Tuesday, October 28, 2008

Pin The Tail On The Bull

Pin The Tail On The Bull
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By Dan Denning | 28 October 2008

Has this brutal bear market finally ended? Has a new bull market arrived? …Only Warren Buffett knows for sure… The rest of us have to guess. But before guessing, let’s stick our index fingers in the air and try to gauge the direction of recent financial trends

The good news is that the credit market is unfreezing. The bad news is that no one in the stock market seems to care. All the hot money being pumped out by central banks is finally starting to de-thaw the inter-bank lending market. You probably now know more about the inter-bank lending market than you ever expected or wanted to know. But the decline in the rate banks charge each other to borrow overnight (LIBOR) really just means that banks have slightly more trust in each other this week than they did last week.

Yet on Wall Street, the Dow merely convulses. The S&P 500 is down 39% year-to-date and 43% from its high last October. You’d think the de-icing of the credit market would have produced a little more joy in the stock market. But investors have other worries on their just minds now. Earnings, for one. In the bigger picture, they are wondering just how big and how deep this global recession [already conceded] is going to be. How many more layoffs will there be? How bad will it get? Judging by current stock prices, around the world, pretty bad.

Oil has slumped to less than $70. Gold to nearly $700. These are not the signs of economic vitality. Copper and aluminium are also falling by dreadful amounts. If you look at the action in these market, investors are pricing in a shocking 2009, not just a run-of-the-mill recession. Are the slumping prices of commodities an indication that inflation poses no threat?

"History shows that recessions solve inflation problems, so, much of the world is about to have their inflation problems solved— and pretty rapidly," an interest rate analyst opined recently. Maybe this analyst is correct, but OTHER history shows you can have rising prices AND a recession. That’s the good old stagflation of the 1970s.

But maybe we’re overly worried about inflation. After all, most central banks target or tolerate annual official inflation of 2% and call it "price stability." And Jeremy Grantham, who’s been bearish on stocks since at least 2003, seems to think that value will be destroyed in financial asset markets faster than new lending and credit can reflate it into a new bubble. [Grantham is the insightful founder of the investment management firm, Grantham, Mayo, Van Otterloo, and a generally acknowledged stock market seer.]

"Don’t worry at all about inflation," wrote Grantham in a note to investors. "We can all save up our worries [about that] for a couple of years from now and then really worry! Commodities may have big rallies, but the fundamentals of the next 18 months should wear them down to new two-year lows."

Grantham is dipping his toe into equity waters anyway. "At under 1000 on the S&P 500, U.S. stocks are very reasonable buys for brave value managers willing to be early. The same applies to EAFE and emerging equities at October 10th prices, but even more so. History warns, though, that new lows are more likely than not."

The S&P 500 made its bear market low in October of 2002 at 776. That’s 13.3% below yesterday’s close of 896. And should it decline to that level, it would be exactly 50% below its all time intra-day high of 1,552 (set on October 31st of last year).

By any historical standard, that’s a whopper of a bear market. So Grantham dipping a toe in now is an assumption that this bear market is roughly consistent with similar bear markets of the last 137 years. Take a look below and you’ll see what we mean.

The bear market of 2008 already ranks up there among the all time greats. The only question now is whether the bear market in stocks triggers a big enough recession in the economy that it leads to an even greater fall in stocks in the coming years. So is it 1929 [[or 1980: normxxx]]; or 1974 [[or 2002: normxxx]]?

It’s tempting to call the massed selling of stocks 'irrational'. But this is based on some investors looking at stock valuations and finding them cheap on a [history of] earnings basis, or looking at the cash on the balance sheet. But what we have right now are extremely motivated sellers. We call these sellers, "hedge fund managers." They HAVE to sell… for many different reasons. They have to sell because almost all of their leveraged bets on stocks, bonds and commodities are blowing up… which means they MUST de-lever to meet margin calls. At the same time, these guys are receiving tens of billions of dollars worth of redemption notices. So that means they have to sell even more to raise the cash to send to their investors. This is not a pleasant situation.

Normally, when a seller has to sell is a very good time to be a buyer, hence Buffett’s chest-thumping op-ed piece. But you don’t want to be a buyer just yet if there’s [substantially] more forced selling in the pipeline [[Buffet can afford to ignore another downmove of 10%, or even substantially more…: normxxx]] And that is now the key question in the market. How much leverage is left to be unwound?

Well, before the crisis hit, 'hedge' funds controlled US$2.4 trillion in investor funds. They would have used that capital to secure trillions more dollars worth of borrowings (with leverage ratios of 20-1, 50-1, and on up to 100-1). But now, all those assets purchased by 'hedge' funds with borrowed money are being liquidated. And those 'hedge' funds that were not hedged at all (long-only, but with the most massive leverage) are not long for this earth. Who are they going to take with them?

"In a fairly Darwinian manner, many hedge funds will simply disappear," Emmanuel Roman, co-chief executive officer of GLG Partners Inc., told investors at a hedge fund conference in London. "This will go down in the history books as one of the greatest fiascos of banking in 100 years."

True that.

Governments now want to regulate hedge funds. [[They want, finally, to close the 'barn door'.: normxxx]] They’ve already begun to do so by preventing them from shorting. But remember, if a hedge fund can’t short, it can’t really hedge. Performance suffers. Investor redemptions increase. The more hedge fund investors want their money back, the more that the funds must sell. In fact, only the "lock-ups" that hedge funds impose to prevent investors from getting their money back immediately are preventing an even greater pace of redemptions. So it’s easy to see how a new low in the markets is entirely possible.

Our prediction? Stock markets are going to get a hefty global bounce in November. There are at least three events on the horizon that could provide the boost. First, even if Obama is elected, you have the end of uncertainty about the U.S. election (and some highly irrational optimism that things will now indeed be different, better, and nicer). Second, you’ll get a new stimulus plan from the Democratic Congress in the U.S., which should give stocks a bit of a kick. And third, the big G20 meeting in Washington. Something that 'looks and feels good' should come from that.

Those three factors should conspire [or just provide the excuse] to produce a convincing-looking bear-market rally into Christmas. That would be like the sucker’s rally of 1929 - 1930 that preceded the stock market’s epic collapse over the ensuing two years. Or, we could be dead wrong and deleveraging may simply overwhelm everything else and take the market down to much lower lows right now, right here, without much of a bounce at all.

Stocks are very cheap. That makes them a buy. Unfortunately, they might get cheaper; much cheaper. That makes them a sell. And so we defer to the seasoned wisdom of Jeremy Grantham, an investor who is BEGINNING to buy, but fully expecting prices to fall even lower. [[Or, John Hussman, who is simply 'scaling in' as risk reduces and stock valuations go up.: normxxx]]

  M O R E. . .

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