistics and a performance chart.
The Fed’s interim interest rate cut resulted in a further steepening of the yield curve with the aim of enabling shell-shocked banks to start lending again, and to start making profits so that they might be able to grow their way out of the credit crisis over time. The following chart illustrates how the yield curve has steepened since the first reduction in the Fed funds rate in August, 2007.
US YIELD CURVE
As far as economic statistics are concerned, US jobless claims for the week to January 19 surprised on the downside, reflecting a situation not yet commensurate with recessionary conditions. The US housing market, however, remained mired in weakness, according to the National Association of Realtors’ report for December. Existing home sales declined by 2.2% while the median existing house price was down 6% from one year ago. The inventory situation was looking slightly better, with about nine months of available inventories.
The jury is out on whether the FOMC will announce a further rate cut on Wednesday. John Mauldin (Thoughts from the Frontline) argues as follows: “If I am wrong and the Fed was responding to the stock market [when cutting the Fed funds rate by 75 basis points on January 22], then we will likely not see a cut next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut at the next meeting and the next until we get down to 2% or below. A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking.”
WEEK’S ECONOMIC REPORTS
|Time (ET)||Statistic||For||Actual||Briefing Forecast||Market Expects||Prior|
|Jan 24||8:30 AM||Initial Claims||01/19||301K||320K||320K||302K|
|Jan 24||10:00 AM||Existing Home Sales||Dec||4.89M||5.00M||4.95M||5.00M|
|Jan 24||10:30 AM||Crude Inventories||01/19||2297K||NA||NA||4259K|
Source: Yahoo Finance, January 25, 2008.
In addition to President Bush’s State of the Union Address on January 28 and the FOMC meeting on January 29 and 30, the next week’s economic highlights, courtesy of Northern Trust, include the following:
New Home Sales (Jan 28) – Sales of new homes are predicted to have dropped by 5.0% in December to 645 000. Sales of new homes have declined by 53.4% from their peak in July 2005. On a year-to-year basis, sales have dropped by 35.2% from a year ago. Consensus: 645 000 vs 647 000 in November.
Durable Goods Orders (Jan 29) – Durable goods orders are predicted to have risen in December (+0.4%) after a 0.1% increase in the previous month. In particular, orders of aircraft may have dropped and those of defense items have risen, reversing the performance seen in November. Consensus: +1.6% vs +0.1% in November.
Real GDP (Jan 30) – Real gross domestic product is expected to have risen by 1.2% in the fourth quarter. Positive contributions from consumer spending, non-residential fixed investment and exports are expected to be partly offset by a large drop in residential investment expenditures. Consensus: 1.2%.
Personal Income and Spending (Jan 31) – The earnings and payroll numbers for December suggest a 0.3% increase in personal income. Auto sales posted a small increase in December, while non-auto retail sales were weak. Both of these suggest soft overall consumer spending (+0.1%). Consensus: Personal income +0.4%; consumer spending +0.1%.
Employment Situation (Feb. 1) – Payroll employment in January is expected to show tepid gains (+25 000) after an 18 000 gain in December. Private sector payrolls fell by 13 000 in December, the first decline since June 2003. This report will be watched closely to evaluate the underlying fundamentals of the labor market. The jobless rate is predicted to have risen to 5.1%. Consensus: Payrolls +58 000 vs +18 000 in December; unemployment rate – 4.9%.
ISM Manufacturing Survey (Feb. 1) – The consensus for the manufacturing ISM composite index is 47.0 after a 47.7 reading in December.
Other reports – Case-Shiller Price Index, Consumer Confidence Index (Jan 29), Chicago Purchasing Managers’ Index, Employment Cost Index (Jan 31), Construction Spending and auto sales (Feb 1).
The performance chart obtained from the Wall Street Journal Online indicates how different global markets fared during the past week.
Source: Wall Street Journal Online, January 27, 2008.
US stocks started the shortened week markedly lower on Tuesday, following a sharp sell-off in global stock markets due to growing concerns about the overall health of the economy and Société Générale’s clean-up operations of its rogue derivatives trader’s positions. Markets, however, managed to recover and reclaimed higher ground as the week progressed. By the close of trade on Friday the Dow Jones Industrial Index (+0.9%) and the S&P 500 Index (+0.4%) were both in positive territory for the week, but the technology-heavy Nasdaq Composite Index (-0.6%) was less fortunate.
