Equity Markets: The Thaw Begins

Includes: DIA, QQQ, SPY, UDN, UUP, XLF
by: Fat Prophets

All data as of Friday, October 24

In the current market environment, a week seems like a year. So much is happening on a daily basis it can be difficult to see the wood for the trees. This week, we try and untangle the web of information and examine what this means for equity markets.

We have little doubt that the volatility of September/October 2008 will go down as the most extreme in financial history. A complete breakdown of trust in the international banking system nearly froze the provision of credit to businesses around the world. The credit market turmoil spilled over into the global economy faster than anyone expected. These two negative forces resulted in global stock markets crashing.

However, we are now seeing tentative signs of an easing in credit market stress, if not investor fear just yet. The chart below shows the volatility index, commonly known as the VIX. After spiking to a record high of over 80 last week, the VIX is still at extreme levels, but could be in the process of working its way back down to calmer levels. This will however take some time.

click to enlarge images

The extreme levels of fear relate to the dysfunctional global financial system. On this front, the extraordinary measures seen in recent weeks - including huge provision of liquidity, co-ordinated interest rate cuts, governments injecting capital into banks and providing blanket deposit guarantees – have served to ease credit market pressures.

The chart below shows the TED spread, which is the difference between three-month LIBOR (London interbank offered rate) and three month US Treasury yields. The spike in the spread from mid-September reflected the combination of investor flight to safety (which pushed treasury yields to historically low levels) and increased risk aversion towards banks.

Over the past week or so, the spread has started to fall. While still high by historical standards, the spread is now moving in the right direction and indicates that some much-needed trust is beginning to return to the credit markets.

This is good news for equity markets and suggests the worst of the fear for the international banking system may now be behind us. But this does not mean the final lows have been reached. We are now in the midst of third quarter earnings season and earnings downgrades will be common. This is likely to keep investors nervous.

From a charting perspective, the price action, unsurprisingly, remains bearish. In a repeat of last week, the S&P500 started strongly, climbing more than 4 percent on Monday. However, upward momentum has since waned, suggesting further consolidation below the 985 and 1044 resistance band is now likely. While the index remains below this resistance region, we cannot rule out an extension below the October low of 839 in the weeks ahead. Should this move eventuate, the 2002 and 2003 lows of 788 and 768 provide significant long-term support.

Of course, governments around the world are doing everything in their power to ensure that stock markets stop falling, recessions are avoided, and banks continue to lend. Central bank’s the world over are yanking their monetary policy levers in all directions, and fiscal policy is now making a long awaited comeback.

The US government recently reported a budget deficit of US$454 billion in the year to September 2008. Estimates are now surfacing that the US budget will be in deficit to the tune of US$1 trillion in 2009. This would represent just under 10% of gross domestic product, a huge number.

The Financial Times recently reported that British Prime Minister Gordon Brown has made a commitment to spend his way through the downturn. At the half way point of the fiscal year (September) the British budget deficit stood at £37.6 billion, not far off the full year estimate of £43 billion.

Even in Australia, the Rudd government has wasted no time in announcing a $10.4 billion fiscal stimulus, aimed at propping up the housing market and encouraging people to consume more. Like George Bush’s $100 billion one off tax rebate earlier in the year, we doubt Mr Rudd’s plan will have a lasting effect on the economy.

Moving back to the US, below we show a chart of the massive expansion of the Federal Reserve’s balance sheet. Fed credit has nearly doubled in less than a month. In effect, the Fed is taking on illiquid assets (mostly mortgage backed securities, we would guess) and issuing cash (Federal funds) in return.

This is debt monetization on a scale never before seen, at least not from the issuer of the world’s reserve currency. Being without precedent, no one can be sure what the effects will be. However, we’ll stick with our assumption that all this liquidity will not necessarily return to the overpriced assets it was exchanged for (mortgage related securities) and that significant inflation in other parts of the economy will result.

All this dollar creation, along with massive fiscal deficits and lower interest rates will not be healthy for the US dollar. But such an outlook is not being reflected in the current performance of the dollar, as shown in the US Dollar Index chart below.

As illustrated, the US dollar began to rally strongly in mid-year as the leveraged speculation community (hedge funds) began to unwind their short US dollar trades. This increased the demand for US dollars.

Reinforcing this move, consumer spending and borrowing began to slow in the US, which reduced the supply of US dollars. To explain, during the boom years when household sector borrowing and consumption was strong, US dollars were borrowed (created) and then sold to purchase foreign made goods. The slowdown in household consumption in the US in recent months has therefore now reduced the supply of US dollars into the global market place.

So the process of deleveraging (both households and the financial sector) is serving to increase demand for, and reduce the supply of, US dollars. But with the government poised to run huge annual deficits we believe the US dollar will struggle to hold on to recent gains.

Following the USD Index’s break back above the important 80 level this month, in the shorter term we believe there is potential for a move towards the 84.2 to 85 region. However, a break back below 80 would signal an end to the current rally, and the longer term bear market trend would continue. In our opinion, such a move is just a matter of time.

This has implications for gold. In the shorter term, the US dollar gold price may remain under pressure, and we have certainly seen that occur this week. While further downside would not surprise, we believe the US dollar rally may be coming to and end.

In summary, we believe the intense fear experienced in the past few weeks is waning. Investors are therefore likely to return to focusing on fundamentals - like valuations, earnings expectations and economic growth. We still think volatility will be a feature of the market for some time to come, however not quite at the levels experienced in the last few weeks.

For the last few months of 2008 and into 2009, we will be fascinated to see the effect of government efforts to save the financial system’. We fear the result will be inflation, and lots of it, hence our persistent recommendation to buy gold.

Throughout the ages, governments have always turned to the printing presses when debts have grown unmanageable. This time will prove no different. This is why we continue to focus on real assets as a way to protect against the coming inflation. The strategy might not make sense now when deflation appears to be the biggest threat and everyone is scrambling for cash, but we believe that in time, real assets will strongly outperform. 

Disclosure: none