The Evolution of the Bear

There’s something happening here. What it is ain’t exactly clear..... There’s battle lines being drawn.

- Buffalo Springfield, “For What It’s Worth”

Sooner or later in a bear market, even the glory stocks start to come apart.

As a bull market ages and becomes a bear market, stock groups turn down one by one, until even the strongest roll over. That may be happening now to energy and other commodity related stocks.

- “Bear Trap Opens for Resource Stocks” (subscription required), E.S. Browning, The Wall Street Journal, Monday July 7

The climactic selloff on Tuesday July 15 seems to have marked a significant inflection point for financial markets. Oil and the Euro put in a major top that day and have been selling off since while the financials put in a significant bottom and have been holding up well.

These charts: USO 3 Month Chart (Oil), $ Euro 2 Month Chart ($/Euro), XLF 3 Month Chart (Financials), tell the story better than words ever could.

What does it mean?

Oil, the premier commodity, continued to trade strong through the first half of this year even though the U.S. economy was in the tank on the premise that worldwide growth would continue to be strong.  Indeed, all commodities and commodity stocks did.

That premise has lost credibility over the past three and a half weeks.

On Thursday, ECB President Jean Claude Trichet suggested that the European economy might be weaker than previously realized and investors sold off the Euro in anticipation of a rate cut on the horizon (“Dollar Rallies Against Euro After ECB Admits Growth Risks” (subscription required), The Wall Street Journal, Friday August 8th).

What this could mean is that we are witnessing an evolution in the bear market as the global economy and investors begin to reckon with the second order effects of the U.S. housing bust.

That is, the housing bust and its immediate effects on banks and consumer discretionary companies - primarily in the U.S., have marked the first stage of this bear market. Now, this is mostly priced in - the bottoming of the financials is evidence for this -but economies and investors are starting to feel the effects of the U.S. bust on the rest of the world.

Exports to the U.S. are a huge part of the economies of the emerging markets. Sky-high commodity prices are in the end linked to U.S. consumer demand. Falling U.S. demand means falling commodity prices - which in itself hurts many emerging market economies, which are heavily weighted towards commodities - and decreased demand for exports, which means unemployment and declining income overseas.

What this probably means for financial markets is that commodities, emerging markets, infrastructure plays, etc., which have until recently been so strong are now broken and will lead on the downside. Financials and consumer discretionary stocks might not be strong but they will no longer lead on the downside.

Comments

[fatcat:]

I agree with your premise,but also believe that financial prices will continue to erode with the unrelenting bad news.Also,lower comm.prices are short term good news for countries like India...thoughts anyone?

2008 Aug 10 06:47 AM

[adan:]

re: "...this is mostly priced in - the bottoming of the financials is evidence for this...." -

i think it's only evidence that the world's greatest power has used that power to sustain a particular sector, and said, ok, now shift the bear to something else, we have too much of our own $ in these banks and brokers

2008 Aug 10 09:49 AM

[Bhakta:]

It is one bubble bursting after another, and the bear is only begnning to growl. I don't believe the financials have come close to bottoming, as yet. This is DEFLATION happening before our eyes, while we worry about inflation.

2008 Aug 10 10:11 AM

[bearfund:]

The only deflation is in bubblicious asset values and low-grade electronics from the Far East. Anything people actually care about is still far more expensive than it was a year ago or five years ago. Any hint that second-order effects are moving deflationary pressure into any sector other than the hated commodities will bring swift and certain interest rate cuts up to and including "quantitative easing" aka unlimited money printing.

The powers that be are absolutely determined not to allow a major deflationary slowdown to occur. The bear evolution into energy and infrastructure is largely over, though there may be a little money left to be made there. The nascent dollar rally is also tradeable. The bear will move on to other sectors in the future, and those moves too will be tradeable. But don't get caught betting long-term against the Fed and its policy of easy money. I expect another big leg up in hard assets when they decide that 2% isn't getting the job done and the "commodities bubble" appears to be safely in the past. Traders will have to stay nimble to react to extra-market activity. Bear markets just aren't what they used to be.

2008 Aug 10 11:11 AM