Market Crash: It’s Still Too Early For This Correction to Turn Into a Crash

“Come on Australia,” Leyton Hewitt might say, trying to get the share markets turned around. But in Monday’s early going, shares in Sydney are acting an awful like shares in New York, doing a big flop, but we shouldn’t see a market crash just yet.

When will the buyers step back in the market? Well, that begs the question, why would you be a buyer right now? We can think of several general reasons…strong earnings growth, cheap valuations, the China growth story largely intact, and global liquidity conditions likely to become even more expansive. But none of them hold up to specific scrutiny.

Earnings season is over. All the good earnings news was baked into the cake before the fall. Valuations? The S&P ASX/200 trades at just about 13 times earnings. It’s not dear. But historically, it’s not cheap either. Relatively cheap compared to say, tech stocks, yes. But absolutely, nope. Not cheap.

China? Maybe that’s where the floor in resource stocks will come in. But at this point, you can probably throw fundamentals out the door when trying to explain market movements. There are two things to keep your eye on. The first is the Dow and the second is the volatility index (VIX.) As the VIX is a measure of fear and panic, it’s largely a lagging indicator. But it does make for dramatic viewing, and it reminds you of a point we laboured to make last week, namely that when faced with mounting losses, investors tend to seek risk, not avoid it. We think that means more selling ahead, but just how much?

On May 12th of last year the Dow Industrials closed at 11,642. Just about everything else (oil and gold) topped out shortly thereafter, including oil and gold. The Dow, however, went on to higher highs later in the year. The Dow theorists-those who watch the technical trading patterns of the market for buy and sell signals-have circled 11,600 on the Dow as a key level of technical support.

Friday’s trading in New York was a bit ominous. The market closed on its lows, down 142 points for the day, with most of the heavy selling coming after noon. A market closing on its lows indicates there’s more pent up selling. And with the Australian market setting the tone for the day, more selling is just what you might see. But how much?

Well, the Dow’s Friday close at 12,109 is exactly 777 points lower than its May 12 high, or about a six percent decline. If the Dow were to descend all the way down to its May 12 level from last year, that would make for just about a ten percent correction from its closing high of 12,786 on February 20th. A ten percent decline in two trading weeks is a healthy correction (in the same way that a prostate exam for a middle aged-man is a ‘healthy’ exam.) Anything worse than that-say a breach of 11,600, and then you have to flip a few pages in your dictionary from words that begin with “cor” to words that began with “cr” and end with “ash.”

It is just a hunch, a feel really, but we still think it’s too early in the year and too early in the stages of psychological reaction for an epic market crash to well and truly kick in. After all, central banks have not yet felt the need to respond to this latest round of market distress because, well, it’s rather normal. When the Fed cuts rates in the middle of the day in between scheduled meetings (as it did in January of 2001), you’ll know true panic has set in.

The truth is, there’s not much exceptional about this latest market activity, in either nominal or percentage terms. The market was just a little rusty when it came to going down, and perhaps this caught traders off guard. But the market can’t go up in a straight line forever. It’s not a market if there all buyers and no sellers, is it?

If there is anything exceptional to this latest market correction, it’s probably the way it’s been tracked on a nearly 24-hour basis. It’s a little like watching a global stock market relay race, where action is continuously handed off from Sydney to Hong Kong and Tokyo to Shanghai to London to New York and back to Sydney. It’s a nearly uninterrupted feedback loop which does not give the global market much room to take a breath and step back from the madness. When the buying feeds on itself, everyone marvels. When the selling feeds on itself, everyone gags.

And of course it’s not just a matter of psychology. Changes in the values of the major indexes and local currencies affect all sorts of cross-border, cross-currency trades and bets by major market players. You are engaged in a real-time, global effort to assess, recalibrate, and react to what’s going on. Some traders can pull this off. Some cant.

For instance we read that John Meriwether, former head of the ill-fated Long Term Capital Management, made a killing in Japanese stocks and the yen last week. If it’s true, Meriwether was long about the only asset in the world that went up as the rest of the world went down-namely the yen.

Indeed, of all the surprises last week it’s the comeback of the yen and the rally short-term U.S. Treasury notes and bonds. It proves how hard some mental habits are to kick that U.S. bonds are getting a bid right now. But gold, old as it is, is still too new as an alternative asset class to a generation of investors who have yet to be fundamentally betrayed by an asset class they believe in. It’s not entirely a matter of habit, to be fair. There is the little matter of performance too.

Gold stocks, as we’ve pointed out in the past, tend to act more like stocks and less like gold in a stock liquidation. That’s not to say the yellow metal itself showed any backbone either. In fact, the next few days will tells us a lot about gold’s fortitude as an anti-inflation, flight-to-safety asset. It’s down over 11% from its May high of last year at $725. On a 52-week basis, however, element number 79 on the periodic table is up 20 per cent. If it’s able to rally in Sydney and Hong Kong, and pick up some speed in London and New York, then gold’s own ten per cent correction will be over.

Who can say how markets will behave, though? Markets, like the earth’s ecosystem, are dynamic things. You can know their general rules without knowing where they will go on any given day. Some of the trading is automatic, based on pre-set buy and sell levels. If those pre-set levels are breached (whatever they are), more selling is triggered. And after awhile, buyers begin to get so nervous that the markets just keep on falling.

As we mentioned, we think that central banks still have some psychological bullets left to fire, and would take aim should markets “overshoot” what bankers consider normal. Markets, of course, always overshoot, both on the upside and the downside. Extremes are more normal than we would like to believe. We engage in the pleasing bias that “overshooting” to the upside is okay since it makes us wealthier. But we should not confuse a pleasing sensation with a benign one. Overshooting works both ways and we might be just about to see it work in reverse (with leverage overshooting to the downside is even worse, of course.)

Did you see CNBC wants to cover the Sydney market opening with a Squawk box show from the city? It makes sense to us. If you’re telling the story of global capital flows on a 24-hour basis, you have to cover the first market to open after the New York close. Australian trading kicks off the global business day, and on the bright side, CNBC’s coverage would coincide with Happy Hour in New York. You might see a few fund managers, two whiskey sours into the evening, deciding to buy a few shares of BHP to end the day with.

More coverage of the Aussie market is probably good for Aussie shares. These days liquidity isn’t much of a problem, though. There’s plenty of money around, too much in fact. There’s just not much good to buy, and not many good reasons to buy now, until the selling has blown itself out. Then we’ll see what’s left standing.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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