Seven worries for Wall Street, and what's next

Jon Markman's Speculations


May 22, 2010, 1:35 p.m. EDT

Seven worries for Wall Street, and what's next


Commentary: Global margin call sends stock investors scurrying

By Jon Markman

SEATTLE (MarketWatch) -- Stocks traded over the past week with all the panache of the drunk uncle at a shotgun wedding, stumbling through four and a half weak-kneed sessions before snapping to attention at last call in the final half hour.

The concept of a random walk doesn't really do the week justice, as the selling virus that started in China and Greece last month suddenly developed into a worldwide pandemic that saw the major developed markets lose more than 7% and emerging markets lose 10%-plus.


The multidecade bull market could have a classic last phase with a rush into gold in a "paper-chase trade," according to Damien and Derek Hoffman of the finance blog Wall St. Cheat Sheet. David Weidner reports.

It was a global margin call, and no risky asset classes were spared a scrape with the capital-eroding bug. The weird thing, though, is that there really weren't any especially nasty headlines this week. The U.S. economic news wasn't red-hot, but markets have blithely cold-shouldered much worse in the past 12 months. So what's really going on? A few thoughts spring to mind:
1. Worse times ahead

Remember how last year stocks rose and rose out of the March low even though the economy looked terrible? At that time, a lot of experts were saying it was just a bear-market rally and that the public should not get involved. Then it turned out that stocks were rising because they were anticipating an improved economy in six months.

Well now the opposite is occurring. Stocks fell even though the economy looks great. And the inverse of the prior explanation might be a legit reason: Investors are anticipating a worse economy in the next 12 months. If you think about how much taxpayer money is going to service interest payments now instead of creating productive assets, this is not an unreasonable concern.

2. Unilateral action

Remember how last year the G20 leadership huddled in London and came up with a firm plan to attack the financial crisis in a coordinated fashion? And then they stuck to their scripts, all flooding their countries with fiscal spending and ultra-low interest rates. I said many times last year that the unanimity was amazing and unprecedented, like cats and dogs sleeping together.

Well now again we have the opposite. German finance officials declare an end to short-selling of bonds and credit default swaps without telling the rest of their European Union partners. And then we learn that the British, Italian and U.S. finance officials plan no such move -- and moreover U.K. officials essentially say that if you want to short German bonds you are welcome to do so in London.

And of course we have never gotten a straight answer out of the euro zone as to which countries support the $1 trillion rescue package for Greece, or exactly how it will be financed. And don't forget that while interest rates are still scraping along at 300-year lows in the United States and the U.K., China and Australia are either raising rates or increasing bank reserve requirements.

 
In short we've gone from total global lockstep approach to battling the global financial crisis to every man for himself. One minute it's all "kumbaya" and the next minute it's all chaos theory.

The importance of this is that the variation in approaches have allowed the credit bears to worm their way into the chinks in the governments' armor and arbitrage the differences. You could even go so far as to say that we're seeing a revival of the "manipulated short sale" first invented by the likes of Daniel Drew in the 1830s America, where bears spread lies and fear in such a way that their enemies start accusing each other of wrongdoing instead of focusing on their jobs.

3. Risk repricing

The repricing of expected risk and expected return is occurring in a step-wise fashion rather than in a long, slow glidepath.

That is to say, rather than price/earnings multiples for the likes of IBM and Boeing declining over many months to account for tighter business opportunities in a slowed-down Europe, now the global financial system decides to get it done all at once. One day you're priced for certain 15% growth and the next day you're priced for a more uncertain 12% growth. Big drug makers like Pfizer have been stuck in this devaluation trend for 10 years.
4. Prowling bears

Fourth, the credit bears really are out there making trouble via their favorite instrument, which is credit default swaps on both government and corporate debt.

Basically the bears exploit the fact that CDS prices are a large part of the formula used to price credit. When CDS goes up in value because bears are trying to make it look like the company or country is in trouble, a series of calculations are triggered that can force the bond rating agencies to lower the organization's credit rating. When that negative announcement is made, the equity market freaks out and dumps stock -- which in turn also makes the credit even look worse. That boosts the value of the CDS further, emboldening the bears. Rinse and repeat.

This is why banning the "naked" buying and selling of CDS is a great idea, because there is no legitimate economic reason to buy or sell CDS unless you actually own bonds whose value you want to hedge. CDS was supposed to be insurance for bond holders but has instead turned into a highly leveraged form of off-track betting in which you get paid for scaring people into thinking a horse is dead. I have nothing against the shorting of stocks and bonds, but the use of CDS for this purpose has become a sick and destructive joke and it ought to be stopped.
5. Negative 'mojo'

The worse people feel about a security the more that negative "mojo" can leak over to other people with that security, who may then sell it without even really knowing why. This sort of thing is really what I mean by "contagion." The meme of "stock hate" gets in the air and is ingested around the world at the speed of a CNBC or Twitter broadcast, much as "stock love" did only a month before.

