Monday, September 12, 2011

Where's the bottom?

As stocks cratered Friday on renewed concerns over a Greek default, investors are undoubtedly asking, "Where's the bottom?"

I believe that investor sentiment is by no means at bearish extremes for a meaningful bottom to be put in at current levels. Bespoke recently conducted an (unscientific) poll that showed an excess of bulls.

The VIX Index, which is a measure of fear, has spiked. Readings are elevated but nowhere near either recent highs or Lehman Crisis extremes.

In addition, the Sep 7, 2011 reading on DAX investor sentiment shows an astounding level of 64% bulls and 20% bears. No capitulation here.

What's more, the violation of a significant technical support level for the euro is a signal that this decline is nowhere near an end.

Where's the technical support?
Given the current technical and sentiment backdrop, the S+P 500 is likely to violate its recent support level at 1100. The next logical support level is the 50% retracement at about 1020. The big question is, "Should Greece default, which would cause a banking crisis in Europe, would the 1020 level hold?"

Similarly, when I look at the Canadian market, the TSX is in a well-defined downtrend. Will the market hold at the 38% Fibonacci retracement level of 11650, the 50% retracement level of 10900, the 62% level of 10700, or does the market have to test the 2009 low?

Watching Europe
Rather than guessing, you have to go to the source and the source of any financial contagion comes from Europe. The key, then, is to watch the technical condition of European stocks.

The chart below of the STOXX 50 shows the index to be testing support at about the 2070 level. Should that not hold (and it likely won't in the event of a Greek default or banking crisis), the next logical stopping point is the 2009 lows at 1600 - which represents a decline of 24% from current levels.

A look at the point and figure chart of the STOXX 50 shows a downside projection of 1540 (circled in purple), a level that is close to the low seen in 2009.

In addition, this analysis from Brockhouse Cooper shows that European equities have less valuation support on a free cash flow or dividiend yield basis compared to other regional markets.

Moving from denial towards acceptance
The EU has been undergoing the classic stages of grief, which begins at denial and ends at acceptance. Last week, the finance minister of Estonia, a minor EU country, said that it was illogical to exclude the possibility of Greek bankruptcy (h/t Mish):
The economy minister of Estonia, member of the euro area since January, said it was “illogical” to exclude the possibility of bankruptcy, in an interview published Friday.

“I still do not understand how a failure to pay (heavily indebted countries) can be avoided,” said Juhan Parts in German daily Financial Times Deutschland. “In a market economy, this should be an option. It is illogical to want to avoid this issue,” he added.
More importantly, Bloomberg reported Friday that Germany was putting together contingency plans to insulate German banks and financials from the worse effects of a Greek default.
Chancellor Angela Merkel’s government is preparing plans to shore up German banks in the event that Greece fails to meet the terms of its aid package and defaults, three coalition officials said.

The emergency plan involves measures to help banks and insurers that face a possible 50 percent loss on their Greek bonds if the next tranche of Greece’s bailout is withheld, said the people, who spoke on condition of anonymity because the deliberations are being held in private. The successor to the German government’s bank-rescue fund introduced in 2008 might be enrolled to help recapitalize the banks, one of the people said.
It seems that a Greek default is virtually a done deal. A senior IMF economist was quoted as expecting a Greek default by March at the latest. Add to the equation the kind of finger pointing that happened at the G-7 meeting on the weekend: Eurozone blamed by US for world's economic plight. It is clear that the likelihood of coordinated intervention is off the table:
[I]nstead of the predicted economic debate, it emerged on Saturday that the bad-tempered meeting was dominated by American and British warnings that political failures and broken promises in the euro zone were in danger of triggering a wider crisis.

"Seventy-five per cent of the dark things happening in the world economy are because of the euro zone," said a senior US official after a round of talks ended in the early hours of yesterday morning.
Why do we want prolong this agony? Why not just rip off the band-aid and be done with it?
What to watch for
In the meantime, here is I am watching for as signs of a significant equity market bottom:
  • The behavior of European stocks. Will STOXX  hold at its 2009 lows or will it drop further?
  • Wait for the panic to show up in gold and gold stocks. During a panic liquidation, everything gets sold and the USD rallies. Will gold get liquidated in a "margin clerk" market? If not, I would expect at the very least the de-coupling of gold and gold stock prices - gold may rise, but gold stocks decline in sympathy with the broader equity indices.
  • Watch commodity prices and commodity currencies for signs of fear. In 2008, commodity prices cratered on the expectation that a global recession would result in lower commodity demand. This time around, commodity prices have been relatively firm. I would monitor the CRB Index, as well as commodity sennsitive currencies such as the Australian and Canadian Dollar for signs of panic.
  • Watch for credit spreads to blow out and bond index prices to turn negative. During the Lehman Crisis of 2008, bond indices, which included all bonds, turned negative while Treasuries rallied. Watch for a similar event by monitoring the relative performance of AGG against IEF. Right now, AGG (iShare Bond Index ETF) is underperforming IEF (7-10 year Treasury ETF) but levels are nowhere near the lows seen in 2008. Also watch the price of AGG to dip - but that ETF remains in rally mode and upward sloping for now.
Fasten your seatbelts. One day, you'll be able to tell your grandchildren, "I was there.".

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

1 comment:

StagDeflation said...

Wierd thing is that:
Prefered shares are ralying, not collapsing a la 2008. Microsoft and IBM are showing no real signs of break down, its all in the banking/financial sectors.