Can a Stock Market Meltdown Happen from Here?

by: Marc Courtenay

The short answer is "of course it can". No matter how many reasons we come up with for a March 9th bottom and the idea that there is "still plenty of upside from here", reality dictates that there could be an unexpected downside to stocks that could unfold soon... in fact, sooner than we might want to believe.

I've written recently that there are many big economic issues yet to be worked through. Investors don't like negative surprises or high levels of uncertainty. The stock market can climb a "wall of worry" in more economically stable times. But many of us see several versions of "the sword of Damocles" that can't be ignored.

Cicero told the story of the Sword of Damocles in his Tusculan Disputations. The story is based on a legend about the Syracusan tyrant Dionysius II and the fawning Damocles, who called Dionysius the most fortunate person ever.

Dionysius offered him the opportunity to try out his lucky life, and Damocles readily agreed. Amid all the gold and luxuries that Damocles could enjoy, there was a sharp sword hanging from a slender thread (and in imminent danger of dropping) above Damocles' head. Damocles quickly wished to go back to his less fortunate life.

Are you feeling lucky, comfortable and secure right now? Then do nothing and see what happens. Are you seeing some "swords" dangling from slender threads that could drop at any time? Then ask yourself how you can protect what's left of your net worth from the potential consequences.

For many of us it reduces stress and manages uncertainty to make sure we have enough cash for future investing opportunities and to protect at least part of the current value of our investment portfolio. After all, do you and I really know what shoe will drop next (the modern equivalent for the "Sword of Damocles").

That is why we must candidly and honestly admit the downside risks at this moment when it comes to the stock market indices.

We've been moving sideways since April 3rd, and although this week we barely cleared the 8,100 level on the DJIA and closed at almost 870 for the S&P 500 last Friday, the markets are struggling at this point to hold their gains.

I read a European perspective concerning a potential reversal in the US stock markets. Thanks to the BNW Business Newswire we can all be aware of this viewpoint that might be difficult for US investors since we might be too close to "the tree" to see "the forest".

Having correctly anticipated the timing and extent of the March 9th to April 3rd market rally, this is the latest dire warning from Heiko Seibel, a leading German stock market strategist.

"The Director of Research for Munich-based CM-Equity AG now believes that the U.S. benchmark S&P 500 Index will dramatically drop to an ultimate low of around 450 points in late June or in July. The odds favour him being proven right - that is if his talent for correctly anticipating market moves continues.

"Within a few weeks, we will see the stock lows of our lifetimes," he nonchalantly declares.

"Indeed, he was right on the money when he told BNW Business Newswire on March 2nd that the S&P 500 Index was about to reverse a pronounced downward trend. He suggested at the time that it would rally to a high of not much more than 850 points during April before it begins an orderly retreat that soon turns into a panic-stricken rout.

"The S&P 500 closed at 856.56 on April 9th - the culmination of a very impressive five-week gain of 26% over its March 09th low. However, this rebound cannot gloss over the fact that the bellwether index's had lost 58% of its value by the time it ended its slide in early March. And now the S&P 500 is likely destined to trade in an uninspiring sideways pattern for the balance of the month, Seibel suggests.

"Seibel believes that a growing sense of economic optimism shared by many U.S. investors and the Obama Administration, alike, is completely misplaced. He suggests that the rally during March and early April (with the Dow Jones Industrial Average closing at 8,018 points on April 3rd after enjoying the best four-week run since 1933) is merely a false dawn.

"Soon enough investors will be seriously rattled yet again - this time by a devastating after-shock to October's global financial earthquake. One that will see the S&P 500 Index nose-dive up to 40% before it hits rock bottom at around the 450 points level. This bleak scenario contrasts starkly to the S&P's heady high of over 1,550 points in October of 2007.

"A proponent of quantitative analysis, Seibel says this pending nightmarish sell-off will cause plenty of already shell-shocked investors to relinquish their remaining equity holdings. However, investors in gold bullion and gold-backed Exchange Traded Funds (ETFs) will likely be spared the widespread misery, Seibel believes.

"When there is a total loss in confidence in the stock market, then gold will rally. Gold bullion is historically an inverse proxy to the stock market. So, it's only logical that this will happen," he says.

"We should see a culmination of massive price weakness in stocks within weeks, which will cause gold to reverse its current trend to establish new highs beyond $1,000 early in the third quarter of this year - maybe even testing the $1,200 mark," he adds.

"Interestingly, gold equities will not be immune to the market meltdown because investors will engage in "panic selling," to preserve whatever capital they have left, he predicts.

"Meanwhile, the catalyst to the stock market's final capitulation during the coming months will be a combination of the collapse of more landmark U.S. companies, a renewed banking crisis, and other forms of "major economic upheaval," Seibel explains.

However, it is always darkest before dawn. And Seibel reasons that a gradual rebound in equities will finally assert itself during the last quarter of 2009 in anticipation of a spring economic revitalization. One that is already being germinated by massive government-backed infusions of money into the U.S. economy.

"History shows that economic recoveries typically get underway about six to nine months after the markets hit their ultimate lows. So a spring economic recovery appears very probable," he says.

"And gold stocks will lead the way during the market recovery as they're already ridiculously cheap and will get cheaper. But as gold prices begin to push higher, then gold producing companies will become attractive because they will offer investors leveraged exposure to these rising prices," he adds.

When we realize that it is never obvious as to when to sell and when to buy, Herr Seibel's point-of-view stirs in me a reconnection with the lessons we learned in the second half of 2008 and the shocking turn-around in the markets from the end of December 2008 to March 9, 2009.

I've been very happy with the recent resiliency of energy stocks like Chesapeake Energy (NYSE:CHK), and Devon Energy (NYSE:DVN), technology stocks like (NASDAQ:AMZN), EMC (EMC), Texas Instruments (NYSE:TXN) and DJIA stocks like American Express (NYSE:AXP) and Procter & Gamble (NYSE:PG), I'm not convinced these gains can be sustained or increased.

So if we only partially agree with researchers like Herr Seibel, shouldn't we be formulating a reasonable response? Right now the bias of the media and the marketplace is admittedly positive, but we have all learned how fickle both have been the last 12 months.

I'm not saying it is "all or nothing" but I am saying the warning signals are becoming more prevalent with every passing week. We've paid quite the "tuition" to learn the lessons of this costly credit crisis and financial implosion. Now is the time to put what we have learned to good use. An ounce of prevention might again be worth much more than a "pound of cure".

Disclosure: Long CHK, EMC, TXN

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