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Pivotal Events
By Bob Hoye May 14, 2008
The
following is part of Pivotal
Events that was SIGNS
OF THE TIMES: Last
Year: "After
a remarkably permissive first quarter, investors put their
collective foot down in April to slow the pace of refinancings to a
near halt." –
Wall Street Journal, April 27, 2007 "Who
Cares if the U.S. Gets a Cold?" –
Financial Post, May 7, 2007 *
* *
* * This
Year: "Investors
are turning to riskier investments as the turmoil that has racked
stock and bond markets now show signs of fading." –
Wall Street Journal, April 28, 2008 "For
the first time in months, analysts and executives sound
upbeat." "The
optimists believe it is different this time." –
International Herald Tribune, May 2, 2008 "The
worst is over." –
Warren Buffett, on Bloomberg TV, May 3, 2008 "Stocks
Rally on great Expectations" –
Wall Street Journal, May 5, 2008 *
* *
* * Stock
Markets: Our main
theme has been that the plunge into January was of a character that
typically ends important bull markets. As
that panic concluded our view was that the revival in stocks,
commodities, and credit spreads would run into March-April. With this, senior stock indexes would likely retrace around 50
per cent of the loss. This has been essentially accomplished. Although
soaring crude oil prices are stimulating the usual worries on Wall
Street, we continue with the observation that crude is another
commodity that goes up in a boom and down in the contraction. Back
in October, 2002 the S&P set a low of 777 as crude plunged to
17.07, and both started a cyclical bull market. Not all elements of
a cyclical expansion peak at the same time. However,
all cyclical expansions end in a similar way, which was behind our
conclusions beginning last April that the good times would end with
"rational exuberance". By
that we meant that spiking exuberance – particularly in the credit
markets – would mark the beginning of the contraction. The
rational part referred to the pattern whereby a boom runs some 12 to
16 months against rising interest rates and an inverted yield curve.
This has been the way financial history works and as we
discussed last spring, the count had June, 2007 as the 16th month. Also
emphasized was that inversion wasn't the problem, but when the curve
reverses to steepening it shouts that the end of a great speculation
is at hand. Moreover,
we noted that the senior central bank had little, if any, influence
on the curve, or spreads. The
next part of the rational transition to a contraction is the
reversal in credit spreads from narrowing to widening and as
discussed last year – May often sees a seasonal reversal to
widening, which worked out with, so far, rather severe dislocations. Our
theme about "Rational Exuberance" has worked out, and now
it seems time for the next phase of the big picture, which could be
called "Rational De-exuberance". The
process of ending a huge mania begins with a critical change in the
credit markets, and the initial plunge is followed by a vigorous
rebound. On this one we have cited the example that ran until April,
1930. The other example
has been the fabulous bull market that ran until the spring of 1937. The
latter was a five-year bull market out of a collapse of a great
mania in tech stocks, The mania to the spring of 2000 was just such
a bubble and the bull market out of the October, 2002 washout ran
for 5 years. With
so many lamentations about soaring crude oil prices, it is going
against conventional wisdom to point out that the next phase of the
contraction will involve all asset prices going down. And
declining collateral values force a credit contraction, which
disproves the arbitrary notion that Fed injections will force prices
up – the old "pushing on a string" story. Investors
and traders should be prepared for another slide in most prices of
stocks, corporate bonds and commodities. Sector
Comment: After
reigning as the complacency sector bank stocks took a well-deserved
trashing into January when we thought a 50% retracement rally could
run out until spring. However,
as noted at the time the rebound to 98 on the BKX was accomplished
in only 10 trading days and the price-target was met. The
action since has been on one side the favourable period likely to
run into April. On the other side, there have been reports of lending
disasters, which will continue in all countries. Our
propriety Bank Trading Guide provided another sell signal in early
March and some three weeks later the BKX set a high of 89. The
original sell signal was provided last July. The
bank index declined to 76 in mid April, when the street concluded
that the worst was over, and began to look forward to Pope Ben's
scheduled blessing of the markets on April 30. This
took banks up to 88 on Friday, which compares to the last high of 89
and the retrace at 98. The
record high was 121 in 1Q2007. There
is support at 74, but taking that out would resume the downtrend,
which seems likely. It
was not sound banking that created the severe liquidity crisis, but
a wild experiment in financial innovation conducted by a
"new" school of wizards with no concept of risk. Such
innovation has had enthusiasts in academe, government, business,
industry, all political parties and even labour unions – not to
overlook central banks. It
seems that there have been no bankers, in the proper sense of the
word, at the Bank of England or at the Fed. These
senior central banks are still in the thrall of innovation as they
believe that taking garbage securities out of the market will kick
start another credit binge. This
is not banking, but a reckless attempt at more financial
engineering. If it was
in the private sector, one would say that they have bet the ranch. Base
metal miners were also expected to rally up to a seasonal high in
March-April. The low
for the SPTMN was 598 in January, and the high has been 890 set in
mid April. The initial decline was to 790 and the test of the high has
made it to 883 on Tuesday. There
is a negative divergence as the recent highs have been against
diminishing momentum and declining accumulation. Base
metals (GYX) have been showing even worse divergences. Credit
Spreads have been expected to generally to be benign to
narrowing with the revival out of the January disaster, and then the
March trembler. As
noted last week, the lower-ranked sub-prime bonds have been
declining for a few weeks. At 11 on April 9, the BBB has dropped to
7.32. Hey, but no need to worry – they are
stilled rated as BBB, which means investment grade. They were priced
at 100 in August, 2006. These
heading down have led the next decline in the stock market by a
number of weeks, and the warning becomes more acute when the higher
ranked ones such as the AA roll over. That
has happened this week (chart attached), which was accompanied by a
turn to widening in Canadian bankers acceptances, over treasury
bills (chart attached).
SUB-PRIME
PROBLEMS ARE RETURNING ABX Indices – AAA, AA, A & BBB
Top left Chart (AAA) shows an outstanding rally from 66 to 84. Now it is rolling over. The BBB
(bottom right) led the crises of last July, January and March. bobhoye@institutionaladvisors.com
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