Bear Market Rallies?

Bear Market Rallies Only Delay Day Of Reckoning

By Ambrose Evans-Pritchard, Telegraph.co.uk | 31 March 2008

Every slump is punctuated by exuberant bursts of optimism, known to traders as "bear market rallies". Japan had four false dawns during its long slide into the abyss. Each lifted Tokyo's Nikkei index by an average of 53%. Such bounces can be quite intoxicating.

Teun Draaisma, Morgan Stanley's stock guru, expects the current rally to boost Europe's MSCI 600 index by 21% from its trough in late January, with similar moves on the S&P 500. The battered shares do best: builders and banks this time. There have been nine bear rallies since 1970. The average length is four months. The surge misleads investors into believing that sunlit uplands lie ahead. Then the sucker punch hits.

"The Federal Reserve's actions have averted financial Armageddon, but they cannot avert an earnings recession. We don't expect a new bull market until early 2009," he said. Morgan Stanley says earnings will fall 16% this year as debt leverage kicks into reverse. Investor psychology is "asymmetric". The market discounts trouble in advance. Share prices start falling a year before earnings peak. In a downturn investors keep selling until earnings hit bottom. "Bear markets are terrible for the human psyche. You get one profit warning after another. People see their hopes dashed so many times that they stop believing," said Mr Draaisma.

"You have got to be very disciplined and not buy shares too early just because they look cheap. Things can go down further than you ever dare believe," he said. He is not predicting a bloodbath along the lines of 1929-1933 (-88%) or 2001-2003 (-49%): just a long slog, with failed rallies. For now, the markets are flashing a tactical buy signal. Mr Draaisma's "capitulation indicator" has crashed to the lowest level since the 1998 LTCM crisis: the share "valuation indicator" is near an all-time low. UBS is also gearing for a big rebound, convinced that the Fed's move to shoulder $30bn of Bear Stearns liabilities has changed the game.

In its latest report— "Ready for a Rally"— it said financial shares rose 448% in the 12 months after the Swedish rescue in 1992, 88% after Japan's Revitalisation Law in 1998; and 82% after Roosevelt's Emergency Banking Act in 1933. The pessimists at Société Générale remain sceptical, even though the Fed has gone nuclear. "We expect global equity prices to fall by up to 75% from their peaks as a deep global economic downturn unfolds over the next few years," said Albert Edwards, their global strategist. He fears a 50% collapse in earnings, compounded by an "Ice Age derating of equities".

It may echo the Lost Decade in Japan, where stocks fell 80%. The yields on state bonds kept falling as debt deflation engulfed the banks, thwarting efforts to nurse lenders back to health by the usual device: "steepening yield curve". The authorities were left chasing their own tails. Having lived through this, Japan's chief regulator Yoshimi Watanabe has advised Washington to go for a quick taxpayer rescue, rather than trying "to fix the hole in the bathtub".

Whatever happens, there will always be tactical rallies. Mr Edwards cites four Wall Street bounces above 25% in the 2001-2003 bust. The buying cue is when investor gloom nears black despair. The put/call ratio on options is now at a bearish extreme of 0.90. "That would historically suggest that a joyous 25% spring rally is close at hand," he said. Yet Mr Edwards remains wary as long as analysts cling to their belief that earnings will rise 11% in 2008. This is not the sort of "washout" level of gloom required to clear the air.

Still, the oldest adage on Wall Street is "never fight the Fed". In short order, Ben Bernanke has slashed interest rates by 300 basis points to 2.25%, and invoked the emergency clauses of Article 13 (3) of the Federal Reserve Act for the first time since the Great Depression to take on direct credit risk. The Bush administration has told the housing agencies Fannie Mae and Freddie Mac to absorb $200bn of extra mortgage debt. It has implicitly nationalised them in the process. The network of Federal Home Loan Banks has mopped up $900bn of mortgage securities. Congress has rushed through a $170bn fiscal blitz.

This is not to be sniffed at. It is worth a good spring rally, until the inexorable logic of a 25% house price crash prevails once again. Bernard Connolly at Banque AIG, who foresaw this crisis with uncanny accuracy, believes central banks will resort to full-throttle reflation, setting off a fresh boom in shares and gold. But this will occur only after the economic slump has spread to Europe and beyond.

The authorities will wait too long to act, believing their own decoupling myth. Unemployment will ratchet up. Civil unrest may rock Latin Europe. In the end, the whole industrial world will stoke a fresh credit bubble to put off the day of reckoning, for another cycle. The capitalist system is now so deformed by debt that it requires ever lower interest rates to keep going. It survives on perma-bubbles. Monetary rigour at this late stage would endanger democracy.