I'll bet if you ask people who sold Procter & Gamble down 2.5% last week why they did so, they could not give a coherent answer. The herd mentality to do what everyone else is doing is one of the things that makes us a mammal, and is very hard to explain or avoid. Hopefully you can just recognize it when it's happening and try to avoid or exploit it.
6. Death by taxes

This was a truly rotten, no-good week in the greater China complex, as the Australian and Brazilian markets have gapped down twice. Moreover major individual stocks in Brazil and Australia closed well under their flash-crash-day lows on Wednesday, including big steel maker Gerdau (NYSE:GGB) , giant forestry products firm Fibria Celulose (NYSE:FBR) , miner Vale do Rio Doce (NYSE:VALE) and Aussie bank Westpac Banking (NYSE:WBK)

This is a graphic example of the unwinding of the U.S. dollar carry-trade. Every time the dollar ticks higher in reaction to the decline of the euro, it forces fund managers out of their cheaply funded bets on commodities and commodity-producing countries.

But another reason for these declines is fascinating, frightening and emblematic of what world markets face now: Australia plans a massive 40% tax on mining companies' profits to defray the cost of all the borrowing the country did to rescue its financial system last year.

This tax is expected to severely reduce earnings forecasts for mining giants BHP Billiton (NYSE:BHP) and Rio Tinto Plc (NYSE:RTP) , which make up a large percentage of the Australian stock market's total market value.

The worst part is that other countries will consider this a great idea. And that's why Brazilian giant VALE is sinking. Tom Price, commodities analyst at UBS in Sydney, told Bloomberg it could create a "tax contagion" worldwide in which miners in Brazil, Peru, Chile, Canada, South Africa and the United States could face the same fate.

Moody's has estimated that mining companies' earnings could be cut by a third in Australia in 2012 when the tax kicks in, and markets have wasted no time in pricing that into the companies' shares and bonds.

The tax has already boomeranged on the Australian economy, as the country's currency has dived almost 8% since the tax was announced earlier in the month and Fortescue Metals Group, the third-largest iron ore miner in Australia, has already put $15 billion in projects on hold, according to Bloomberg. Think about the rippling effect that will have on machinery makers, individual miners, the transportation subsector and the like. This is the kind of government intervention that could stifle investment around the world.

Government intervention in financial markets is having similarly troublesome effects in Europe. The sudden German ban on naked short selling of stocks, bond and credit default swaps this week was a perfect example. It is becoming clear that Germany decided to launch this plan unilaterally without first consulting its partners in France, the United States or the United Kingdom, catching both investment bankers and other EU policymakers off guard.

As I have mentioned before, the best way that politicians can shrink the impact of speculators is to enact more credible fiscal and monetary policies. It's a classic mistake of trying to kill the messenger rather than to fix the message.
7. Normal reaction

Maybe this is all just a typical reaction to a currency and sovereign debt crisis. Consider the Nasdaq 100 in 1998, when the dot-com boom shot the market up a rockin' 50% by mid-year. But then the Clinton presidency started to unravel at the same time that the Russian ruble came unglued and it looked like Moscow would default on sovereign debt.

The Nasdaq plunged 22%, culminating in the wipeout of the famed hedge fund Long Term Capital Management. Once Russia did default, the market got back in gear and the Nasdaq 100 swiftly rose 60%, in part fueled by a rapid series of coordinated global interest rate cuts.

It would not surprise me to see the same scenario play out. A 22% decline in the Standard & Poor's 500 Index (MARKET:SPX) from the April high would put it at 950, which also happens to be its 50% Fibonacci retracement zone as well as the July breakout level. If the crisis were to come to a head in some fashion, then a big rally could certainly take place, most likely even taking the market to a new high.
Bounce house

Stocks will almost certainly rebound continue to rally in some fashion in the next few days, perhaps as high as 1,175 on the S&P 500 Index, and the character of that advance will give us a chance to assess the path of the next few months.

If the rally shows weak buying intensity on low volume, then active investors should fully exit from equities and put on some inverse ETFs to prepare for a new leg down. A reasonable target would be the 940-950 area of the S&P 500.

If the rally shows strong buying intensity and good volume, then get fully long again only once some simple criteria are met: A rise in the S&P 500 over its 10- and 20-day averages, and a cross of the 10-day over the 20-day. That can happen pretty fast if buyers are serious about coming back into the game; in both July 2009 and February this year it took less than a week after the rebound began.

I think the weak advance followed by a stunning decline is the more likely scenario, as disunity among world governments gives credit bears the opportunity to wreak havoc for a while. Yet the strong breadth witnessed at the April top promises that even an early summer collapse could be reversed by autumn, and stocks may surprisingly have a shot at making new highs by winter. And then we'll look back at these days and wonder what all the fuss was about. That happened in 1998, as well as 1999, and 2004, and it could very well happen again.

Jon Markman is a money manager and investment adviser in Seattle. For more ideas, try a two-week trial to Markman's newsletter, Strategic Advantage , published in partnership with MarketWatch.