FYI | Jul 28 2007
By Greg Peel
The pattern breaks: +21, -53, +82, -149, +92, -227, +68, -311, -208
This might actually be a good thing, as if we were to have seen a rally of sorts on Friday, Monday would have needed a 400+ point fall. Or maybe Monday would have been “black”. It does seem, however, that this correction may proceed in an orderly fashion.
The Dow was down 208, or 1.5%, on Friday. The S&P fell 1.6% and the Nasdaq 1.4%. The Dow is now down 5.2% from its high of 14,000. The S&P has fallen 5.8% and the Nasdaq 6.1%. Experience suggests a healthy correction is 10%, so it could be we have passed half way.
When the Dow hit 14,000, it was up 12% in 2007 and 26% in twelve months. So we’re now at about 7% and 21% up. Looking at those numbers, you’d have to think there has to be more downside. For what is going to turn this correction around?
Last night saw the release of the second quarter GDP figure. The expectation was for 3.3% growth. Before the release of the figure, the Dow futures were down nearly 100 points. What would a good/bad figure do? Well, that’s when Arthur and Martha stepped in again.
A low figure would definitely be bad, said Arthur. With the market in a panic, the last thing we need is to learn that the US economy is slowing again. Ah yes, said Martha, but if the figure is low, there is a chance the Fed will ease rates. That would have to be good news while there is a credit crunch going on. Hmmm. Well if the figure is good, said Arthur, that should spur the bulls because it means earnings should continue to grow. Sure, said Martha, but then there is a chance the Fed might have to raise rates, and that could prove devastating when there’s a credit crunch going on.
The figure came out at 3.4%, as good as on the money. Now what?
At least it means that the Fed should keep rates steady, perhaps, which is probably not a bad idea under the circumstances. The Dow futures responded by pulling back to almost the previous close. Then the market opened, and was sold, off, then recovered to be up 50 points, then was sold off to be down 100 points, then vacillated, then was sold off another 100 points to close on its lows.
Suffice to say, the index moving north the fastest at present is the VIX – the CBOE volatility index.
There were more earnings results on Friday, and 60% of S&P companies have now reported. Cap-weighted profit growth is at 14% year-on-year. More than 60% of companies have beaten earnings expectations. But then, who cares? The bulls are clinging to this result and the GDP result to suggest it has to be a buying opportunity. You’re looking in the rear-view mirror chums, say the bears. The second quarter ended in June when the market was surging along nicely.
It would not have helped the bulls that oil returned to normal programming last night, and shot up US$2.07 to US$77.02/bbl. Oil had tried this rally the night before based on fundamentals, but wavered when a falling Dow was extrapolated to mean falling economic growth. But then we got a good economic growth number last night so oil took off again, Dow fall notwithstanding.
One opinion on The Street is that oil is following an identical pattern to its movement twelve months ago. The same demand/supply fundamentals existed, the same geopolitical tensions existed, and there was a real fear that the commencement of the hurricane season in the Gulf would bring a repeat of 2005’s Katrina. While oil initially tipped over from its highs when Israel withdrew from Lebanon, it continued to fall as each day passed with a calm Gulf. This would tend to suggest (all things being equal) that the key to third quarter oil will be the weather.
The bulls have also taken heart that the credit crunch is driving a continued flight to quality, with the US ten-year bond yield slipping under 4.8%. The lower the bond yield, the less the discount to future earnings, the higher the valuations on equities. As share prices fall, PEs are becoming very attractive. A strong GDP growth figure also allowed the US dollar to post a bit of a rally.
This was never going to help the Aussie dollar. Yen carry trade unwinding continued apace on Friday and the Aussie fell to US$0.8512. In two days the Aussie has fallen 3.56 cents from its high of US$0.8868. The Kiwi has come in for similar treatment. Just how far the Aussie’s correction will run is hard to gauge. If 1998 is any indication, the yen has to spike a lot higher yet. But then the collapse of LTCM was an overnight shock, not a slow-burn like the mortgage crisis. Eventually, the Aussie’s fall will have to be pulled up by pending interest rises and the existing interest rate differential.
A rally in the US dollar was never going to be good news for gold, already tumbling on liquidation. However, a US$2.50 fall to test US$600/oz support was not a bad result all up. Oil no doubt helped, but at some point gold’s liquidation will also be pulled up and safe haven buying will be established.
Base metal bellwether copper also held up well, even posting a small rally, responding to the US economic data. Lead and nickel continued their corrections however.
The Dow has now suffered its worst percentage fall in a week since 2003. The ASX 200 has fallen 4.9% from its highs up to Friday’s close, with more to come to catch up to the US on Monday. The SPI Overnight was down 75 points. The ASX 200 was up 13% in 2007 at the high, and up 28% in twelve months.
The “junk spread” in the US – the difference between the US Treasury yield and the yield on subprime quality paper – has now blown out by 200 basis points. Without any buyers in the market, it’s hard to know when this will stop, but it has to eventually. At some point the spread will be deemed to have returned to “normal”. One interesting development in the Dow’s fall on Friday was that the financials closed largely flat. In other words, the market did not decide to hit the banks any harder than they already have been. This might just be a breather, or it might be a sign that we are nearing the worst of it. But bargain hunters will do so at their peril, one assumes.
