Monday, December 8, 2008

Putting in a bottom

I've been highlighting signs of improvement in the underlying fundamentals for several weeks now, and the equity market seems to be catching on, finally. Short-maturity swap spreads peaked in early October, and have since fallen significantly. The implied volatility of equity options peaked in late October and again on November 20th, and has since fallen. The low in the S&P 500 to date was November 21st, and the equity market is now up over 20% from that low. There are no clear signs of a bottom, of course, but the evidence is slowly accumulating.

The newspaper headlines cite Obama's nominees for cabinet posts, his apparent willingness to forget about tax hikes, and his ambitious infrastructure proposals as probable causes for the rally, but who's to say it's not just a market that is finally figuring out how to cure itself? Hedge funds have undoubtedly completed the bulk of their deleveraging by now, and anyone who feared further losses in his or her portfolio must surely have read the calamitous headlines over the past several weeks and rushed to liquidate their holdings. Whatever the reason for the recent rebound, it's nevertheless true that prices had fallen to levels that were consistent with economic destruction exceeding the depths of the Great Depression; and as long as the reality proves to be less dire than the end of civilization as we know it, prices have to rise.

If indeed we have seen the bottom, and I think we have, nerves will still be on edge. Those who sought the shelter of cash (and there are plenty who have, since the value of cash and cash-like instruments stands today at an all-time high) will now suffer the embarassment of cash, as they compare their paltry returns going forward with double-digit gains on competing investments. Those who wished they had sought the shelter of cash will now see every rally as a second and third chance at salvation. Those who suspect they may have underestimated the economy's ability to right itself (e.g., the Fed) will fear the consequences of their actions. And those who suspect that now is the time to get back into the market will wait for selloffs, only to find their fears returning as prices drop. In short, the market is going to be climbing terrifying walls of worry for a long time to come.


SpeakToMe said...

The wildcard for another step down is a concerted effort by Obama to initiate redistribution. Higher taxes on the wealthy, national health care -- both of these are net negatives for the financial markets.

Increased incidences of terrorism and protectionist policies could also happen, but one wildcard at a time.

Scott Grannis said...

I agree that higher taxes on capital and nationalized health care are real threats. But I think the market is pricing in a good deal of the risk of these events already.

CDLIC said...


I was not sure what topic to post this under; therefore, this is as good as any.

Have you seen the INK Sentiment Indicator for the TSX & TSX Venture exchange lately?
Also the INK Indicator Readings for the S&P/TSX Composite Index?

The meltdown in equities since August has quality companies so vastly oversold that insiders are jumping at the opportunity, driving the INK Indicator to approximately 3 times higher on the TSX/TSX Venture exchanges to “extremely bullish” levels as is also happening on the S&P Exchange but to a lesser degree.

Your thoughts?

Scott Grannis said...

CDLIC: Very interesting, and it confirms my own belief that valuations have been driven down to levels that are almost absurdly low. To be bearish you have to believe that almost half of the companies in the US will default in the next 5 years; if not, you are effectively bullish. Insiders should know more than others about the likelihood of their companies going under.