Watch out, it is starting to look like Sept 2008 all over again

By ANDREW MARKS
22 May 2010

The great ‘de-risking’ of 2010 has seemingly just gotten underway, and with the ghosts of September 2008 lurking, it looks like plenty more is in store for equity markets in coming weeks. Rampant fear and uncertainty brought on by Europe’s headline-making sovereign debt crisis and an onslaught of high volatility in the stock markets has led to a flight to the US dollar and gold by investors looking to reduce the damage many expect in equity-laden portfolios.

‘The financial markets are telling us they are far from convinced the European Union’s debt rescue plan will prevent defaults and won’t choke off growth. The markets want assurances from the EU, similar to when the US government took equity stakes in the big banks,’ said Mary Ann Bartels, chief technical analyst at Bank of America – Merrill Lynch.

‘We’ve broken key support levels at 1150 on the S&P 500, and that tells you we’re in a corrective phase now. We’re facing a situation where the question is how deep is the correction.’

In the face of continued negative sentiment and economic uncertainty – and big selling in the European markets, Wall Street had another day that was best forgotten on Thursday, with the Dow Jones industrial average, Standard & Poor’s 500 and Nasdaq Composite Index closing down significantly.

But by midday yesterday, sentiment appeared to turn slightly with the Dow Jones up 91.82 points at 10,159.83 after dropping briefly below 10,000 earlier. The S&P was up 14.53 points, at 1,086.12 while Nasdaq was up 30.40 points at 2,234.41.

Yes, instead of Lehman Brothers failing and AIG, Citigroup and Merrill Lynch on the brink of disaster, investors now have Greece, Portugal and Spain in danger of defaulting on their debt.

This crisis around, the catalysts for the rush to the exits in search of safe havens are currency volatility by way of the euro’s crash, worries over market structure, as seen in last week’s 20-minute, 970-point ‘flash crash’, and government legislative action, ranging from the EU’s US$1 trillion debt rescue package and austerity measures to Germany’s naked short sale ban, the debate over financial regulatory reform in the US and China’s moves to put the brakes on its economy.

Throw in worries over the possibility of new bubbles forming in Chinese real estate, and add precious metals, for good measure. ‘Add all that up and many investors now see a greater risk of a ‘double dip’ in the global economy than they have in the last year,’ noted Nick Colas, chief market strategist at ConvergEx. ‘We’ve had a textbook recovery from the lows, but that textbook will probably not be much help in hiding from the challenges facing investors and the world’s economies, and their ability to do real damage to risk markets in the weeks ahead,’ he said.

Said Ms. Bartels, ‘The market is telling me we’re going to test the 1050 range on the S&P 500, and then the question became whether we break through the key support at 1044, which is the February low.’

‘If we do break the February lows, then we probably test the 1000 to 950 range, which is the next level of support,’ she said on Wednesday afternoon.

There’s some good news. ‘American companies appear to be in far better position to weather this European-borne storm than they were the one made in the USA,’ noted Mr. Colas.

But for now, Ms. Bartels cautions, there are only more signs of technical deterioration in the key charts she’s focusing on to forecast market behaviour in this cycle.

Her two ‘favourite’ indicators overseas are the LIBOR OIS spread, which measures the health of credit markets by comparing the London Interbank Offered Rate and rates on Overnight Index Swaps, instruments that allow financial institutions to swap fixed for variable interest rates on their loans; and the Shanghai stock market, which has been a leading indicator for the US and European markets for the several months.

‘Both are pointing toward more deterioration. The Shanghai market is showing no sign of bottom, and that’s especially troubling,’ she said.

‘Once we finish this pull-back there will be a great opportunity in high quality US mega-cap companies, especially financials,’ Ms. Bartels believes. ‘The question is how far the market has to correct before we get to that point. It’s 50-50 between whether the February lows can hold and we get a 15 per cent correction, or we break through them and get a 25-30 per cent correction,’ she said.

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