Short Takes

Extreme volatility and panic buying are typically associated with bear markets. In the examples below, all the gains were retraced. We posted these charts in the past, but they are worth another look.

If you are reading this analysis when the S&P 500 is experiencing a monster rally, keep the three historical rallies below in the back of your mind:

The three rallies above occurred in the context of a bear market. If the current market can rally and the S&P 500’s 200-day moving average can turn back up, then we would be more willing to push our bear market concerns aside. But a rally that occurs with a downward sloping 200-day moving average, even a big rally, should be viewed with a dose of skepticism.

The charts of the three rallies above illustrate two important points about bear markets:

1. Volatility picks up
2. Sharp rallies are common

According to the Wall Street Journal:

Central-bank interventions like Wednesday’s move, which gives European banks easier access to U.S. currency, have a record of jolting stocks higher. Traders must react to an immediate influx of new liquidity and they typically do so by driving markets sharply higher. But the underlying, and usually troubling, reasons for the banks’ actions tend to trump the action itself in the long run.

For example, the Federal Reserve triggered a series of sharp, brief stock-market rallies with its newly aggressive posture in late 2007 and most of 2008. The central bank cut the fed funds rate from 5.25% to a range of zero to 0.25% over the span of Sept. 18, 2007 to Dec. 16, 2008, with stocks chopping higher before reversing with even bigger drops.

However, over the same time frame, the unemployment rate rose to 7.3% from 4.7%, and the storm clouds of the financial crisis darkened. The Dow Jones Industrial Average fell 35% during the time span of those aggressive moves. The reasons the Fed took the actions were what mattered more for stocks.

In the present case, most investors are keenly aware the sovereign-debt crisis that has put markets on edge the last several months won’t be solved by any single central-bank action, even a dramatic one like Wednesday’s.

Today’s announcement is a band-aid, not a solution. Again from the WSJ:

“It is troubling to think that we were possibly at a Lehman moment over the last couple of days,” said Channing Smith, co-portfolio manager at Capital Advisors Growth Fund. “This is by no means over in Europe.”

The fundamental problems have been, and continue to be, very, very serious. From the Guardian:

European finance ministers were warned on Tuesday night that Italy’s liquidity crisis could leave the eurozone’s third biggest economy insolvent with devastating impact on the fate of the single currency and its big core economies, Germany and France.

The seriousness of the threat to the global financial system is clearly evident in this story from Forbes:

It appears that a big European bank got close to failure last night. European banks, especially French banks, rely heavily on funding in the wholesale money markets. It appears that a major bank was having difficulty funding its immediate liquidity needs. The cavalry was called in and has come to the successful rescue.

The announcement made by central bankers this morning is a form of quantitative easing (QE). The central banks create money out of thin air and swap it for collateral. Freshly printed dollars are being injected into the economy.

As money managers, it would be much easier for us to take a bullish stance. However, from an integrity standpoint we have to take action based upon the evidence in hand. There is no question, given what we know today, the present day market aligns well with the early stages of a longer-term bear market. The previous statement is made based on numerous inputs. As we mention in the video, central banks creating liquidity and/or printing money can possibly be a game changer. We will continue to monitor the situation with an open mind. We are willing to migrate to a bullish stance if conditions improve.

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Update as of 10:55 a.m ET: The next few days are very important. Currently, the central bankers have flipped the daily and weekly charts of the S&P 500 into a bullish position. If the gains hold up into week’s end, it is possible with one announcement central bankers have stopped the bleeding. It is too early to tell - it depends on market action over the next three days, but we have to respect actions of central bankers. The S&P 500 could reach 1,249 or 1,250 in short order. 1,256 is a retracement level.

Today’s announcement does help with liquidity, but it does not address the bigger issue of solvency. As mentioned earlier today, positive reactions to this type of news tend to be short-lived. From MarketWatch:

WASHINGTON — Global central banks announced Wednesday that they are acting to strengthen the existing swap lines that allow them to provide dollars to domestic banks in an effort to ease financial market tension. Under the new arrangements, the Federal Reserve has lowered the cost of the swap lines. The arrangments have also been extended until 2013. The central banks also agreed to set up bilateral swap lines so that all currencies can be made available if needed.

Here is the Fed’s Q&A on swaps.

The markets are cheering a move to inject more cash into the financial system. Experience tells us reactions to this type of news tend to be short-lived. From Reuters:

Stocks and the euro recovered early losses to rise on Wednesday after China surprised with its first cut in banks’ reserve requirements for nearly three years, moving into easing mode as Beijing looks to soften the country’s economic slowdown.

Using 112 years of stock market data, we explore the questions: (a) How long do bear markets typically last?, and (b) How far do stocks typically fall? Some of the data used in the video came from Robert Colby’s site: robertwcolby.com.

After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.

Other than numerous meetings and ongoing talk if you take a close look at what Europe has accomplished to stem the crisis, you will see they have done very little relative to effective solutions. Reuters captures the gravity of the situation:

Europe faces a crucial 10 days to save the euro zone after agreeing to ramp up the firepower of its bailout fund but acknowledging it may have to turn to the International Monetary Fund for more help to avert financial disaster.

“We are now entering the critical period of 10 days to complete and conclude the crisis response of the European Union,” Economic and Monetary Affairs Commissioner Olli Rehn said on Wednesday as EU finance ministers met.

Euro zone ministers agreed on Tuesday night on detailed plans to leverage the European Financial Stability Mechanism (EFSF), but could not say by how much because of rapidly worsening market conditions, prompting them to look to the IMF.

“It must also be remembered that the EFSF is already funding at very wide (borrowing) levels over Germany, struggled in its last auction to raise the required funds and would have its rating put under severe pressure by any rating downgrade of France,” Rabobank strategists said in a note.

“This must call into question any plans related to the EFSF. It is yesterday’s solution and the market has simply moved on.”

Two years into Europe’s sovereign debt crisis, investors are fleeing the euro zone bond market, European banks are dumping government debt, south European banks are bleeding deposits and a recession looms, fuelling doubts about the survival of the single currency.

“We are now looking at a true financial crisis — that is a broad-based disruption in financial markets,” Christian Noyer, France’s central bank governor and a governing council member of the European Central Bank, told a conference in Singapore.

The prospects of drawing the IMF more deeply into supporting the euro zone are uncertain. Several big economies are skeptical of European calls for more resources for the global lender.

The United States, Japan and other Asian states are hesitant to chip in unless Europe commits to first use its own resources to fix the problem and peripheral euro zone states map out more concrete steps on fiscal and economic reforms.

Guess who the largest contributor is to the IMF? U.S. taxpayers. Europe is now calling on the rest of the world to bail them out.

There is no question the results from Black Friday were positive. However, as a Reuter’s story points out it may not translate into a strong selling season or economy. Some highlights:

A deeper look at the data reveals it would be wrong to suggest that conspicuous consumption is back in any way. Experts warn that the report gives just a snapshot and should not be given too much weight.

Consumers merely bring forward spending that they would have done later to take advantage of retailers slashing prices for “Black Friday,” the day after Thanksgiving that marks the beginning of the shopping season.

“If people chose to spend more on holiday gifts but offset that by spending less on discretionary services like restaurants and movie tickets, the retail sales numbers will overstate the big picture,” Ian Shepherdson, chief U.S. economist at High Frequency Economics, said in a note.

Many experts expect consumers to go into a prolonged spending lull from now until close to Christmas, as they have in recent years. “I think there is going to be hangover,” said independent analyst Brian Sozzi, who follows retail stocks. “You’re going to see that fatigue with the consumer.”