Following the surprise reduction in the Fed funds rate, the announcement of the tax stimulus package and a mooted rescue plan for bond insurers, interest-rate- and economically sensitive stocks gained strongly. Examples include banks (+11.4%), REITs (+8.6%), retailers (+5.4%) and small caps (+2.3%).
Elsewhere in the world, stock markets closed mostly in the red. Emerging markets, in particular, had a rough ride and lost 2.2% for the week, including the Shanghai Stock Exchange Composite Index’s decline of 8.1%.
The lower stock markets at the start of the week helped drive the yields on government bonds lower, but the gains were given up as the week wore on, and prices closed the week little changed.
Currency markets also experienced a fairly volatile week and saw the US Dollar Index closing the week 0.7% down. The euro, on the other hand, gained 0.2% on the back of hawkish comments from the ECB. Risk considerations resulted in investors exiting risky carry trades early in the week, pushing the yen to a two-and-a-half-year high against the dollar. As markets calmed down, the yen declined again to end the week lower against both the US dollar and euro.
With most of the action concentrated on stock markets, commodities were somewhat out of the limelight during the past week. Base metals (-0.9%) and agricultural commodities (-1.9%) closed in the red, but crude oil (+0.9%) managed to claw back some of the previous week’s losses.
Precious metals, however, rallied strongly subsequent to the Fed’s rate cut, resulting in gold gaining 3.3%, platinum 7.3% and silver 1.7%. Both gold ($924.3) and platinum ($1 694.9) registered new all-time highs on Friday prior to some profit-taking setting in.
With the FOMC’s meeting on Tuesday and Wednesday, and Q4 GDP and January’s payroll numbers out on Wednesday and Friday respectively, another key week for financial markets lies ahead. Hopefully the words (and graphs) from the investment wise will assist in guiding us through the murky waters and keeping our investment portfolios in good shape.
US economy: Danger from all directions
Source: Slate, January 24, 2008.
Moody’s Economy.com: Survey of Business Confidence for World
“The global economy is stalling according to last week’s business confidence survey results. Sentiment is consistent with a contracting US economy, soft European and South America economies, and an Asian economy that is expanding at the low end of its potential. Expectations regarding the six-month outlook have never been as negative in the over five years of the survey. Confidence is weakest among real estate firms and financial institutions, but it has declined considerably in recent weeks among business service firms and even heretofore more optimistic manufacturers.”
Source: Moody’s Economy.com, January 22, 2008.
International Herald Tribune: US in role of wounded giant at Davos
“The United States has filled various roles at the World Economic Forum over the past decade: dot-com dynamo, benevolent superpower, feared aggressor, and now, wounded giant. On the first day of this conference, a parade of bankers, economists, and political officials expressed deep fears about the faltering American economy, peppered with blunt criticism of its institutions, chiefly the Federal Reserve, which some accused of sowing the seeds of today’s crisis.
“George Soros, the financier who made a fortune betting against the pound, went so far Wednesday as to say that the downturn would put an end to the long status of the dollar as the world’s default currency. ‘The current crisis is not only the bust that follows the housing boom,’ Soros said. ‘It’s basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency.’
“Signs of a new economic order abounded in this Swiss ski resort: the minister of commerce and industry of India, Kamal Nath, noted that China had overtaken the United States as India’s largest trading partner – buttressing his view that India could largely sidestep an American recession. The head of the National Bank of Kuwait, Ibrahim Dabdoub, said Americans who opposed sovereign wealth funds like the one run by his government needed to come to terms with the new reality.
“Nouriel Roubini, an American economist, whose frequent predictions of a downturn have made him something of a soothsayer in Davos, predicted the United States would suffer a recession lasting at least a year. He foresees a flood of defaults on car loans and corporate bonds, as well as a prolonged bear market. ‘The debate is not whether we’re going to have a soft landing or a hard landing,’ he said. ‘The question is only how hard the hard landing will be.’
“The Federal Reserve ‘made bad judgments’, said Joseph Stiglitz, the Nobel Prize-winning economist. ‘It looked the other way when investment banks packaged bad loans in non-transparent ways.’ The rate cut this week, Stiglitz said, would be too little, too late, because monetary policy usually takes between six months and 18 months to be effective, and the United States is in distress now.”
Source: Mark Landler, International Herald Tribune, January 23, 2008.
Asha Bangalore (Northern Trust): Fed cuts rate in surprise move
“In a surprise inter-meeting move, the FOMC lowered the federal funds rate and discount rate 75 bps to 3.5% and 4.0%, respectively.
