The downtrend in equity prices will resume after the current largely short-covering rebound runs its course. The plunge in equity prices, especially in financials, had accelerated at too fast a pace, reaching levels that made the shorts vulnerable to even the slightest hint of positive news or developments that encouraged profit taking. The market positives included geopolitical developments that lessened fears of war-induced disruptions in oil supplies, an SEC attack on short positioning in key financials and some less dire earnings reports than had been feared. Taken together, these developments suggest this is merely another temporary bear market rally interrupting a longer extended cyclical drop in equity prices that has much further to run. Expect a further 10% to 20% drop in equity market indices from here. But, this pessimisitic view of the sustainability of this past week's rally is not how many in the market see it.
The consensus market opinion appears to be that the bear market selloff in equities has not only ended, but that a sustainable rally has begun, especially in the beleagured financial sector. There is also a growing belief that the selloff in oil prices is recent days is merely the beginning of a sustained popping of the commodity price bubble. The mantra of some hedge funds is now to completely reverse their pet trade of shorting financials and being long energy by going long financials and shorting energy. That switch will be the correct move eventually. But not now.
Before explaining what underlies my long-term views, it is worth citing some of the real causes of this past week's market developments. The decision of the US to try to negotiate a verifiable freeze of Iran's march to nuclear weaponry put reported preparations for an Israeli air attack on Iran's nuclear facilities on hold. Senior US officials were dispatched to Israel to explain the new policy. That took a huge chunk of the fear factor and uncertainly supporting the surge in oil prices out of the market. The consequent drop in oil prices to below $129 a barrel was viewed as a major plus for those companies and individuals most squeezed by high energy prices. Comments by some Fed spokesmen that a Fed firming should not wait until calm returned to the financial markets may also have had an impact by raising expectations that a consequent firmer dollar would lessen upward pressure on oil and other dollar denominated commodities. The reports of an increase in domestic inventories of crude oil and gasoline and growing support for offshore US oil drilling were also factors, but likely less significant in a global oil market. The limited reduction in demand for oil in the US (the so called price-induced demand destruction)is still being offset by oil demand increases in China and elsewhere.
The Administration this week threatened short sellers, particularly in key financials into covering their short positions. The SEC fired warning shots across the bow of short sellers by prohibiting naked short selling in 19 of the largest financial institutions and, perhaps most significant,instituting broad-scale investigations into the practice of false rumor mongering for financial gain. Naked shorts are defined as selling stocks without borrowing the stock sold within three days of the short sale. It certainly does not appear to be merely a coincidence that the most beleagured financial institutions named (or more appropriately, defended) by the SEC for special protection were among the biggest gainers from the SEC's Tuesday notice through Friday's close. For example, in just that four-day period Fannie Mae's stock price was up an astounding 90%, Freddie Mac rose 74%, Bank of America was up 48%, Lehman rose 45% and citigroup increased 33%. Did the underlying situation for these institutions change that radically for the better in those four days? I think not. Many mistakenly attributed the rise to less than feared negative earnings reports by some institutions and a few relatively positive earnings reports. That and growing confidence that Treasury support of Fannie and Frddie will not extend to nationalization and a wiping out of shareholder equity were also factors but less so. Most likely shorts in the 19 financials named by the SEC will be reset at higher price levels as the rally runs out of steam. In addition, the focus of the shortsellers will increasingly shift to the regional banks and financials that are seen as the most vulnerable. The FDIC prudently expects dozens of these regional institutions to fail.
From all this it should be clear that this past week's rally was not spurred by a change in market fundamentals. But where the markets go ultimately does depend critically on those fundaments. The plunge in home prices and spike in food and energy costs are the major underlying forces driving financial institution distress, the credit crunch, the consumer financial squeeze,the US economic downturn, the corporate profit squeeze and the bear market in equities. There has been no meaningful change in the impact of and outlook for those critical economic determinants. The drop in home prices is projected to be significantly extended, perhaps to twice the decline thus far experienced nationally. That price drop will be impelled by an outsized inventory of unsold homes, mounting bank distress sales of foreclosed or soon to be foreclosed homes, reduced credit availability, and worening employment prospects. As the drop in home prices continues, it will increasingly wipe out the equity of even the 20% down, conventional-motgage home buyer. That will extend the problems well beyond the holders of subprime and Alt-A mortgages and such mortgage related paper. Accordingly, financial institution losses will continue to mount increasing the volume of writeoffs and need for new capital injections.
Even with oil prices off their highs, the financial burdens that will be imposed on consumers and corporate energy puchasers will still be horrendous, especially this winter, curtailing nonoil purchases and corporate profits and deepening the recession. Also, there is no guarantee the negotiations with Iran will be sucessful. In that event, there are rumors of an air attack scheduled for January, before the new President takes office. It is hard to know if there is truth to the rumor, if it is a negotiating ploy or merely an attempt to boost oil prices. Perhaps the latter given comments by a senior pentagon official that the last thing we need now is a third military front. Also, there is concern that China has sharply limited polluting production to improve air quality prior to and during the Olympic games. It is not clear what will occur after the Olympics end. Will china increase its demands for critical resources, boosting prices for oil and other commodities, as it resumes highly polluting production for export, or has there been so much overbulding ahead of the Olympics that there is a domestic construction slowdown, reducing the pace of commodity demands? Probably both. But China's demand for oil is likely to remain strong until the slow moving onset of the global recession finally takes hold.
Philip Braverman, President
Braverman Economic and Financial Consulting
One Hewitt Square #249
East Northport, New York 11731
E-Mail Address: philipbraverman@Gmail.com
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