Acute Phase of Liquidity Crisis Has Passed; Bear Market Bottom Around the Corner?

Stock markets enjoyed a well-deserved relief rally last week, repairing some of the damage sustained in the free-fall that began in late September. In the dreadful five-week period from September 22 to October 24, the MSCI All-Country World Index (ACWI), a broad measure of the world's stock market value, plunged 34%, which is on par with the worst one-month declines in history. Global stock investors suffered a mark-down in their holdings of approximately $15 trillion during this period. 

There have been two principal reasons for the sharp drop in asset prices this fall: the liquidity crisis (e.g. the combination of a credit freeze, fund redemptions, de-leveraging, and a general flight to cash) and the sharp contraction in global economic activity.

There are encouraging signs that the immediate liquidity crisis is over, thanks in large part to the actions taken by governments and central banks around the world, which have included providing capital to banks and commercial paper markets; guaranteeing money markets and bank deposits; slashing official bank lending rates; and approving funds for the outright purchase of "troubled assets."  The Fed has expanded its balance sheet by $985 billion, or 111%(!), over just the past seven weeks. Nothing remotely close to this rate of growth has ever previously happened during the Fed's history.

Evidence that the acute phase of the liquidity crisis has ended can be found in the recent drops in the interest rates on high-grade commercial paper [CP] and in LIBOR, the interest rate that banks charge each other for short-term US funds.  During the freeze in short-term credit markets that started in mid-September and ran into mid-October, both rates (CP and LIBOR) spiked from around 2.5% to around 4.5% to 5%.  Since mid-October, and particularly last week after the Fed's Commercial Paper Funding Facility [CPFF] went into operation, LIBOR and CP rates have dropped back to near pre-crisis levels, demonstrating that the inter-bank credit and commercial paper markets have thawed to a considerable degree.

This easing of liquidity is extremely important and has helped to stabilize global stock markets. Now markets will be driven to a greater degree by the question of whether asset prices have already discounted the worst-case economic scenario.In the past several weeks, virtually every piece of economic data has shown a sharp deterioration. It is no exaggeration to say that since credit markets froze in mid-September and stock prices fell off the proverbial cliff there has been a profound weakening in the economic outlook.

However, current economic data (e.g. consumer confidence coming in at its lowest level in the 40 year history of the data) may be unduly influenced by the recent freeze in credit markets and meltdown in stock markets. Investors must keep in mind that the stock market is a forward-looking mechanism that usually bottoms just after the midpoint of a recession. Some investors appear to be just recently waking up to the reality of recession, but the stock market has been discounting economic weakness since prices began falling over a year ago.

Ultimately, I think the current recession will be seen to have begun in the fourth quarter of 2007. As such, even if the recession stretches well into 2009, the stock market is now in the phase where the ultimate bear market bottom can occur.

The bottom line is that you can't time the market by following economic news. It's the other way around; the market will bottom long before the economic news starts to improve.  This is why the stock market is one of the most reliable leading economic indicators.

It will be very important to watch the behavior of the stock market over the balance of the 4^th quarter. Now that the liquidity crisis has passed its most intense phase, the stock market itself will provide valuable information as to when and how strongly the economy can recover. At some point (hopefully soon!) the stock market will be resilient and able to rally in the face of a continuing stream of bad economic news. This will be an important clue that the economy won't be as bad as is currently feared, or that the stock market has begun to look ahead to the next economic recovery.

Psychology is still a big wildcard in this respect.

If investors and consumers remain convinced that a Great Depression-like market and economy is inevitable, the recession could drag on and markets will be slow to recover.

Even though this recession may well turn out to be more painful than the past two (2001 and 1990-1991), stocks are already trading well below levels seen in those recessions on a price-to-book and a price-to-smoothed earnings basis.

In other words, current stock valuations have already discounted a severe recession. Accordingly, while I think it is too early to declare a major bottom in stock prices, any further retests of the October lows should be limited in price and time due to the easing of the recent liquidity crisis and the attractive longer-term valuations that now exist in financial assets.

Comments

[Buprestid:]

Lets see if your right or close to right. I give you kudos for calling the previous markets lows not the bottom.

2008 Nov 04 04:26 AM

[Smarty_Pants:]

Recent market activity looks as though the current down leg may have run out of steam. Bear market rally may commence, but it's likely we haven't seen the utlimate bottom yet.

Short term traders may get a playable bounce here. Be ready to exit on first sign of weakness though.

2008 Nov 04 11:34 AM