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October 28, 2008

Latest Market Comment

The market staged a big rally on Tuesday that looked quite similar to the one-day wonder on October 13th. Both rallies started from almost the same levels on the major averages. If we can hang onto to Tuesday's gains, you will see lots of commentary about a successful retest of the October 10th lows.

While the economic outlook has soured considerably since October 10th there are some signs of hope. On a purely technical basis, the chart patterns look better. As painful as the last week has been it looks like a trading range may be getting established between the lows (S&P 500: 840) and recent highs (S&P 500: 1000).

More importantly, the efforts by the Federal Reserve, U.S. Treasury and Central Banks and Governments around the world are beginning to thaw the credit markets. Inter bank lending rates are slowly falling and well off their highs. Commercial paper issuance by US corporations soared this week after weeks of meaningfully declines. Mortgage rates dropped a bit and statistics on housing sales, inventories and starts suggest the possibility that the initial source of the problems we face is losing downside momentum and could bottom in 2009.

The latest problem is in the currency markets. This was a problem I did not foresee that has significantly magnified the risks faced by the global economy and stock market investors. Last week currencies around the globe collapsed versus the dollar and yen. In some cases the drops were 20% or more and the carnage was not just restricted to emerging markets. The British pound actually fell 8 cents in one day last week. In recent years a penny move was considered volatile.

Many of the collapsing currencies in emerging markets are happening even though the economies of those countries have been performing well and the local banking systems are not unusually exposed to the credit market meltdown. But panic is panic and when the Brazil or Ukraine or Hungary or even South Korea loses control of their currency the blow back on their economies can be quick and severe.

Since emerging markets have been the backbone of global economic growth for several years last week's loss of confidence in those markets undercut the final hope of investors that the world could avoid a really nasty recession. A new downward spiral of collapsing currencies, stock market sell-offs, and rising risk premiums suddenly appeared. And it way too closely mimicked similar spirals in the credit markets that accelerated the downward trend in stocks from early September onward.

On Wednesday investors will be laser focused on the Federal Reserve expecting an interest rate cut of 50 basis points. I think that is the minimum required to prevent a sell-off in stocks. However, I think on a longer term basis we should keep on eye on currency markets. What we want to see is further weakness in the dollar and yen and a rebound in the euro and especially emerging markets. The euro has rallied 2-3 cents in the last few days. Emerging market currencies rallied 2-3% on Tuesday. An extension of these gains will parallel improvements clearly evident in the credit markets and set the stage for a period of greater stability for stocks.

While I find many stocks to be really cheap on a 2-3 year basis, I think the most helpful thing right now would be a period of stability. Even just a week of something that looks normal on my screens would remind investors that the world is probably not ending and that the decisions they make and the tools they use can still be valid.

I have been negatively surprised by the way the initial subprime problem spiraled out of control and seemed to randomly ricochet around the world of global finance and economics. The velocity and severity of the movement caught me by surprise and led me to make some incorrect decisions in the stock market – at least incorrect in the short-term. I am still learning but what I missed was how tightly connected global markets and economies were due to the use of derivatives and how much larger and less stable those derivatives actually were than I understood.

The market is actually higher today than it was on October 12th when I wrote my last market comment but it remains far below where it was when I wrote my initial comments in mid-September.

Throughout this period I have felt it was best to sit tight and ride out the storm. For the last two weeks that has been OK advice. I still think it makes sense even though my forecasting ability has proven no better than the nightly weatherman.

If we can stabilize in the next few weeks, I think we could rally another 10-15% before year end. After that I think we face a period of several months at least where we will see just how bad the economy becomes. Right now, I think a good working assumption is that the economy is growing again in 4Q09.

If that is the case and stock prices follow their previous pattern, a more sustainable upturn in stocks would occur next spring. I think stock prices are low enough today to warrant the risk that this forecast proves too optimistic. In the meantime, I'll have to make tough decisions on some of the losing investments. A few may be sold on a rebound while others deserve to be averaged down.

Unfortunately, the only thing I know for sure is that events will continue to move rapidly and responses will have to constantly re-evaluated.

Posted by Steve Birenberg at October 28, 2008 05:19 PM in Stock Market