“The statement noted that (1) ‘weakening economic outlook and increasing downside risks to growth’, (2) ‘deepening of the housing contraction’, and (3) ‘some softening of labor markets’ were reasons for the easing of monetary policy. The statement did not mention equity markets explicitly but cited that ‘broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households’. After the January 21 drop in global equity prices when the US market was closed, a continued downward trend today in these markets and the sharp drop in US equity futures markets this morning before opening probably played a role in today’s Fed action.
“Further easing of monetary policy is on the table, but the magnitude and timing is less clear. There could be preference to wait until the March 18 FOMC meeting to assess the impact of the monetary and fiscal policy easing put in place. The futures market has priced a 50 bps cut for the January 30 meeting. For today, we maintain a Fed on hold at the January 30 FOMC meeting, with a small possibility of further easing.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 22, 2008.
BCA Research: Fed trying to get ahead of curve
“The Fed does not like to act between meetings, and today’s rate cut was designed to send a signal that policymakers will do whatever is necessary to stop the slide in market confidence and minimize the damage to the economy. It is too late for the Fed to prevent a recession, they cannot rescue monoline insurers, and they cannot turn bad paper into good paper. But engineering a positively-sloped yield curve will help financial intermediaries, and ultimately will put a floor under the economy.
“The initial market reaction has been volatile, with downside risks remaining a huge concern. It is too soon to assume that a bottom in equity prices and peak in financial strains has been reached. Near-term caution is still warranted until credit spreads start to narrow.”
Source: BCA Research, January 22, 2008.
International Herald Tribune: Fed’s big easing a ‘once-in-a-generation’ event
“The US Federal Reserve, responding to an international stock sell-off and fears about a possible US recession, cut its benchmark interest rate by three-quarters of a percentage point Tuesday, an aggressive move that came a week ahead of a regularly scheduled meeting of the central bank.
“The move, unusual in both its scale and its timing, underscored the severity of the current strains facing the US economy.
“‘It’s a once-in-a-generation event,’ Mark Zandi, chief economist at Moody’s Economy.com, said. In recent years, the Fed has rarely acted between scheduled meetings of the committee, and almost always in increments of one-quarter or one-half point. It was the biggest single cut since October 1984.
“Jan Hatzius, chief US economist at Goldman Sachs, said the timing of the cut, which came after a significant sell-off in Asian and European stocks on Monday, may turn market performance into a referendum on the Fed’s move. ‘By itself, it’s not necessarily a wrong thing to do if you’re worried about systemic stability,’ Hatzius said. ‘Nevertheless, it’s a little tricky because it ties you from a short-term perspective to what happens in the stock market.’ A sell-off could be viewed as a vote of no confidence from investors, he said.
“‘This is an effort to catch up and get ahead of flagging confidence in the weakening economy,’ said Zandi, who has criticized the Fed for not responding faster to the current crisis. A smaller cut ‘might have created more panic among investors,’ he added. ‘But the fact that they moved in such a decisive way strongly signals that they are going to work very aggressively to shore up confidence in the economy.’”
Source: Michael Grynbaum and John Holusha, International Herald Tribune, January 22, 2008.
Bloomberg: Pimco’s Gross says Fed rate cut a ‘sad testament’
“‘It’s a sad testament to think the Fed has to cut interest rates eight days in front of a meeting to salvage the equity markets,’ said Bill Gross, the founder and chief investment officer of Pacific Investment Management Co, in a Bloomberg interview. ‘The US economy is in a rather sad state of affairs in that it depends on housing and stock prices to keep going.’”
Source: Kathleen Hays and Deborah Finestone, Bloomberg, January 22, 2008.
Times Online: Fed rate cut triggered by fear of bond insurance collapse
“Fears that America’s bond insurance market could implode triggered the US Federal Reserve’s biggest interest rate cut for more than a quarter of a century, Wall Street economists claimed yesterday.
“Market analysts said that Wall Street had spent last week gradually realising the grave consequences of a major bond insurer defaulting on its commitments and attributed the surprise rate cut to averting such a crisis.
“As well as guaranteeing company debt issues, the bond insurers underwrite paper from local government in the United States. The failure of a bond insurer would reduce funding for state governments or increase its cost, threatening infrastructure projects such as building of schools and roads, slowing the US economy further.”
Source: Suzy Jagger, Christine Seib and Tom Bawden, Times Online, January 23, 2008.
Financial Times: Banks pressed to bail-out bond insurers
“Leading US banks are under pressure from New York state’s insurance regulator to provide as much as $15 billion to support struggling bond insurers, people familiar with the matter said on Wednesday night.
