Rallies on Negative News Signal an Oversold Market

Financial market conditions have improved notably from the extreme panic conditions that persisted into late November. The "waterfall" decline that overwhelmed markets from mid-September through the third week of November appears to have been broken, or at least temporarily suspended. This is a critical first step to any possible resolution of this crisis, which has vividly demonstrated how a financial collapse feeds upon itself in a vicious circle of selling in a mass flight from risk to liquidity.

From the November 20 closing lows, the S&P 500 has rallied 18%; the MSCI EAFE Index (foreign developed stocks) has rallied 20%; and the MSCI Emerging Markets Index has gained 35%. Commodity prices are also bouncing, and spreads on very high quality corporate debt have begun to tighten.

Stocks have been able to rally in the face of bad economic news, which is likely more reflective of how oversold stocks had become than it is any reliable signal of a turning point in the economic outlook. Indeed, the leading economic indicators we track from the Economic Cycle Research Institute remain at their cycle lows. According to ECRI, "a business cycle recovery is nowhere in sight." Moreover, ECRI's leading home price indexes are still falling, which is troubling because in addition to the typical recession dynamics of falling production, employment, income and sales, this recession has the added dimension of sharply falling home prices and home foreclosures, which is preventing any significant healing from occurring in the financial sector and in credit markets.

The profound uncertainty of the economic outlook is the principal reason that the VIX Volatility Index (a gauge of expected volatility) remains at an extreme level of 54 (though this is down significantly from October's and November's readings in the 60s and 70s). The range of realistic economic outcomes includes, at one extreme, the worst recession in the post World War II era and millions of additional job losses, and at the other extreme, the possibility that a new economic recovery will be underway by the middle of 2009.

In the former scenario, investors are faced with the prospect of bear market rallies that ultimately fail, and further testing of the October and November lows. In the latter scenario, a new cyclical bear could be in its early states and the stock market could deliver very strong returns in 2009. Investors must have a strategy in place that is equipped to deal with this broad range of potential outcomes, and must maintain the flexibility to adjust to circumstances as they evolve. For instance, if we do experience a stronger, more sustained stock market rally in the weeks ahead, but the economic outlook remains extremely cloudy, investors who are uncomfortable with the prospect of a return to the recent lows should consider reducing their risk exposure.

In addition to the continuing drama surrounding the U.S. automakers, investors this week will be fixated on the Federal Reserve Open Market Committee (FOMC), which meets today and tomorrow and will announce Tuesday afternoon its latest policies to combat the debt-deflation dynamics that have taken hold. Markets expect the Fed to make history by cutting the Fed Funds rate below 1%. Given that 90-day T-bills have been trading under 0.1% for over a month and have been trading at 0.01% (!) for the past two weeks, this development will be of less interest to market participants than announcements concerning the "unconventional" policies the Fed has undertaken in recent weeks (e.g. debt monetization) to unclog credit markets and bring down longer-term interest rates.

In a speech on December 1, Chairman Bernanke hinted at the possibility of the Fed targeting long-term interest rates through direct open market purchases. Since that time, the 10-year Treasury yield has fallen 40 basis points from 2.96% to 2.56%. Given that this drop in T-Note yields to record low levels has occurred alongside a rebound in the stock market and a rally in gold prices, it reflects investor anticipation that the Fed will follow through on a program of "pegging" long-term rates, rather than investor expectations of a growing deflation risk.

It is certainly analytically challenging to account for a 2.56% Treasury yield when the government is engaged in the largest reflation and deficit spending operation in history. Ultimately, the Fed's strategy is to entice investors to put their money into riskier assets, not Treasuries. Since Bernanke's speech on December 1, Treasuries seem to have become even more alluring to deflation-minded bond investors, so the Fed is no doubt refining its policy or communications on this topic to draw capital out of Treasuries into other credit instruments, most of which remain under a great deal of stress.

Comments

[herbert hoover:]

Another possibility: Rallies on bad news mean a lot of stupid traders

2008 Dec 15 11:19 AM

[maelstrom:]

Or Hedge Funds holding the line for anoyher week or so

2008 Dec 15 11:47 AM

[LWH:]

With the significant number of housing loan foreclosures and severe drop in housing prices, coupled with an anticipated rise in unemployment rate, the American economy is already seeing a drastic cut in consumer spending.
In the highly likely event that the Automakers will be dealt with in an 'ordely bankrupcy' manner, even as Obama takes over the helm in January, there really seems to be little positive economic indicators in the short 3-6 months term.
In my opinion, the current rally post end-November-watershed is simply a case of traders encouraging traders empirically. I would not go to the extent of calling them 'stupid traders' as some have done so, but i believe many opportunistic traders, and that include what remaining hedge funds, are essentially trying to blow some more oxygen into a dying fire.
It is truly astounding a phenomenon, one that goes against all rules (but then again, the past 3 months had seen nothing following any conventional rules), but it simpy just cannot last, and I strongly believe we stand to see another new low in the first quarter of 2009, very soon after many companies release their annual financial data in Dec 08/Jan 09.
A good recap of what the author has mentioned is: if you believe that the economic datas are going to be bad in the coming months, and you are the more conservative type who is not out to make a quick day-trading buck here, don't rush into buying during these 'window dressing' periods. Wait it out. The first quarter of 2009 will present a definitely better opportunity.

2008 Dec 15 11:50 AM

[Fred Voetsch:]

"The profound uncertainty of the economic outlook..."

Read your own comments above that statement and you will see that there is no uncertainty. The economy is getting worse and the stock market will also once the "relief rally", such as it is, blows off some short term pressure. The market will soon enough contune to drop and the Dow will get below 6,000 within months and will likely drop another 50% or more from there, based on current economic conditons, long-term over-valuation of stocks and the need for a generational lesson being taught to people who really thought that it would be different this time.

Preserve your capitol and be prepared to go long once everyone else is SURE that stocks are a terrible investment. I predict that will take at least a few years and likely as much as a decade to really shake out the "investing genuises" that were created over the past three decades.

--Fred Voetsch

2008 Dec 15 12:15 PM

[update:]

Two excellents comments from Fred and LWH...

If only traders would stop trying to tell the general internet surfing public that it is a great time to leap back into the market sure to die....

2008 Dec 15 12:53 PM

[jepittman:]

There is nothing wrong with being bearish HH. Blaming it on 'stupid traders' only reveals the truth.


On Dec 15 11:19 AM Herbert Hoover wrote:

> Another possibility: Rallies on bad news mean a lot of stupid traders

2008 Dec 15 05:08 PM

[geewow:]

J.D. what are you saying? There is a reason to buy stocks now? When unemployment continues to climb, not only for middle America but for upper America, more foreclosures and bankruptcies, evaporating retirement savings, extended credit card debt, and less than desirable corporate earnings, unless one is Wal-Mart, there is absolutely no reason for stock rallies, unless it is all about stock manipulations and quick buy/sells. The 2009 forecast is bleak. More of the same bad news, and a worsening economy. The Fed rate going to zero, and the 3 month Treasury at zero are both negative. Interest payments coming due to foreigners hold Treasuries. Mounting US debt. Treasury printing money. China saying they will no longer buy US debt. Chinese factories shutting down and civil unrest in two regions. Declining tax revenues coming in to Treasury. People need to come down to earth and stop reading formulas.

eye-on-washington.blog...

2008 Dec 16 11:18 AM