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October 12, 2008

Special Market Comment: October 12, 2008

Several times last week I started typing a market comment but each time events were moving so fast that my thoughts felt dated before I was done.

Now that the weekend has given everyone a chance to breathe, I wanted to offer a few thoughts even though I worry that when Asia opens on Sunday night, followed by Europe early Monday morning, markets and news events may make these comments look behind the times.

Since the market began its accelerated decline in mid-September I wrote several comments that have proved to be off base. I thought what is now the initial phase of the decline would put in a bottom to the year long bear market since stock prices finally appeared to be reflecting the magnitude of, and risks posed by, the credit crisis.

It turns out I was wrong. I never expected another stock market crash. I was already a five year market veteran in 1987. Those things are supposed to happen at most once a generation.

What Seems To Be Happening

The immediate problem for the stock market is that the issues in the credit markets appear to be overwhelming the government and central banks response. A vicious downward spiral has developed. A new problem emerges in the credit market. The stock market takes another big leg down. A financial institution's stock implodes. The implosion feeds back into the credit markets which tighten further. Stocks re-open and more financial stocks collapse. All of this is exaggerated by derivatives contracts on debt which have a value far in excess of even the balance sheets of the world's central banks.

A parallel cycle is at work for the economy and non-financial companies. Stocks collapse in response to signals from the credit market. Weakness in both markets leads consumers and businesses to freeze spending triggering worries that the economy will get even worse. Forecasts and budgets for 2009 drop. Fear that the economy will collapse grow. Credit markets tighten further. The stock market drops again.

2008 vs. 1987

In the short term, the most important thing is to break the downward spiral. We need to start with signs that credit market conditions are easing. If that occurs, stocks will have a huge rally. In 1987, the worst 9 days of the market crash saw a decline of 29%. On days 10 and 11, the market rallied 15%. So far, in the 10 days starting with the 778 point drop in the Dow on September 29th, the major market averages are down by 25%.

The 1987 pattern saw a slow decline after the initial bounce until the crash low was retested in early December, six weeks later. The retest held, the economy was not as bad as feared, and a new bull market began. From the low in October 1987 until the next major correction began in August 1990, the Dow rose 80%.

This pattern offers hope. However, I think there is a big difference between 1987 and 2008. In 1987, there were some developing economic problems due to a weak dollar and high and rising interest rates (10 year Treasury yields broke 10%). Stocks crashed which led to deep worries about the economy.

In 2008, the stock market is reacting to potential problems in the economy triggered by the credit market collapse. This time the worries are about the economy and a collapse of the global financial system. Stocks markets are where those worries are immediately priced, where investor fear about the future is reflected.

In other words, the credit markets and economic concerns are driving stocks instead of the other way around. This is a more dangerous situation.

Trying to Look Ahead

It is almost impossible to look ahead and make predictions with any confidence about the near future of the stock market. I firmly believe that if we can break the downward spiral for just one or two days, there will a huge rally, the biggest ever. We will not be out of the woods at that point as the severity of the declines in the last three weeks will lead to difficult economic conditions well into 2009, possibly longer.

However, if we get the relief that will come with a rally, central bankers, government leaders, consumers, and businesses will get a chance to relax. We will all realize that the world as we know it is not ending. Stocks of many companies are extremely cheap looking at their prospects over the next several years. Right now, no one cares because there is no reason to believe any forecast. That will change if we can break the downward spiral.

What will break the spiral? Honestly, at this point, I am not certain. The markets are in control. We just need an up day. The Federal Reserve, Treasury and similar institutions around the globe have thrown massive resources at the problems: unprecedented liquidity, coordinated interest rate cuts, capital injections, direct intervention in credit markets, the guarantee of bank deposits and money market funds. In a rational world, one not driven by panic and fear, this should be enough to stabilize markets.

Once the market stabilizes, people will remember that bull markets can still occur. They will look back at 1987 and see that from the low the market rallied 80%. We won’t rally like that right away but we will rally again.

Everything in my experience tells me it is too late to sell but I'd sure feel a lot better about my belief if we could get the relief that will only come from an up day.

What To Watch

This weekend the markets want a coordinated government response with specific details. Keep a close eye on Europe. There are signs that a specific plan to pump money directly into the banking system is taking shape. The plan is built on the UK strategy announced on Friday. The UK stock market and bank stocks have done badly but late last week the damage was not quite as bad as elsewhere which I think is a sign that the UK plan is something that global credit and stock markets will support.

In the US, look for the Administration to make a concrete step in the direction of the UK plan. Watch Morgan Stanley and Goldman Sachs shares. Morgan Stanley has a lifeline from a Japanese bank. It is important that the deal closes on schedule this week or another rescue plan for Morgan takes its place. Goldman shares reflect the financial system fears on a minute-by-minute basis. They only recovered slightly from their lows in Friday's final hour rally.

Other financial stocks need to recover. On Friday, some of the banks deemed secure like JP Morgan Chase had nice up days. Follow through is important. Technology stocks had an OK day lifting the NASDAQ into positive territory. Small cap stocks were up big as measured by the Russell 2000. Financial, technology, and small cap stocks are where investors will buy if we get a turnaround because that is where the biggest rebound will initially occur.

Posted by Steve Birenberg at October 12, 2008 01:06 PM in Stock Market