“There is widespread concern that rating agency downgrades of the specialist insurers known as monolines could force a fresh round of writedowns by banks, which could damage already battered investor confidence. This has led to speculation that banks would band together to prop up the insurers, which guarantee payments on thousands of billions of dollars worth of bonds issued by municipal governments and other borrowers.
“People familiar with the matter said the specifics of a possible capital infusion had yet to be decided …”
Source: Ben White, Aline van Duyn and Francesco Guerrera, Financial Times, January 24, 2008.
John Mauldin (Thoughts from the Frontline): Credit Default Swaps reason for concern
“There are a total of $45 trillion Credit Default Swaps (CDSs) outstanding. No one is really sure who owes what and to whom, and what the risk is that there may be no one to pay that CDS when it comes due? The entire mess is going to have to be unwound in the coming quarters. It may take a year or more.
“I think the concern that there is the potential for a much worse credit crisis than we are currently experiencing is what is driving the Fed. They are looking at the problem from the inside, and realize that they simply have to engineer a much steeper yield curve to allow the banks to make enough profits so that they might be able to grow their way out of the crisis over time.
“If I am wrong and the Fed was responding to the stock market [when cutting the Fed funds rate by 75 basis points on January 22], then we will likely not see a cut next week. But if we get another 50-basis-point cut, as I think we will, then it means the Fed is responding to concerns about the credit crisis. And we will get another cut the next meeting and the next until we get down to 2% or below.
“A 50-basis-point cut takes the rate to 3%. It they had cut the rate by 1.25% next week, the market would have collapsed. Better to do it in two leaps is what I think they are thinking. We will see. And it is not just the Fed that is concerned.”
Source: John Mauldin, Thoughts from the Frontline, January 26, 2007.
MarketWatch: Stimulus deal announced by White House
“The White House and the House leadership have reached an agreement on a plan to juice the economy this year with $140 billion in temporary stimulus measures. The plan would give most US workers a tax rebate of $300 to $1 200. A vote in the House was promised at ‘the earliest date’.
“It would give businesses tax breaks to invest in new equipment this year, and would boost the limit on mortgages eligible to be purchased by Fannie Mae and Freddie Mac. House Speaker Nancy Pelosi and Republican leader John Boehner said the plan was a true compromise, with neither totally satisfied. But both said they believed the plan was essential and would help the economy this year. Senate leaders have not agreed to the plan yet.”
Source: Rex Nutting, MarketWatch, January 24, 2008.
Joseph Stiglitz (Times Online): Day of reckoning in the US glasshouse
“Even the Fed is beginning to realise that, although misguided monetary policy and inadequate financial regulation got the US into the mess, reversing course will not get it out.
“Can fiscal policy do the trick? President Bush’s cureall for any of the nation’s ills – making the 2001 and 2003 tax cuts permanent – will drive up the deficit but not the economy. In some sense, they are at the root of the problems that have ensued. Tax rebates for lower-income Americans will have the biggest stimulant per dollar of deficit (in the jargon, the biggest bang for the buck). And it will be fast-acting.
“But will the Bush Administration, so long focused on helping the rich, be willing to change course? And is it wise to encourage America on its consumption binge? What America desperately needs is more investment, in infrastructure, in research, in education. This, too, would provide a big bang for the buck. But while defence spending has soared, including billions for weapons that don’t work against enemies that don’t exist, will it be willing to countenance more government spending in these areas?
“This is an election year and anything is possible. My betting is that the Administration won’t want to admit just how bad the economy is, and that even if a compromise is achieved, it will be too little too late.”
Source: Joseph Stiglitz, Times Online, January 21, 2008.
Bill King (The King Report): Questions about state of the US economy
“… how about the clowns, including Bush, who keep averring that the economy is sound and whatever downturn appears will be short and shallow? Then why are 3rd World Countries bailing out the leading US financial institutions and the Fed cannot allow a 20% decline in stocks?”
Source: Bill King, The King Report, January 23, 2008.
Asha Bangalore (Northern Trust): Further slide in US house prices
“On a year-to-year basis, the median price of an existing single-family home fell 6.5% in December, the second largest drop on record, with the 6.7% year-to-year drop in October 2007 holding the record for the largest decline.
“The inventory of unsold existing homes fell to a 9.6-month supply from 10.1-month supply in November. The high level of inventories suggests that additional price declines in 2008 are likely. Unlike the market of new homes, sellers of existing homes can remove signs and postpone sales, which is probably what is occurring.”
