The Dow Jones Industrial Average and the S&P 500 hit all-time highs on Oct. 11, 2007. But since then, the Dow, S&P 500 and the Russell 2000 have endured huge volatility and losses ranging from approximately 15% in the Dow to nearly 24% in the Russell. The government is responding, President Bush and Congress are wrangling over an economic stimulus package and the U.S. Federal Reserve Bank cut interest rates by 125 basis points over the course of eight days in January. It’s safe to say the subprime contagion has spread from housing to the broader economy.
“Last quarter of last year was as volatile as I have ever seen it and I have been trading for 17 years now. And this year is going to make last year look pale in comparison,” says Larry Young, broker for Infinity Futures. “It’s going to be a very exciting market for traders and speculators, but for individual investors, it’s going to be pretty nauseating.”
The Dow dropped 306 points on Jan. 17, the day that Fed Chairman Ben Bernanke offered his economic outlook to the U.S. Congressional Budget Committee. Equity markets across the world sold off dramatically into Jan. 21. Some of that now may be attributed to Societe Generale unwinding trades initiated by “rogue trader” Jerome Kerviel; but with the U.S. markets closed, and in the absence of knowledge about Societe Generale, Bernanke called a special session of the Federal Open Market Committee (FOMC); and on Tuesday, Jan. 22, eight days before its next scheduled meeting, the FOMC cut both the Fed funds and discount rates 75 basis points, bringing the Fed funds rate to 3.5% and the discount rate to 4%.
It was the largest rate reduction in more than 20 years and the first inter-meeting Fed funds rate adjustment since the aftermath of 9/11 when the Fed cut rates by 50 basis points. In a statement, the FOMC said it was responding to “a weakening of the economic outlook and increasing downside risks to growth.” In response, the major equity indexes dumped more than 5% of their value, with the Dow plunging 460 points before closing down 150 points for the day, enduring a 662 point range. And there was more to come. At the scheduled meeting on Jan. 30, Bernanke and crew cut the Fed funds rate to 3% and the discount window rate to 3.5%. The markets closed down for the day.
“We thought it was going to be a close call but it was not,” says Ashraf Laidi, chief currency analyst for CMC Markets US. He says without a scheduled meeting in February, the Fed hoped to avoid another inter-meeting rate cut.
To fear from greed
The idea that something has fundamentally changed for the worst in the U.S. economy is gaining traction. Investment banks and financial services firms have endured well documented write-downs, taken huge quarterly losses and shed layers of senior management as a result of their investments in subprime mortgage related instruments. The decline of the U.S. housing market has accelerated, with new housing permits and prices falling while inventories build. A recession in the United States is now considered inevitable with the rest of the world eventually to follow. Already the Bank of England, the Bank of Canada and others are discussing or implementing coordinated reductions in interest rates.
But the most recent series of interest rate cuts have softened an already weak U.S. dollar. Gold, crude oil and agricultural commodities are trading at or near all-time highs, indicating rising inflation. Headline inflation in December was 4.1%, compared with 2.5% a year prior.
“The dollar is the ultimate gauge of what’s going on,” says Michael Hinman, senior market strategist at Lind Waldock. “You start looking at these open interest numbers, I’ve never seen anything like it. The entire world is short U.S. dollars and they are buying gold.”
And with the Fed aggressively cutting rates with Fed Funds futures projecting a 2.5% rate in April, there is no relief in sight for the green back. “I could see the Dow down anywhere from 11,000 to 10,000 before we bottom out here. I am going to be short the entire year,” Hinman says. “Every rally needs to be sold.”
Tom R. Willis, VP of commodities management at Mesirow Financial, says the rally that peaked in October was different from the 1990 to 2000 rally, which was based on a strong dollar and a strong economy. “This has been inflationary, as evidenced in the prices for gold, crude oil and agricultural commodities,” he says, and with the U.S. dollar index near 77, just two points off its all-time low, the equity indexes have merely been repriced in that weaker currency. “I wouldn’t be surprised to see them down 20% on the year. I was assuming that wasn’t going to happen in the first month of the year,” he adds.
