Financial Market Commentary

Posted by Rob Weigand.  Well, at least the Royal Bank of Scotland’s prediction for a global market crash passes the Revelations 3:15-16 test (which abhors those who cling to wishy-washy opinions and advises that we take a strong stand, one way or another).  In case you missed it, on June 18, 2008 RBS issued an advisory calling for a 20% crash in the S&P 500 accompanied by significant global contagion.  Their thesis is based on economic weakness, runaway inflation and an impotent Fed, who is apparently reluctant to join the ECB and raise rates to combat global inflation.

You can check out the report on CNBC at the following link.

Not surprisingly, this has gotten me thinking.  First of all — can it really be the case that the “strategists” running the world’s elite financial institutions are just waking up to all the negative factors that have been weighing on markets for the past year?  You know, things like the overleveraged U.S. consumer dealing with $4 a gallon gasoline and declines in the value of residential real estate; high energy costs putting a drag on the general cost of doing business, paticularly global transportation (FedEx reported disappointing earnings today, which is troubling, because global growth depends on a robust shipping infrastructure); bubbles yet to pop in commodities and emerging market stocks; and a banking/credit creation system that remains extremely reluctant to finance any sort of deal, even high-quality ones.  Apparently the answer to this question is yes — these deep thinkers could not work through the math of all this until it hit them right between the eyes.  Perhaps they are finally “getting the memo.”

My second thought is, why should we listen to RBS (or Merrill, or Lehman, or any of them)?  Collectively, the world’s investment banks have lost almost half a trillion dollars in the credit crisis, with more steep losses to come.  If they weren’t thinking clearly when they were building all those sophisticated risk management models (that turned out to be useless), why should we believe they’re thinking clearly now?

Third on my list is the old rule of contrarian sentiment, and one of my favorite stock market terms, capitulation (read more on capitulation at CNBC.com).  I love that word.  Regarding sentiment, research shows a strong inverse relation between overall stock market sentiment and future returns.  In other words, when the majority of professional opinion is unusually bearish, future returns tend to be better than average, and when opinion gets unusually bullish, markets tend to correct downward.  How negative is current market sentiment?  Well, for example, Thomson/Reuters reports that short interest (volume of shares sold short) on the NYSE is currently at its all-time high (story available at the following link).  Perversely, history tells us that all of this negative sentiment can be interpreted as a positive sign.

Strong negative sentiment is related to the idea of capitulation, which says that, in a bear market (and this is definitely a bear), we have to have several waves of cathartic selling before we can find the bottom and set the stage for a future bull market (and yes, there will be a bull market in our future, it just may be a long way off).  Investors capitulate in the sense that they surrender to the overwhelmingly negative market sentiment and everyone just sells, sells, sells.  Old-time technical analysts believe that true market bottoms require a few waves of capitulative selling.  I would propose that every time the Dow dips below 12,000 (which has occurred 3-4 times in the past 12 months) we are in “capitulation country.”

So it looks like more rough going ahead before markets right themselves.  The market hates uncertainty, and there are too many unresolved questions standing in the way of a bull market.  Foremost among these are Will banks ever feel like lending money again? and How can the global economy grow robustly and fight inflation at the same time?  (Answer: it can’t, but history shows that the long-term effects of inflation are worse than the short-term effects of recession — the U.S. Fed is playing a dangerous game by refusing to take a tough stand on inflation.)

I think it’s going to get more interesting (on the downside) before we can breathe easy.  The next bull market will begin after the market overshoots fair value on the downside, which has not occurred yet.  Given all the risks out there, a level of 12,000 on the Dow translates into a risk premium that is just barely necessary to get investors interested in owning equities again.  Investors won’t rush back into equities until they perceive a profound bargain, probably around Dow 11,700 (or a little lower). 

Looking for a silver lining, it’s a great time to study investments.  This is the most rational markets have been in the eight years since the great U.S. stock market bubble began its extended unraveling (eventually finding a bottom at Dow 7,700 in November 2002).  All the classic themes are playing out, just as the Warren Buffet/take-the-long-view-of-things investment philsophy says they should.  Read The Wall Street Journal and watch a little CNBC every day.  There is no better investments education than living through a protracted bear market.  It’s even better if you’ve got some wealth at risk and are suffering some losses.  These experiences are great for focusing your attention.

You can write to write to Rob Weigand at profweigand@yahoo.com or find him on the web at Rob Weigand’s Home Page.