Source: Asha Bangalore, Northern Trust – Daily Global Commentary, January 24, 2008.
BCA Research: Asset markets – already discounting a recession
“Several indicators suggest that a recession is already priced into risky assets. Our press indicator for recession has surged in recent weeks, in line with the sharp drop in both economic sentiment surveys and net forward earnings revisions. This indicator is now at readings consistent with past recessions.
“Similarly, the collapse in the global stock-to-bond ratio is on par with previous recessions or crashes in risky asset prices. Many equity sectors have already experienced a bear market, including US small caps which are down more than 20% from their highs.
“In addition, the fed funds rate is expected to plunge to 2% by next January, which leaves real short rates at similar levels to past (mild) recessions. Corporate bond spreads have also blown out to recessionary levels in both the US and Europe. In fact, the gap between US corporate spreads and underlying fundamentals is now at a cyclical extreme. Bottom line: Market participants have adjusted rapidly in recent weeks and are already factoring in a recession.”
Source: BCA Research, January 23, 2008.
Jeremy Grantham (GMO): Cash is king
“As was the case with Japan’s problems in a very severe credit crisis, the issue of which bank survives and which doesn’t is more about politics than economic solvency. Many financial companies will approach technical insolvency before this crisis plays out and before they desperately raise new capital. This is not another shot across the bow as March 2007 and April 2006 were; this is the real McCoy.
“So what to buy? I’m afraid cash is the ugly answer that no one ever wants to hear. For the first time in many bear markets traditional value stocks are unlikely to help much and may even hurt as they entered the decline badly overpriced. And once again if you literally cannot resist buying some stocks, we recommend a mix of the highest quality US blue chips and emerging markets.”
Source: Jeremy Grantham, GMO, January 22, 2008.
Nouriel Rubini (RGE Monitor): When the US sneezes the rest of the world gets the cold
“The collapse of global equity markets on Monday, January 21 is not just an episode of financial contagion from the US stock market to other stock markets. It rather signals that global stock markets are now beginning to price the following things.
“First, the US recession is unavoidable and has already started; and this recession will be ugly, deep and severe, much more severe than the mild 8-month recessions in 1990 – 91 and 2001.
“Second, the rest of the world will not decouple from the US since many trade, financial, currency, policy, confidence links lead to a transmission of negative growth shocks in the US to the rest of the world that will lead to a sharp global growth slowdown: 2008 will be the year of recoupling rather than decoupling.
“Third, the US stock market has already started to reflect in the last few weeks the consequences on earnings and corporate profitability of a severe US recession.
“Fourth, a growing realization that even aggressive Fed easing will not prevent this severe recession, i.e. that we are at the last leg of the stock market’s sucker’s rally and that the Bernanke put has very little value as massive financial losses will increase regardless of what the Fed does.
“Fifth, other global stock markets are now starting to price the effects of the US hard landing on the rest of the world growth, the phenomenon of recoupling.
“Thus, the Monday Massacre in global stock markets is – more than a case of financial contagion – a revenge of economic fundamentals as investors are waking up from the delusion that the US would avoid a hard landing and that the rest of the world could decouple from such hard landing.”
Source: Nouriel Rubini, RGE Monitor, January 21, 2008.
Jeffrey Saut (Raymond James): Start compiling a buy list for stocks
“Last week Treasury Secretary Paulson, when referring to the potential economic stimulus plan, averred, ‘This is not an emergency. There is an urgent need.’ To which we ask, ‘If this is NOT an emergency, then why is it urgent?!’ Clearly the politicos are worried about a recession and are pulling out all the ‘stops’ to prevent the normal business cycle … While we don’t think the recession question will be answered for months, we do think the selling stampede is coming to an end and suggest getting your ‘buy list’ together for at least a trade and maybe something more.
“And lo and behold, in a surprise move the Fed has panicked this morning and cut the Fed Funds target interest rates by 75 bp to 3.5%. It will be interesting to see if like us the Street interprets the Fed move as ‘panic’. Whatever the outcome, we think a change for the better is approaching … So get ready, get set.”
Source: Jeffrey Saut, Raymond James, January 22, 2008.
David Fuller (Fullermoney): US rate cut positive for global stock market sentiment
“… what will be the effect of this reactionary rather than anticipatory move to cut rates by the Fed today? It will help to cushion downside risk for the stock market and economy somewhat, although not nearly so much as would have been the case if rates had been lowered ‘like an elevator’ some weeks ago. Unfortunately, risks increased rapidly as the Fed fell further behind the curve. Sentiment deteriorated and US stock market indices completed top formations. Contagion and the Wall Street leash-effect caused most other stock markets to capitulate recently.
