Global stocks endured another volatile week of losses, with many indices closing at a 5-1/2 year low. The selling pressure began outside the U.S. amid growing fears that the world economy is entering recession. However, the real story is the massive mutual fund and hedge fund redemptions that are driving forced liquidation of assets. Over $100 billion has been redeemed from equity mutual funds in the last six weeks, and investors pulled $43 billion from hedge funds in September. Estimates for October put hedge fund redemptions in the hundreds of billions of dollars. This explains why the market goes down day after day with little in the way of “new” news.
Last week’s market drop occurred despite improving conditions in the money markets. The Libor rate has declined significantly since the Treasury announced measures to support the markets, indicating the inter-bank lending market is beginning to thaw. However, longer term areas of the credit market, such as corporate credit, continue to show signs of distress. The Fed is likely to cut the Fed Funds rate by a half point to 1.0% on Wednesday.
On Thursday of this week, the first estimate of U.S. economic growth in the third quarter will be released. Consensus estimates call for a 0.5% decline in GDP. Back in August, the consensus was for 3.5% growth in Q3. The question now is not whether we are headed for a recession, but rather how severe and prolonged it will be. The stock market rout and credit freeze in September and October virtually guarantee GDP declines over the next few months. Given that we are experiencing the bursting of the biggest debt bubble in history, the recession is unlikely to be short.
Friday’s Market Action
As I drove to the office early Friday morning, I learned that trading in the equity futures market had halted “limit down”, meaning the futures were down 5% and no trading would occur until 8:30am, nearly three hours away. I don’t recall this occurring since 9/11. Following an initial sense of dread, I began see a positive angle. After all, many have been looking for “capitulation”: if the first “limit down” on the futures since the 9/11 disaster wasn’t at least one sign of capitulation, I don’t know what is. The market decline on Friday fell far short of the dire predictions on CNBC. In fact, we saw a few encouraging signs in Friday’s action. One is the lighter trading volume on the downside, potentially indicating that selling pressure is abating. Another is the development of divergences as some bellwether stocks did not fall to previous lows, during the morning sell-off.
As we wrote on October 16th, the market is in the process of testing the October 10th low of 840 on the S&P 500 and 7,882 on the Dow. As you can see on the S&P chart below, the 840 low has continued to hold. In the event that the October 10th lows do not hold, the market would be set up for a retest of the October 2002 lows around 770 on the S&P 500 and 7,200 on the Dow, or 12%-14% from current levels. Futures trading this morning suggests we will retest the recent lows today.
Valuations Are Historically Attractive
One of the long-held axioms of investing is “don’t fight the Fed.” Today we are witnessing the largest attempt to reflate the markets in history, as central banks around the world take unprecedented measures to provide liquidity and restore order to the financial system. We will likely see another round of fiscal stimuli following the election. These measures will take time to work, but make no mistake, they will work. The avalanche of forced selling has left historically attractive valuations in its wake, as shown in the table below. Once this selling abates, valuation should be the catalyst that leads to a strong rally.
In closing, last week offered this sampling of commentary from prominent market participants:
- Barton Biggs, respected former strategist at Morgan Stanley: “We’re at very, very cheap levels. One of these days, even if the world is going to hell, we will have a tremendous run-up. There is an extreme level of pessimism and almost despair. As long as I’ve been in the business, those have always been good signs.”
- Art Cashin, Director of Floor Operations at UBS who has been in the business since 1959: “We will soon have a jaw-dropping rally.”
- Mark Mobius, well-known emerging markets manager at Templeton Asset Management: “It is impossible to guess the short-term direction of the market. Needless to say, there are wonderful opportunities to buy, but that does not mean that prices can’t go down further.”
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