Capitulation in Debt/Credit Markets

Yesterday, Rick Santelli, CNBC's Bond Market Specialist, reported that he saw capitulation in the credit markets. The ten year swap rates were plunging and 10-year US Government Bond yields spiked. He said that the biggest safety net in history may have put a bottom in the US Treasury rates and ended the flight to safety. He believes this is a huge beacon of light at the end of the tunnel for the markets.

Market Declines Like This Have Happened Before; History Shows Us What Happens After

Equity market declines like this are not unprecedented. This has happened before. The circumstances during sharp market sell-offs are always slightly different, but the response of the markets is often the same.

While there has always been very negative economic news and a high level of anxiety during times of severe market declines like this, equity markets have always risen substantially 12 months later if there was not a "bubble" or extreme overvaluation before. Here are the facts showing what happened to US stock markets after declines like we are experiencing now. Canadian markets typically follow the US markets.

Statistics prepared by Dr. Steve Sjuggerud on Oct. 7, 2008.

The two occasions where the markets did not rebound significantly occurred after stock prices reached an extreme overvaluation in 1929 and 2000. You can see that stocks were still trading at a relative high 18.2 times one years earnings after the October 1930 low and 25.3 times at the September 2001 low compared to 12.4 today. History shows that there have been powerful advances after times like this. I will keep you informed.

Volume I, Issue 41

ALL INDICATIONS OF AN EQUITY LOW ARE IN PLACE BUT IT ISN'T OVER UNTIL IT IS OVER. THIS IS THE WEEK WHERE MOST MAJOR MARKET LOWS HAVE OCCURED IN RECENT HISTORY. THIS IS IN ESSENCE A CREDIT CRISIS, NOT A STOCK MARKET CRISIS. THE TED SPREAD IS THE INDICATOR TO WATCH. PRIVATE EQUITY IS STARTING TO BUY. IT IS NOT USUALLY A GOOD IDEA TO SELL A CONVERTIBLE IN A SNOWSTORM.

Stocks are very under valued, insider buying is high and there has been a panic selling. All the characteristics typically seen at a market low are present. While markets should bottom anytime, how much more damage is done before a turn around occurs is anybody's guess. The most recent crisis for the economy and the markets was the Sept. 11, 2001 terrorist attacks. The markets declined sharply for a week after North American equity market reopened. A recession was widely expected as the tragic loss of life resulted in consumers staying home, not knowing when another attack would strike. However, the equity markets bottomed after the selling was exhausted on Sept. 21 and rose by 22% by the end of the year and kept on advancing into 2002. History has shown that the American economy, consumer and equity markets are much more resilient than ever expected. The most memorable equity declines have occurred in 1929, 1974, 1987, and 2000 after stock prices rose too high and became very over valued. This is not the case this time. This is a debt crisis, which is affecting the economy and the equity markets. Therefore, debt markets will likely languish for some time, but equity markets could recover faster than they did after periods of overvaluation.

The TED spread is the difference between the interest rate on short-term US government debt and the interest rate that banks charge each other for loans. This chart only goes back to 1992. The TED spread went to all time record highs in recent weeks as it broke above the 2.7% level that was reached during the 1987 crash. A decline in the TED spread will be a clear sign that the credit situation is improving.

During the last 40 years, more significant market lows have occurred during the early days of October than any other time. For example, Oct. 3, 1974 (Nixon impeachment/spike in oil prices), Oct. 19, 1987 (stock market crash), Oct. 11, 1990 (Iraq invasion of Kuwait), Oct. 8, 1998 (Russian default/hedge fund collapse), Sept. 21, 2001 (terrorist attacks) and Oct. 11, 2002 (end of 2000 - 2002 bear market) are dates when severe declines of the US SP 500 Index have ended in the past. In most cases, a cut in US interest rates was the catalyst for the turn around. Perhaps history will repeat itself in the days ahead.

While there was very little control over what terrorists could do in 2001, politicians and regulators around the world can take, and are taking meaningful action to improve liquidity and confidence, which should ultimately be successful. One of the first signs that this is happening will be a decline in the TED spread as seen above. I believe that is the indicator to watch to signal a positive change.

Governments are spending tax payers' dollars to support troubled financial institutions, but the return of the corporate and private buying is required to get money flowing again. Warren Buffet has said, "Be fearful when other are greedy and be greedy when other are fearful." He recently put his money where his mouth is when his investment fund purchased a $5 billion of shares in Goldman Sachs and a $3 billion in General Electric. Last week, CIBC sold over $1 billion worth of subprime loans and Citicorp and Wells Fargo are both eager to buy troubled Wachovia Bank. At some point the money will rush in to take advantage of these bargain prices.

