BY JURRIEN TIMMER, DIRECTOR OF INVESTMENT RESEARCH, CO-PORTFOLIO MANAGER OF FIDELITY DYNAMIC STRATEGIES FUND, FIDELITY VIEWPOINTS — 05/26/10
It’s been a volatile month. After rallying from the May 6 “flash crash” stocks have been up and down, hitting the correction mark—a 10% drop from the most recent market peak. This week brought more volatility as investors have become concerned not only about Spanish banks but also about geopolitical tensions in the Korean Peninsula.
So, what are the odds that we are at a meaningful low? As a technical analyst, I watch chart patterns carefully for signals, so let’s look at the charts.
First of all, many technical conditions are now extremely oversold. In fact, some measures such as the Breadth Oscillator1 (see chart below) and the 30-Day Traders Index2 (TRIN) are now as oversold as they were at the March 2009 bottom—even though that low came after a 57% decline and this one after only a 14% correction. Plus, we are sitting right on major support—an area that has been repeatedly tested by sellers—at the 1,050 area.
Investor sentiment also has turned bearish on stocks, which historically has been a bullish signal. The Daily Sentiment Index (DSI) has fallen to a mere 21% bulls, and AMG Data Services reported a significant outflow last week of some $4.3 billion from equity mutual funds. The intraday VIX index of New York Stock Exchange volatility spiking to 48 is another sign of extreme fear (although not as extreme as during the 2008 meltdown). Meanwhile, the DSI for T-Notes, considered a safe haven, hit 98% bulls recently. On the other hand, the DSI for crude oil was only 15% bulls.
What worries me?
I don’t believe the PIIGS (Portugal, Ireland, Italy, Greece, Spain) crisis is likely to be contagious in and of itself, the way the sub-prime debacle was in 2007. There just isn’t the same degree of leverage in the system. Also, U.S. banks don’t have exposure to Greek debt, the European Central Bank (ECB) has stepped in with its own version of TARP II, and I believe the Federal Reserve (Fed) is likely to do whatever it takes to keep the party going.
My broader concern is the notion that the U.S. could become the next Greece if we don’t grow our way out of debt. But, to the extent that scenerio could occur to some degree, it likely would be a few years away. After all, economic momentum seems to be quite strong in the U.S., plus the latest de-risking attack actually bid up Treasuries as a safe haven. If it were our turn for the bond market vigilantes to drive up long-term interest rates, then certainly Treasuries would have been the first line of attack.
Still, it concerns me that indicators like the LIBOR-OIS spread3 and the Bloomberg Financial Conditions Index (BFCI)4 have deteriorated in recent weeks. If that has to do with real contagion and not just a general move by investors to reduce risk, then my near-term outlook would be wrong.
Ironically, the threat of contagion could be seen as bullish. Why? Against a background of positive economic momentum, we now have a situation that could cause the Fed to become even looser than it has been.
What made 2009 so positive was the combination of an improving economy and an easy monetary policy. As the expectation mounted that the Fed was eventually going to take away the punchbowl, the bullishness faded.
Now, the Fed may feel it needs to recommit to an easy policy. That could mean renewed asset purchases, and, if necessary, liquidity facilities to prop up the funding markets.
So, instead of the Fed starting to get ready to take the punchbowl away, it may now have to pour even more into the bowl. That could put a whole new lease on life for the U.S. recovery and therefore the asset markets.
Long Term Capital Management redux?
This notion that the Fed is staying loose even though the recovery is continuing reminds me a bit of the 1998 Long Term Capital Management (LTCM) episode. Back then the economy was fine but we had systemic risk in the credit markets (because LT Capital had amassed a trillion-dollar book it couldn’t unwind). The Fed responded by cutting rates three times even though the economy was growing. What followed? The dot-com bubble. What could it be this time?
The Fed, the ECB, the dollar, the Euro
The DSI recently hit 2% bulls for the Euro and 98% bulls for the dollar, and speculators are record short on the Euro. On top of that, it would not surprise me if there is some coordinated G7 intervention in the U.S. dollar-Euro exchange rate. I think the only argument among the G7 would be which currency to buy. After all, nobody seems to want a strong currency these days—certainly not the U.S.
It makes sense to me that the speculators were dumping Euros in recent weeks. If Europe enforces fiscal austerity on its southern members, that drag on growth has to be offset somehow by something else, and that something else is likely to be loose monetary policy. Combine fiscal tightness with quantitative easing and what do you get? A weaker currency.
So, the weak Euro argument makes perfect sense. But what about the dollar? If a budget and debt crisis at the state level becomes our version of Greece, and the 2012 elections enforce some sort of fiscal austerity here, what could be the outlet for growth? My conclusions would be an easy Fed and a weaker dollar.
When confronted with a debt crisis, many countries throughout history have done what comes easiest, and that is not austerity. Rather, they inflate and debase their currency. So, the race to the bottom continues. We just had the Euro’s turn. Could the greenback be next?
A buying opportunity?
Let me put my technician’s hat on again. Given the oversold condition of this market, my best guess is that we could rally from here. I suspect the market may be volatile all summer long, before possibly heading higher later this year.