The Case for a Bounce

The price action in the equity markets Friday was nothing short of impressive. We literally had a W shaped trading day where stocks opened down 600 points, rallied back into positive territory, sold off again by another 600 points before recovering most of its losses by the end day. The volatility that we have seen in the currency market is only an extension of the movements in equities. On an intraday basis, the Dow saw a 1000 point swing, with stocks up as much as 300 points in the last hour of trading. Two very different factors drove the sharp reversal - no one wanted to be short carry trades going into the G7 meeting and the money from the Lehman (LEH) credit default swaps are coming back into the markets.

From Marketwatch

The Case for a Bounce Next Week

Even though the economy could still be in for more trouble over the coming months, there is a case for a major bounce next week. Many people are arguing that this week’s sell-off in stocks is tied to the need to raise cash to settle the Lehman Brothers’ credit default swaps. For those who bought protection against a bankruptcy on Lehman brothers, they are set to get 91.375 cents on the dollar. The sellers of the protection will now have to make cash payments of more than $270 billion to the buyers. As the money changes hands, those who have bought protection could now put their payments to work in the equity markets which could pave the way for a serious bounce.

A Look at P/E Ratios: Are Stocks Becoming Good Values?

The Dow Jones Industrial Average has fallen more than 40 percent over the past year, leaving many investors wondering whether stocks have finally become cheap. Price to Earnings or P/E ratios has fallen to the lowest level in 23 years. With the S&P 500 trading at 860, the estimated P/E ratio according to the NY Times was just below 12. Over the past century, the average P/E ratio was approximately 15.5. According to a study by Yale Economics Professor Robert Shiller,

the P/E ratios in the UK and Germany have fallen to levels that have only been seen 4 or 5 times in 150 years. From that perspective, P/E levels have fallen significantly but it is important to remember that earnings are expected to decline and P/E ratios always fall below the average in recessions. If economic conditions are as bad as the stagflationary period of the 1970s, then P/E levels could still fall to single digits. USD/JPY is due for a bounce, but in the long run, the prospect of further rate cuts from the US should continue to drive the currency pair lower.

In addition to the G7 meeting, we are expecting US producer prices, consumer prices, retail sales, manufacturing and housing market reports next week.

Comments

[Jimmy Lathrop:]

Stocks wont stop falling until hedge fund redemptions and margin calls end. Anyone got a table, chart or index for that? Yeah, I didn't think so.

2008 Oct 12 10:44 AM

[CLH:]

Very good Kathy. Solid information and not the panic information we have been getting. I agree there is a very good chance of a significant bounce in the market this week even if the market has not found its final bottom. Keep up the good work.

Jimmy the hedge funds will not sell if the market continues up for awhile unless they are short which they probably are. We will then have a short sqeeze and the markets will soar.

People dont need to sell for margin requirments in a rising market. Any way you look at it the chance is good for a rally.

2008 Oct 12 12:03 PM

[User 143167:]

PE is low ONLY because the earning estimation is way too high. MSCI world Index trades at PE of 10 now. The US stock market is still the MOST expensive market in PE around the global.

2008 Oct 12 02:16 PM

[Matt Blackman:]

Kathy;
Curious about your comments about that the insurers who bought the CDSs will now have the $270 billion to pay their Lehman claims. Where do you think this money will come from? The US government has already committed to more than $2 trillion, where is another $270 billion coming from?

2008 Oct 12 10:05 PM

[Howard Sun:]

PE is not a good measurement in this current state. Fundamentals DO NOT matter in the short-run. However, I also suspect there will be a bounce next week as shorts cover and as bailout plans begin to take some effect. However, the market will likely continue to fall after that.

2008 Oct 13 12:16 AM

[Moon Kil Woong:]

What good is PE when the SEC issues the directive that all institutions can value their illiquid assets at whatever they feel (which they did). And then declaure this is not suspending market to market since these assets are not marketable to start with. Righto... socializing banks is also capitalism because you put capital in them. Gees, when the world needs trust and transparency they throw the balance sheet in the fire and hope we say it's all better now.

2008 Oct 13 12:24 AM

[Richard Col...:]

I agree with CLH. I would also like to add that we need honest analyst. We have banks like J.P. Morgan lowering estimates and downgrading corporations and they don't disclose their holdings in that company or that sector. Does J.P. Morgan have a short position in the company they are downgrading? This is true of all the analyst whether it be Morgan Stanley or Bk. of America etc.
I don't trust analyst and neither should you. If you notice they all disagree with each other unless a company is booming or going bankrup, then they all agree.
Daniel Kowkabany

2008 Oct 13 10:45 AM