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What's Ahead for the U.S. Stock Market?

(March 11, 2008)

Dear Subscribers and Readers,

Based on my many technical, sentiment, anecdotal indicators – as well as my personal experience and my studies of past stock market cycles – there is a good chance we put in a significant low in both the Dow Industrials and the S&P 500 on Monday afternoon.  While the Fed’s action earlier today is not a wholesale bailout of the financial sector (more banks will no doubt file for bankruptcy over the next 9 to 12 months), it did go a long way towards revitalizing the “Shadow Banking System” that I discussed yesterday – which is essential in order for the modern, capitalist economy to function.  However, we are not out of the woods yet, even though we made a lot of headway today.  The next steps for the Fed and the Administration are:

  1. Continue to ease rates aggressively.  At the very least, the easing campaign should continue to surprise members of the Shadow Banking System on the downside.  Moreover, the Fed needs to reassure these participants that they will keep rates relatively low for as long as needed.  Through this dovish “reaction function” (as the Bank of England calls it), the Fed should be able to induce the investment banks and the GSEs to start lending and to aggressively expand their balance sheets again – which will provide a much-needed boost to financial market liquidity as well as liquidity to the “real economy.”  At the end of the trading day, Fed Funds futures was pricing in a 62% probability of a 75 basis point rate cut on March 18th.  The Fed needs to surprise on the dovish side by cutting by at least 75 basis points.  Otherwise, all the hard work they have done over the last few weeks to stem the current crisis would have been for naught.  Cutting by 75 basis points would also effectively freeze the median adjustable subprime mortgage rate that would reset after March 18th.

  2. Make sure the fiscal stimulus is implemented as quickly as possible – thus giving a boost to consumer spending in the latter half of the second quarter.  At the very least, this would allow the U.S. economy to steer away from the official definition of a recession, which is two consecutive quarters of negative GDP growth.  In the case of the fiscal stimulus, subscribers should keep track of what U.S. consumers really do going forward, not what they say they will do.  While most U.S. consumers “claim” in various surveys they would either save their checks or use the proceeds to pay off debt, the experience of the 2001 rebates shows otherwise – with a NBER study showing that households spent 20% to 40% of their proceeds on non-durable goods during the three-month period in which their rebates were received, and a further 1/3 of the proceeds during the subsequent three-month period.  To quote Fed Chairman Ben Bernanke: “This will not be window-dressing.”

  3. Continue to look for creative ways to fight the “smaller fires,” should they ever erupt over the next few months.  This may include continued emergency funding through the Federal Home Loan Bank System, or even a drastic measure such as the creation of another “Resolution Trust Corporation” – which was set up by the government to take over and liquidate real estate assets and mortgage debt held by insolvent S&Ls from 1989 to mid 1995.  If the Fed continues to ease rates aggressively, and if the GSEs such as Freddie Mac and Fannie Mae begin to expand their balance sheets aggressively, then it may not come to that, given the generally sound balance sheets of the commercial banking sector today versus that of the late 1980s and early 1990s.

With credit default swap spreads for U.S. Treasuries widening from 1.5 basis points last summer to 16 basis points earlier today, there was no doubt that sentiment was, literally, pitch black.  The Fed’s quasi-easing this morning, as well as 1) the SEC’s announcement that they have been monitoring the capital adequacy levels of the investment banks – some on a daily basis – and their basic “stamp of approval” of their balance sheets, 2) the relatively optimistic report of the UCLA Anderson Forecast (one of the most renowned economic forecasting entity in this country) early this morning, and 3) the dramatic upside breadth and upside volume in the U.S. stock market today, chances are that sentiment is now starting to reverse – and we will start to see investors (domestic and foreign alike) “dip their toes” back into the stock market over time as long as there is no major U.S. bank failure (which is not very likely to occur – given today’s statement from the SEC).  Sure, the bad news will continue to flow, but in all likelihood, these will be brushed aside by investors as most have already factored in the worst-case scenario.

I believe the Fed will continue to ease rates aggressively and reassure financial market participants that they will sustain the Fed Funds rate at a lower level for as long as they can – in order to encourage and cajole them to lend and expand their balance sheets again.  Until they have started to do this – and until it gathers some momentum – any talk of a rate hike is very premature.  But again, we are totally not out of the woods yet, although the trend of the U.S. stock market is definitely up, for now.

Given the volatility of the U.S. stock market, the most probable scenario is for the U.S. stock market to “enjoy” a “hard rally” of two to three months – one that will squeeze the bears and convince retail investors that we are in a new bull market again.  Given the severe pessimism among retail investors, I would not be surprised if either the Dow Industrials or the S&P 500 tests its all-time high in the process.  The liquidity and the amount of “fuel” both on the short side and sitting on the sidelines is certainly there – not to mention the amount of foreign capital that could come in should the U.S. Dollar Index start to rise, which is also very conceivable, given its hugely oversold condition.  After this “hard rally,” I expect to see at least a 50% retracement if not a retest of Dow 12,000 (there will be other stuff that market participants can worry about at that point, such as the threat of higher dividend taxes under a new Democratic President, etc.).  My alternative scenario is for a longer “grind” on the upside over the next 6 to 9 months – this kind of rally is certainly more sustainable and more bullish over the longer-run but given the “schizophrenic” nature of the U.S. investors today, I highly doubt it will be this easy.

Should we be in a cyclical bear market, the kind of bottom that we witnessed today should be good for at least a four to six-week rally.  However, as I have mentioned before, I do not believe we are in a cyclical bear market.  That will come eventually, but not in 2008.

I hope none of you was whipsawed by the stock market over the last few days.  As I have mentioned before, the most important thing you can do when it comes to investing successfully is not to read our commentary (although it certainly does help – I hope!), but to know yourself and understand your own capacity as an objective investor.  I hope the latest volatility in the stock market has taught (or re-taught) the right lessons.  In closing, I expect the market to stabilize for the rest of this week.  Most likely, I will be taking the rest of the week off – so you won’t hear from me until our weekend commentary.  For now, if you want to keep track of my opinions on a daily basis, please visit us at our MarketThoughts discussion forum.

Yours truly,

Henry To, CFA

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