Pension funds and mutual funds usually invest between 45% and 65% of their assets in equities, but hedge funds can invest between 0% and 100% of funds in equities. Sources in New York have told me that some of these billion dollar hedge funds have sold most of their equities. With so much money in hedge funds now, perhaps that is why the markets seem to be more volatile than usual. When markets recover, these same hedge funds will have to participate, which could also drive up faster than normal. Only time will tell.

US market commentators have said that selling stocks now is like selling a house before a hurricane. Here, in Canada, I would compare it to selling a convertible in a snowstorm. A person will likely have to drop the price for a convertible substantially below what it would normally be worth, in order to sell it in a snowstorm. Waiting a few month until better weather arrives in spring would give the seller a much better chance to realize the full value of the convertible. The same principles can apply to stocks at this time. Hopefully signs of "spring" will emerge soon!

Bonds - US bond yields are not declining to new lows, as one would expect given the flight to quality. That is not very positive for bonds. Short-term cash is king.

Commodities - In spite of the greatest concern about the global financial system in a generation, on Friday the price of gold was almost $200 below the March $1,011 high. This is not positive for gold. US cash still seems to be the preferred asset when there is widespread fear. It is unlikely that oil and other commodities will not move higher until there are signs that liquidity in the financial system is improving.

Currencies - After being despised for years, the US dollar has regained its reputation as a safe haven. However, the oscillators suggest that the euro and CAD$ could quickly turn up along with any positive developments.

The long-term oscillator for the SP 500 is declining again after turning up from the fully oversold position in mid-July when the financials and US homebuilders hit lows that still stand to this day. A reversal to the upside is required to confirm a new up trend.

Believe it or not, most US and Canadian financial stocks are still much higher than they were in mid-July. This shows what happens when the selling is exhausted, even if there is still bad news. The same thing should happen to equities soon. The financials are correcting/consolidating after a sharp rise until this oscillator turns up again.

The fear indicator (Volatility Index) has reached the highest level since the 1987 crash when it peaked at 150! However, the oscillator is not as high as it was in July when the VIX only peaked at 31. This often signals a downturn. A decline in the VIX and the oscillator would be positive for equities.

This chart shows the steep decline of the TSX in the last 2 weeks. Surprisingly, the long-term oscillator is still on the verge of turning up. The selling in resource stocks is so heavy that Russia has halted trading in their markets for several days. Today Brazil temporarily halted trading in their markets twice for the first time since 1999 when their currency started trading freely. The uncertainty, fear, complete lack of confidence and panic selling seen around the world this morning are classic signs of a market low. Time will tell.

The oscillator is still rising for gold stocks. It is difficult for gold stocks to rise if the markets in general are declining.

Oil stocks gapped lower this morning as recession/depression fears mount. However, the oscillator is suggesting that oil stocks could rally as soon as confidence begins to return. Prices just about always rise to fill the gaps.

US bond prices have risen, but not any higher than they did late last year even though the financial concerns are much greater now. This is not positive for bonds. The oscillator could turn up again if bonds stay at these levels.

So far, the up trend for gold is intact, but the pattern of lower highs since March is worrisome. Gold performed better after the crash of 1987 as the situation stabilized than it did during the crash. Perhaps gold will move to the upside when confidence returns and investors look for places to invest cash.

Most asset and commodity prices are falling as investors flock to cash. Oil is no exception. However, the oscillator suggests that oil could have a good rebound when confidence returns. A depression was forecast after the 1987 crash and there have been forecasts of recessions after every serious market sell-off. Many of those forecasts turned out to be wrong. Today's dire forecasts could be wrong too.

The euro has fallen sharply after rising for almost 3 years. This is not unusual. I would not be surprised to see the euro, TSX and commodities begin to rise again and the US$ weaken after this corrective phase is over.

SELLERS HAVE TO SIGNIFICANTLY LOWER THE PRICE IF THEY HAVE TO SELL AS THE HIGHWAY OF GLOBAL LIQUIDITY REMAINS BLOCKED BY A MAJOR ACCIDENT. THE FINANCIAL COMPANIES PULLED THE MARKETS DOWN LATE LAST YEAR. IN SPITE OF MASSIVE FAILURES, THE SHARE PRICES OF MOST FINANCIAL COMPANIES ARE MUCH HIGHER THAN THEY WERE OVER TWO MONTHS AGO. IN FACT, ON FRIDAY, JP MORGAN WAS NEAR A ONE YEAR HIGH, WELLS FARGO WAS CLOSE TO AN ALL TIME RECORD HIGH AND THE ROYAL BANK WAS UP 29% FROM THE JULY LOW. AFTER RISING FOR OVER TWO MONTHS, THE FINANCIALS ARE BOUND TO PULL THE EQUITY MARKETS HIGHER ANYTIME.