“The US’s economic problems are real and a serious concern, but there is also a healthy multinational / export sector, profiting from stronger growth outside the States. Equity valuations are quite reasonable, even after allowing for profit downgrades, and they are very competitive relative to long-dated government bonds.
“Assuming that the Fed is now determined to catch up with the curve of events – it isn’t there yet but has taken a big step today – further rate cuts would help a weak economy, as would the emergency stimulus package. This would lend support to the stock market.
“Assuming that we see additional rate cuts of at least another 100 basis points in coming months, which I believe are necessary and likely. Wall Street should avoid the grinding, lengthy bear market that many fear. However it will take time to repair technical damage, not least for the financial sector.
“Today’s move by the Fed makes it much more likely that other central banks will also lower rates, in regions where there are legitimate growth concerns. This will do no harm to global stock market sentiment.
“Technically, today’s rebounds from the day’s lows for stock market indices in Europe and the Americas suggest that we have seen climactic lows of at least near-term significance.
“The rate cut is a big headwind for the US dollar, but bullish for precious metals.”
Source: David Fuller, Fullermoney, January 22, 2008.
John Hussman (Hussman Funds): Bear market rally quite likely
“The recent bull market began at the highest valuations of any prior bull market in history. It has predictably achieved below-average overall returns, and the cycle isn’t even over yet. Though every market cycle is different, an ‘average’ bull market represents a span of about 3.75 years, with total returns averaging about 27% annually, followed by a bear market of about 1.25 years, with total returns averaging about -27% annually. That means that, on average, a typical bear market loss of just over 30% has shaved a typical bull market gain of 145% down to a cumulative return of about 65% (for a full cycle of about 5 years and overall annual total returns of about 10.6%).
“The failure to understand the dynamics of market cycles is a major reason why investors repeatedly overextend their risk near market peaks, hold onto their stocks over the full course of a bear market, and finally abandon stocks near market troughs. Though less than half of a typical bull market’s gains typically remain by the end of a bear market, those bear markets rarely move in a straight line. Instead, they typically include several declines of 10% – 20%, punctuated by very hard rallies. As I’ve noted before, the 2000-2002 decline, which took the S&P 500 down by nearly half, included three separate advances of about 20% each. These advances serve to keep investors ‘holding and hoping’, as Richard Russell would say.
“It’s important to recognize that ‘one-fell-swoop’ market plunges typically feature rising interest rates, so even if the US market follows through on the international weakness we saw on Monday, a bear market under current conditions would in all likelihood be punctuated by some powerful recoveries (though ultimately temporary – probably several weeks in duration) with additional failures later.
“Given my view that the US economy has probably entered a recession, it appears fairly unlikely that the full decline in the S&P 500 will ultimately fall short of a minimal bear market decline of say, 20%. Taken from the market’s recent high, that would set an initial expectation at about 1260 on the S&P 500. Of course, the average bear market has typically exceeded 30%, but I would be surprised if the market weakened below that level without producing a sustained clearing rally first.”
Source: John Hussman, Hussman Funds, January 21, 2008.
John Authers (Financial Times): Earnings cycle – a headwind for stocks
“It is popular in the US to value equities by comparing the earnings yield on stocks with that available on Treasury bonds – a system known as ‘the Fed model’ because Alan Greenspan, the former chairman, once appeared to use it while giving evidence. With bond yields at their lowest in four years, this has prompted some analysts to find ‘compelling’ valuations. However, this does not take account of the level of earnings. Earnings tend to follow a cycle and so earnings multiples tend to be lower when earnings appear to be cyclically high. The market entered the current turbulence just as S&P earnings had grown 10% or more for a record 14 consecutive quarters.
“Once multiples are adjusted for the earnings cycle, by comparing prices to average earnings over the previous 10 years, the market no longer looks particularly cheap. On this crude measure, the S&P is priced at a multiple of 26.6 – significantly down from the 32.3 level which it hit in May last year, but far higher than is usually seen when the market hits bottom. Cyclically adjusted multiples were lower than this immediately before the Black Monday crash of October 1987.
“Earnings themselves are another source of uncertainty. According to Thomson Financial, analysts now expect S&P 500 earnings to fall by 19%, year on year, in the fourth quarter. When the quarter started, they expected growth of 11.5%. The sharp fall in Apple’s share price in after-hours trading on Tuesday following its results showed that the market remained vulnerable to negative earnings surprises. This suggested that the market had still not capitulated.”
