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The MSCI World Index shed 11.0% between its high on July 19, 2007 and August 16, with the S&P 500 Index declining in similar fashion by 9.4%. At that stage, high-yield debt markets had completely stalled, investment funds had blocked redemptions, and the VIX had reached a high not seen since October 1987.

However, rescue was at hand as the world’s central banks – the Fed, the ECB, the Bank of Canada, the Bank of Japan and others – let it be known that they were dumping money into the system. The Fed went one step further, and announced a discount rate cut of 0.5% on August 17.

Calmed by the central banks’ actions, stock markets around the globe staged a rebound. By Friday of last week (September 7), the MSCI World Index and the S&P 500 Index were respectively -6.8% and -6.4% below their July highs.

Although investors are relieved by the recovery, they are wondering what to do next. Before debating this critical issue, let’s focus for a moment on the graph of the broadest U.S. stock index, namely the Wilshire 5000 Index.

click to enlarge

Source: StockCharts.com

The most notable observation is the fact that Friday’s sell-off resulted in the index again closing below its 200-day moving average, although this primary trend indicator was still rising. But perhaps more important is the volume chart showing that the rally since mid-August has been characterized by rather poor volume. This lack of breadth is worrying, and casts doubt on the sustainability of the bounce.

This viewpoint is augmented by Dr. John Hussman’s remark in his September 3 commentary:

… the market climate for stocks remained characterized by unfavorable valuations and unfavorable market action. The market has now cleared the oversold condition that we observed several weeks ago, yet breadth and trading volume have not evidenced the strength and persistence that we typically associate with more sustained recoveries from oversold conditions. That’s not to say that we can’t observe further market strength, but at present we have no evidence either from valuations or from market action to reliably speculate on such strength.

At this juncture it is perhaps sensible to reflect on the fundamental picture. A very apt assessment comes from friend Kevin Wilson’s Market Perspectives.

Kevin said: "I don’t believe in hedged answers, so that forces me to make the call in a clear fashion, at least as a mental exercise. I think that the chances are 65% in favor of recession, for the following reasons:"

  • Almost all of the good data about the economy we’re seeing are backward looking.
  • Almost all of the bad data we’re seeing are forward looking, in terms of lagged effects not yet felt.
  • The housing crisis is nowhere near bottom and its impact on PCE is far larger than its 9% share of the economy (on a GDP basis).
  • The consumer is about to abandon ship (even though July PCE is fine), primarily due to the credit squeeze and household deficit spending.
  • The “wealth effect” (if it is real) must be very strongly negative going forward, so it should reduce PCE as well.
  • Many recession indicators have been aligned for two quarters, and even more will align in the third quarter.
  • This brings us to the question of whether the market correction will transform itself into a full-fledged bear market. “I think the answer is scary,” said Kevin. “I would guess the chances of descending into a bear market are 80% within three months. Here’s why:"

  • Earnings have nothing whatsoever to do with short-term market moves; it’s overall valuations that count, and they are really not good.
  • The market thinks earnings matter, so when the financials’ earnings drop over the next few months, it will have a profound effect on sentiment.
  • A general re-pricing of risk is going on, and that is prima facie evidence for the beginning of a secular bear market.
  • Correlations and betas are high for many stocks and their sectors, and were especially so during the sell-off, leaving no place to hide.
  • The Fed valuation model is hokum and events will soon prove it to the satisfaction of all concerned.
  • The credit squeeze is shutting down both buybacks and M & A, which together were the drivers of at least 50% of market gains in the run-up.
  • The retail customer has been a net seller all along and this is accelerating to fund household deficit spending.
  • Against this background should investors increase, or curtail risk in their investment portfolios? As I see it, factoring in a prudent analysis of the possible unfolding of events, it might be sensible to adopt a more defensive approach to risk and err on the side of caution. As a parting comment, somebody famous pointed out that “wishful thinking” (especially of the CNBC variety) is an oxymoron. It’s wishful, but it’s not thinking.

    click to enlarge

    Hat tip: Rob Fraim

    Source: Wall Street: Where to Now?