Because it is the broadest index, Willis says the Russell 2000 has performed the most poorly. “We made our highs in the Russell 2000 in July, and the rest of the equities were rallying until October. When you see a broad index like the Russell on the decline, it just shows you that companies are having a hard time selling their goods.”
Those Russell 2000 components, however, may be more trustworthy because they were not as indulgent with the cheap money that had been so readily available, Young says. “The bright spot is that this could be a great buying opportunity where wealth can be created in terms of dollar-cost averaging into these slippery markets.” Young is looking to the technology sector, and therefore the Nasdaq, to outperform the S&P 500 and the Dow.
Andrew Waldock, principal of Commodity and Derivative Advisors LLC, is more optimistic. He says that sustainable equity bull markets are positively correlated with rising price-to-earnings (P/E) ratios. “Historically, bull market runs begin with a P/E ratio around 10 and climb to about three-and-a-half times their beginning value. Conversely, bear markets have seen the P/E ratio decline by roughly 60%,” he says. The current market’s P/E ratio peaked at 46 in March 2002, and is currently just under 17. “This puts us in the ball park of a normal cyclical correction,” he says, and while the DJIA’s yearly lows may not yet be in, bargain hunters would swoop in between 10,700 and 11,700 preventing a wipeout.
“The Russell 2000 is harder to nail down,” Waldock says. Having more than doubled since 2003, he says the Russell 2000 has the highest relative strength of the major indices, but given a violation of 735, it could trade as low as 615. “If the indices as a whole continue to cycle their way through the global rotation, we could see a strong base formed through the spring and early summer. I expect the volatility to continue as the subprime debacle sorts itself out, value investors pick bottoms and the Fed reaches their inflexion point in this cycle of easing,” Waldock says.
Intervention
Willis is skeptical that an economic stimulus plan will pull the United States out of recession and doesn’t believe that further interest rate cuts will go into saving housing or mortgages. “We have had maybe four rate cuts, and a whisper of another one, and it just hasn’t solved the problem,” and when a market fails on bullish news, traders can only conclude rate cuts are not working. Rather, he says that money likely would chase better returns in the commodities markets. Further, he expects the negative wealth effects from the depressed housing market, tighter credit and increased debt to kill consumer spending and, by extension, equities.
While a resulting recession is likely to be longer and deeper than anticipated, Peter Kefalas, head of research at Denali Asset Management, is more optimistic based on monetary policy. “The degree of aggressiveness that the Fed is undertaking has been enough historically to support a very good upswing in stock prices. As long as the dollar declines gradually, the monetary stimulus is enough to trump any negative decline in the dollar,” Kefalas says.
Kefalas says a break below 1,270 in the S&P, and 11,600 in the Dow would likely lead to an important bottom at 1,200 for the S&P and 11,000 for the Dow. That would be dramatic, but he says it would represent a deep technical correction rather than a breakdown. Those levels, combined with a constructive monetary policy, would be a setup for a low risk/high reward entry point, and possibly the best cyclical bull market since the move from the 2002 lows.
Closing time
Laidi says the aggregate margin debt of NYSE member firms has plummeted to $322 billion from a record high of $381 billion in July 2007 (see “Bad omen,” page 25). The decline is the result of margin calls as client losses accumulate during mounting market volatility. A rapid decline in margin debt correctly predicted a serious correction in the fall of 1998 and a bear market in 2000. From the decline, he expects a prolonged equity bear market. “The S&P is going to drop another 20% easily into the next quarter,” he says. “We are still in the early stages of this recession. And yes, we are in a recession.”
The market has been brutal on clients, many of whom want to get into cash or bonds, says Mike Kimbarovsky of Advocate Asset Management LLC, and while he has changed his focus from liquidity to practical solvency, he says now is the wrong time to exit the market. “I don’t think we are in a collapse of the financial system,” he says. “There are a great many attempts to call a bottom, and I see it by capital flows,” he says, explaining that ordinarily he would expect the Russell 2000 to have a Beta of 1.5 or 2 with the S&P. Instead, they are moving inline, indicating short interest, short covering and liquidity; he concludes that institutional traders are trying to call a bottom.
“I am not an advocate of buy and hold. And yes, it could get nastier in the next three to six months, but we are also at a time when you have to focus on the mountain beyond the valley,” Kefalas says.