Source: John Authers, Financial Times, January 22, 2008.
Richard Russell (Dow Theory Letters): How long will bear market last?
“Obviously I don’t know. But this is a question that’s been bothering me. Normally and based on past history, bear markets tend to last for a quarter to a third as long as the preceding bull market. The bull market in stocks started in 1980 and ended in 2000 or arguably in 2007 at the point where both the Dow and the Transports recorded their last joint highs.
“And I’m wondering – what if this bear market lasts four, five or six years? As you know, the big ‘mover’ in both bull and bear markets are the price/earnings ratios, the multiples people are willing to pay for stocks. As of Friday, the price-earning ratio for the S&P 500 was over 18. In big bear markets, the P/E ratio can decline to as low as 5. Let’s hope this bear market doesn’t end with a P/E of 5 or 6 or 7 for the S&P. That would be an utter disaster.”
Source: Richard Russell, Dow Theory Letters, January 22, 2008.
Tony Kolton (Moneyweb): 2008 will be up year for US stock market
“… I don’t think we’re out of the woods yet. A long, long, long-term view – we’ve had two horrendous Januaries in election years in the United States. They were in 1900 and 1932. In both instances the decline in January caught itself; it caught itself and it stopped; it rallied – turned around March, and it came down and bottomed out in July, and actually ended up the year ahead. So I expect history will repeat itself and the same thing will happen.
“Also … there’s been 12 discount rate cuts in presidential election years since 1960. From the close of the date of the cut until the end of the year, the stock market in the United States has always, always been up. Always – never failed to work. I expect that that will pan out too, and we’re going to end the year on a higher note. But I do believe we’re going to … rally, maybe make a high in March, hit a low in July, and then that will be it. We’ll be up and out from July to the end of the year. And it’s based on history and that’s the way these things play up.”
Source: Tony Kolton, Moneyweb, January 22, 2008.
Bill King (The King Report): Trade of a lifetime – short US bonds
“There has been extraordinary flight to safety over the past year. This has fostered an enormous US Treasury rally. But soon, especially as the recession intensifies, investors’ focus will change from the credit concerns in ‘the system’ to concern about the credit of the US.
“This could unleash a severe bear market in bonds that will be exponentially compounded by the $700 trillion+ derivatives market because over 2/3 of those derivatives are interest rate related. And when those traders start getting ‘gammaed’ to death, the mother of all bubbles, unwarrantedly low US interest rates, will violently burst.
“Very soon, getting short US bonds will be the trade of a lifetime. And anyone with less than 25 years of experience in the financial industry has not seen a vicious bond bear market.”
Source: Bill King, The King Report, January 24, 2008.
Bloomberg: Europe starts to feel pinch as US slowdown spreads
“The European economy may be starting to suffer collateral damage from the US subprime mortgage slump. Banks are making borrowing harder, industrial production is shrinking and investor confidence is waning just as the US skirts recession. With the euro’s appreciation to a record hurting exports, more economists are betting the European Central Bank will be forced to lower interest rates.
“‘There is a clear downtrend in the economy now,’ said Michael Schubert, an economist at Commerzbank AG in Frankfurt. He revised his ECB forecast last week and predicts two cuts by October after previously projecting one in the final quarter.
“The ECB has so far refused to follow the Federal Reserve and the Bank of England in lowering borrowing costs as contagion from the US housing recession spreads, arguing that inflation pressures are too strong. Government and industry surveys this week may nevertheless show growth risks are mounting and finance ministers meet in Brussels today to discuss the outlook.
“Europe’s manufacturing and services industries probably expanded at the slowest pace since June 2005 and German business confidence fell to the lowest in two years, according to surveys of economists by Bloomberg News.”
Source: Simon Kennedy, Bloomberg, January 21, 2008.
GaveKal: European LIBOR rates lagg US
“The Fed has successfully brought its LIBOR rate significantly down; the same cannot be said in Europe …”
Source: GaveKal – Checking the Boxes, January 25, 2008.
BCA Research: ECB drops the ball
“The European Central Bank (ECB) has a history of lagging the curve but yesterday’s comments were especially misguided and disruptive. In order to bring an end to the credit crunch, allow market participants to gain composure and stabilize the global economy, the major central banks need to provide a collective response. The Fed’s bold move on Tuesday was a significant step in this direction, helping to ease investor panic. However, ECB comments today threaten to derail healing in economic sentiment, sending investors running for safety.