Equity markets are experiencing a violent sell-off like they did right after Sept. 11, 2001 and at the end of the bear market in October 2002. When liquidity and the volume of trading for everything but government guaranteed investment declines, investors who want to sell, or have to sell stocks in an instant, have to substantially drop their asking prices. This is why the markets are so volatile.

Selling in global markets is bound to continue until US legislators will meet again in a few days. This time, they will be sure that their effort to clear the massive accident that has blocked the global highway of liquidity succeeds. Even though the market averages declined last week, the technical picture still points to a positive resolution of this crisis. Indeed, the shares of most financial companies, which are at the center of this financial hurricane, have continued to act much better since they bottomed two and a half months ago. Even after AIG, Freddie Mac, Fannie Mae, Lehman Brothers, and Washington Mutual became penny stocks, the index of US Banking Stocks (BKX) still closed 26% higher today than it did on the July 15 low. In Canada, the TSX Financial Index (XFN) closed up 13% from the July low, even after a 4% decline today. What is this telling us? It is very clearly showing us that the worst-case scenario was factored into the price of most financial companies months ago. Just as it took several months for the equity markets to follow the financial stocks lower last fall after the subprime problems were revealed in the summer of 2007, it will take several months for the equity markets to follow the financial stocks higher now. (Two and a half months have already passed since the financial stocks have improved.) When exactly this will happen is hard to tell. But it can happen anytime.

US stocks are trading 24% below fair value, the same level as they did at the low of the 2000 - 2003 bear market. The level of fear and panic is measured by the the Volatility Index (VIX) has now reached the same peak as it did during the long term capital/Russian default crisis market low in 1998, at the market low on Sept. 21, 2001 after the World Trade Center collapsed and the bear market lows in July and October 2002. The amount of cash in money market funds is at levels last seen at the end of the previous bear market. These extremes in fear and panic selling do not usually last very long and markets have had meaningful advances after each of the periods mentioned above. Just as it was prudent not to buy into the overwhelming sentiment that oil prices were going to even higher this summer, the technical information and the very obvious out-performance of financial indexes indicate that it is not prudent to believe that this downturn can continue much longer either. Hang on to both edges of the canoe until we get through these rapids to calm water.

Bonds - Government bond yields are staying within a trading range even though they are the most popular asset right now. If this is all that happens at this level of fear, yields could rise substantially when this is over.

Commodities - The trend for gold and gold stocks is still positive but the lack of a move to record highs in gold with this level of fear is concerning. The up trend for oil and oil stocks has stalled for the time being.

Currencies - No change from last week. The USD is in a downtrend vs. the CAD$ and the euro. The euro is still in an up trend vs. the yen.

The oscillator has turned down for the first time since July. However, it did not get overbought so it can turn up at anytime and still have a long up trend when the crisis ends. Some sort of action by the government, regulators or the Federal Reserve usually coincides with a bottom. A major bankruptcy is also often associated with a market low but we have had more than enough of those!

You can see that the level of fear has now matched the readings seen at the lows of very major market decline in the last 18 years: the 1997 Asian Crisis, the long term capital/Russian default crisis in 1998, the September 11 attacks in 2001 and the 2000 - 2003 bear market. This alone suggests that we are very close to a turning point.

The red and green lines are the price of the US Banking Index. The up trend in the price and the strength in the oscillator are the best in years. Hopefully I will be able to say that about the equity markets soon! The US financials just about always lead the US markets, which in turn lead Canadian and global markets.

This chart from SentimenTrader.com shows that very high levels of cash are reached at market bottoms. It takes a big rise to encourage cash to return to equities so holders of cash miss out on that.

The up trend in the long-term oscillator for the TSX has stalled a month after it got started. This is unusual but it does happen on rare occasions. It is still oversold so it could just as easily turn back up again.

The same comments for the TSX apply to the TSX Energy Index.

According to the oscillator, the up trend for gold stocks is still intact.

Prices on US and Canadian government bonds are not any higher than they were at other times in the last year which is interesting. If this is the best that bonds can do at the worst of times, they will likely not perform well when the investing climate improves. Liquidity of historical proportions has been added to the financial system. This is inflationary, which is negative for bonds.

The trend for gold is still up but the price is not anywhere near the record price of $1,000 that it reached during the Bear Stearns collapse in March. This is worrisome. With much more fear and worry than there was in March, investors should be very alert to how gold responds when fear subsides.

The up trend for oil has stalled. This could be temporary. It is still very oversold so it could resume the trend at anytime.

The euro is still acting relatively well compared to the USD even though bank failures are increasing in Europe too.

The long-term oscillator for the euro/yen price, which reflects the carry trade, still indicates that the euros up trend is intact. This would suggest that most of the de-leveraging using the carry trade has occurred and is now in the process of reversing.