How did we ever let matters reach this pass?




Iceland Contagion May Spread Far And Wide

By Ambrose Evans-Pritchard, Telegraph.co.uk | 27 March 2008

As Iceland goes, so go the Baltics, the Balkans, Hungary, Turkey, and perhaps South Africa. All are living far beyond their means, plugging the gaping holes in their accounts with fickle flows of foreign finance. All have let credit grow far above the safe "speed limit", some exceeding 50% a year. Iceland's precarious economy is a warning to other deficit nations about breaking the safe credit 'speed limit'.

For Iceland, the high-wire act of the last five years may have finally reached its limits. The central bank was forced to raise interest rates to 15% this week in an emergency move to halt the collapse of krona, which has fallen 18% since mid-March. The country's all-conquering banks— led by Kaupthing, Glitnir, and Landsbanki— have pushed the asset base of the Icelandic banking system to a world record of eight times GDP, tapping the global capital markets to launch Viking raids across Britain, Scandinavia and beyond.

This spigot of easy credit has now been turned off. The spreads on Icelandic bank debt have risen above 800 basis points, near levels seen in Bear Stearns' debt before the Federal Reserve's rescue. Which raises a thorny question: Is the Icelandic government— which presides over an economy the size of Bristol— big enough to underpin its encephalitic banks if push ever comes to shove?

"There are clearly limits to what the government can do," said Paul Rawkins, an Iceland expert at Fitch Ratings. "If the government tried to raise billions in the markets it would damage its own credit worthiness. In any case, these debts are in foreign currencies. The central bank has just $2bn (£1bn) in reserves," he said. The banks insist they are well capitalised, with enough liquidity to tide them through to 2009. If the credit crunch subsides, the issue will never be put the test. But Iceland is more than just a Nordic hedge fund masquerading as a country. It is also the first of the deficit states to succumb to investor flight, sending an early warning signal of potential troubles across a great swathe of Eastern Europe and the Mediterranean.

Turkey is first in line for any stress test, said Neil Schering, an East Europe expert at Capital Economics. "I wouldn't want to keep any money in the Turkish lira: the puzzle is how it has stayed so high for so long. There are huge imbalances in the economy. The current account deficit is nearly 8% of GDP, and the chief prosecutor is trying to shut down the government," he said, referring to last week's court move to ban the ruling Islamic AKP party, as well as the president and prime minister, for alleged breach of the country's secular laws. Turkey has a foreign debt of $276bn. The Istanbul bank YapiKredi says Turkish companies may have great difficulty raising some $48bn of fresh loans needed this year to stay afloat.

Until now the country has been the darling of the yen 'carry trade', offering irresistible yields to Japan's army of investors. But the yen's surge in recent weeks has played havoc with these flows. The unwinding of yen positions has undoubtedly been key factor in the sudden capital flight from Iceland this month. Fitch said countries that run current account deficits above 10% of GDP for any length time almost always come to grief. East Asia's debt crisis in 1997 erupted before any state reached double digits. Iceland's deficit is now 16% of GDP. Latvia is at 25%, Bulgaria 19%, Georgia 18%, Estonia 16%, Lithuania 14%, Romania 14% and Serbia 13%. The region will need $337bn in foreign loans this year.

Borrowing in foreign currencies was all the rage in the heady days of the credit bubble. Most mortgages in Hungary over the last two years have been in Swiss francs, with the Balkans and Poland not far behind. This is now turning into slow torture. The franc has risen 5% against the euro since October. The real level of the debt is ratcheting up. The foreign debts have reached 122% of GDP in Latvia, 101% in Estonia and 73% in Lithuania, mostly in euros. For now the debtors are shielded by fixed exchange rates in Europe's ERM system, but this could make the shock even worse should the currency pegs start to snap.

"It's all looks like a pretty ugly cocktail," said Mr Schering. "The good side is that the Baltic banks are not exposed to toxic mortgage securities, and a lot of them are owned by foreign banks, so they are protected." Ed Parker, head of Fitch for Eastern Europe, said the agency had already downgraded Latvia to BBB+ and issued a further alert in January. Turkey is even lower at BB-. "There's now a risk of psychological contagion from Iceland. People are starting to look more closely at all these countries. The deficits were easy to fund in times of abundant liquidity, but we think the global credit crunch is going to make it a lot harder," he said. "The history of financial crises suggests that it can be dangerous to think 'it's different this time'."

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Normxxx    
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