“Specifically, ECB President Jean Claude Trichet stated: ‘Particularly in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility’. It is hardly the time to worry about price pressures: The inflationary impact of food and energy prices has peaked and the world economy is experiencing a disinflationary shock from the US (and potentially UK) housing bear market and slowing global growth. Even the euro area economy has started to downshift materially in response to extremely tight monetary conditions. Bottom line: Stay cautious on risky assets until policymakers capitulate. We also reiterate our overweight euro area bond call and preference over Treasurys.”
Source: BCA Research, January 24, 2008.
Eoin Treacy (Fullermoney): ECB will have no choice but to cut rates
“While I suppose it is laudable of the European Central Bank (ECB) not to give in to peer pressure, I also believe that they will have no choice but to cut rates before the end of the year. The interest rate differential between the US dollar and the Euro is only going to get larger and once the unwinding of leverage has run its course (we are already seeing evidence of this) then the Euro is likely to set new highs. Depending on how large this move is, European companies who consolidate their earnings in Euros will have larger problems than is already the case. The ECB may well then start to see the evidence of slowing growth, they so far fail to recognize.”
Source: Eoin Treacy, Fullermoney, January 24, 2008.
Times Online: Chinese banks facing write-downs
“Signs emerged yesterday that China, which will be the biggest single national contributor to global growth this year, could be hit by serious losses at its banks from the US sub-prime home loans debacle. Until recently, investors had believed that Chinese banks were well-insulated from the crisis. But that assumption was challenged yesterday by warnings from two leading banks that big Chinese banking groups could be forced to write-down millions in losses on sub-prime investments.
“China’s financial regulator said banks in his country had also built up substantial amounts of bad loans during an investment boom.”
Source: Gary Duncan and Roger Boyes, Times Online, January 22, 2008.
Bloomberg: Japan’s inflation rate doubles
“Japan’s inflation rate doubled in December to the fastest in more than nine years, as companies passed rising oil and commodity costs to consumers. Core consumer prices, which exclude fresh food, climbed 0.8% from a year earlier, the statistics bureau said today in Tokyo.
“‘The global economy is slowing while prices of food and energy keep advancing,’ said Hiroshi Shiraishi, an economist at Lehman Brothers in Tokyo, who expects the central bank to keep interest rates on hold this year. ‘That’s the worst combination for the Japanese economy, which depends on exports and has stagnating domestic demand.’”
Source: Mayumi Otsuma, Bloomberg, January 25, 2008.
David Fuller (Fullermoney): Yen steadily edging higher
“The Yen has been steadily appreciating against the US dollar since June … and remains in an overall uptrend. The Yen’s appreciation of 14.26% is symptomatic of the gradual unwinding of carry trades in that currency and the gradual move to greater risk aversion amongst leveraged traders. However, carry trades have also been moved to other currencies such as the US dollar, which remains in a long-term downtrend and has the possibility of further rate cuts. This may also be a factor in the continued strength of the Yen as it removes a proportion of those who would have normally been short of the currency.”
Source: David Fuller, Fullermoney, January 23 2008.
Peter Tasker (Dresdner Kleinwort): Japan’s small-caps trading at bargain prices
“Japan is the only major market in the world to have experienced a savage bear market in small-capitalized stocks, says Peter Tasker, analyst at Dresdner Kleinwort. Japan’s Mothers market for start-ups has slumped about 78% from its peak; 61% of stocks capitalised below Y100bn ($938m) are currently trading below book value, and 26 per cent have a price/earnings ratio of 10 times or less, he says.
“‘What asset class in the world’s major market is as cheap?’ He says that on most criteria, small-cap Japan is better value than large-cap Japan, which in turn appears to be better value than representative US stocks. The area where Japan is weaker is earnings quality, though here too small-caps put in a better showing.
“Mr Tasker says he is often asked what the ‘catalyst’ is to release value in Japanese equities. ‘When stocks become cheap, you do not need a catalyst,’ he says. ‘All you need is for the price-to-book ratio to stabilise. For the low-p/b, low-p/e group, even with an earnings decline of 20%, growth in shareholder value [growth in book value plus dividend yield] will still be at least 8% per year.
“‘In bear markets, valuations often overshoot on the downside, but there are few asset classes in the world that can currently match the historically low valuations of small-capital Japan.’”
Source: Peter Tasker, Dresdner Kleinwort (via Financial Times), January 24, 2008.