“You don’t want to run into one of those,” our brother said. “If you hit it, it will probably flip up into the windshield and crush you to death. So if you can, swerve.”
That was a conversation we had years ago behind the wheel of a car. We were learning to drive in the mountains of Colorado, where you sometimes run into elk, which are pretty big animals. We never did get our license, which is a different story altogether.
The point is, if you see a collision coming, avoid it. If you’re in a small car and you hit a large elk, everyone loses. The elk usually loses its life and you end up with a destroyed car (if you’re lucky) and a lot of bruises. What about the stock market?
Well, just as no bull market goes in a straight line, no bear market is without its convincing critics. On the upside of the business cycle, rampant animal spirits drive stock prices higher. Those same animal spirits fight the decline ferociously, and occasionally they snatch a victory or two.
Now that traders are back at their desks after the long weekend, we get the feeling we may be in for one of those bear-market rallies that it’s best to get out of the way of. That is, you don’t want to short it. But you don’t want to confuse it with a major trend reversal either. How about a chart to show you what we mean?
We’ve left the short-term analysis to our trading expert Gabriel below. But in the long-term, we think this gives you a good picture of where Australian stocks have come from, where they are now, and where they may be going for the rest of this year.
You can see that for the better part of thirteen years, the market traded in a gently sloping upward channel. Then, in 2003 it got a dual shot of adrenaline. Commodity prices bottomed and Chinese demand took off, boosting the earnings of Aussie miners. At the same time, a global bull market boosted the earnings of financial companies. Australia’s market, dominated by the four big banks and the two big miners, took off.
We think the gentler, longer-term trend is still in place because we believe there are more mining and infrastructure earnings to come from Asia’s long boom. For example, the Financial Review reports this morning that Leighton Holdings (ASX:LEI) is close to a A$700 million deal with Accor SA to build hotels in India and China. And in Monday’s Age, we read about the $2.9 billion project by China’s Chalco and massive PR effort to win over indigenous landowners in Queensland so China can tap the massive but low-quality Bauxite in Aurukun.
In the short-term, though, bear market rallies are just pauses along the way to the long-term trend channel. And yes, that means we think a bear market bottom for the All Ordinaries is below 4,400, a long way from where the index has opened up today on the higher Monday lead in New York.
Our friend Porter Stansberry in Baltimore thinks the bear market in financials is over. He thinks commodities are expensive relative to financials. He also thinks the banks won’t lose nearly as much money as stock prices currently suggest.
Porter wrote to his readers, “The “losses” being taken right now stem from mark-to-market accounting and will almost certainly not materialize. Accounting rules require the owners of securities to faithfully mark down any declines in price, regardless of whether or not the holders of the securities would consider selling.”
“These rules have proven disastrous for highly leveraged firms, like investment banks, and other companies with exposure to mortgage securities – for example monoline insurance companies like MBIA, and Freddie and Fannie, which also insure mortgages. The simple fact is, large pools of highly rated, non-subprime mortgages are very unlikely to suffer any permanent impairment – despite their current prices in the market.”
Porter is a great writer and a good analyst, but in this case, we think he’s dead wrong. Valuations have returned to earth with the reality of higher interest rates. The market has priced in lower financial earnings. That much is true. But it has not priced in reduced asset values.
Of course, that is precisely the issue Porter tackles. He believes the mark-to-market valuations on mortgage-backed bonds are overly pessimistic and factor in higher rates of default than will eventually materialize.
But asset quality for anyone with a large portfolio of mortgage-backed securities is clearly an issue. First, there is the little matter of more subprime resets this year. But the larger matter is the falling value of American homes. The latest housing data from the U.S. showed that despite an uptick in sales of existing homes, median home prices fell 8%.
In the long-term, house prices have to fall even more before a market-clearing price emerges where the 9.6 months of inventory (at current sales rates) is reduced. But while falling house prices will clear the market, who knows what they will do the underlying value of mortgage-backed assets? This is why we believe asset quality is the last big domino to fall in the credit collapse.
It’s what everyone one doesn’t want to happen. It would be bad news for everyone, investors, homeowners, and the Fed. Wishing the problem away won’t solve it. It may, however-if investors put their money where there hearts are-lead to a bit of a rally in stocks. Which leads us to what the market actually looks like after all the talking.
We asked our deskmate Gabriel what he sees after reviewing the different sectors in the Aussie market. “The first and obvious point is that there is a real downtrend on the global Australian indices. Since December, the S&P/ASX 200 has fallen from more than 20%, and a further decline is possible as the downtrend resistance is still valid. As long as this trend is not broken, it’s difficult to conceive a solid rebound with a potential bullish turning market.
“However,” Gabriel ads, “a few sectors are still in a positive long-term trend, despite a current strong correction. This is the case of the Metals & Mining sector. The main support of the long-term bullish trend remains in place, and proved to be well tested in September 2007 and end of last January. Both times this support had been considered by investors as a good opportunity to buy back the sector. No major change therefore for this sector as long as this support holds.”
“The same is true for the gold sector. The XGD well rebounded in January on the support created by the previous high of August 2007 (it is a classic technical pattern). The recent sell-off is more a correction rather than a real change in investor’s attitude. A break of this support would lead the prices toward the low of last September.
All in all, the sense of imminent Armageddon has abated. But we reckon the culmination of all the recent trends is still in place, it’s just later down the line. That culmination includes a liquidation low for stocks, and a much higher high for gold. Between now and then, there will be a spirited battle between inflationists and deflationists, buyers and sellers, and the Fed and gold.
The psychology of investment has a lot to do with the “social mood” as Bob Prechter says. The market reflects social mood. Social mood leads the market. Right now, we reckon the market is moody, which means investors are moody. They are weary of losses and would like a return to the good times. Bernanke seems happy to oblige.
What do you need to manufacture good times? You need a lie, a leader, and a crowd. All three seemed to come together last week.
The lie is that the bear market in credit is over, bank losses and bad news are fully priced into stocks, and that the Fed is in control. The leader is Ben Bernanke. Every revolution needs a strong man. Bernanke is an unlikely revolutionary. But he’s taken the Fed to places Alan Greenspan never dreamed of.
Check out the cover of the latest issue of Business Week and you’ll see the striking resemblance between Ben Bernanke and another famous socialist and advocate of government intervention in markets, Vladimir Lenin. Separated by decades, but ideologically joined at the hip?
The crowd? It’s anyone willing to go along with charade. There are a lot of useful idiots out there right now willing to buy financials and sell commodities. Yet like last September, this seems like the kind of rally that allows the insiders to sell and recoup some losses, while the public goes all in, wishing to be clever and call the bottom.
All successful lies come from an idea that the crowd latches on to. The French psychologist Gustave Le Bon, writing in 1895, said there are two types of ideas, the accidental and the fundamental. “Accidental and passing ideas [are] created by the influences of the moment: infatuation for an individual or a doctrine, for instance.”
The other class of ideas are, “fundamental ideas, to which the environment, the laws of heredity and public opinion give a very great stability; such ideas are the religious beliefs of the past and the social and democratic ideas of to-day.”
Today’s accidental idea is that the Fed’s particular plan can undo the damage of ten years of mis-allocated credit. It is a dangerous idea only if you allow yourself to believe it. The more dangerous idea is the fundamental idea behind the Fed. It is the big lie behind the entire modern financial system, that a committee of men knows what the price of money should be all the time. This is a fundamental lie at the heart of the current banking system.
It’s the lie that led Alan Greenspan to create the housing bubble in order to undo the damage of the dot.com bubble. It’s the lie that led Wall Street to create entire industries to speculate with borrowed money. It’s the lie that led million of people to take out mortgages they can’t repay and led to those mortgages being re-sold to investors as triple A quality bonds.
Quite simply, it’s the great financial lie of our times. And we wouldn’t expect it to go down without a fight.
Markets and Money